Chapter 2

Basic Considerations for Successful Forecasting

Six Considerations

Decision Environment - Loss FunctionForecast ObjectiveForecast StatementForecast HorizonInformation Set Complexity of Methodology

Decision Environment

The Loss function summarizes the cost of a forecast error!

The forecast error is actual minus the forecast:

yye ˆ

Examples of Loss functions

BAKERY, Inc. is selling pies for $15 each, our cost is $10. We must choose production for tomorrow. Any pie not sold is wasted. Our forecast is used to determine the amount of pies to bake.

What is the Loss function?

Key Facts: If we produce too few pies(e>0), it costs

us $5 per pie in lost sales If we produce too many pies(e<0), it costs

us $10 per pie because the pie is wasted. Verbally, the loss is bigger if we

overestimate demand than if we underestimate demand

BE CONSERVATIVE FOR THIS PROJECT!!

Using Math, The Loss Function is:

010

05)(

eife

eifeeL

Common Loss Functions

L(e)=e2

L(e)=|e|L(e)=0 if our forecast of the change

in y is correct, 1 if we miss the direction!

Many statistical estimators are based on the first loss function

Forecast Objective

Event Outcome Will LSU men go to NCAA?

Timing Forecasts When will the economy go into

recession? When will sales be highest?

Time Series How much will we sell next year?

Forecast Statement

Point Forecast Our sales will be 32 million next year

Interval Forecast There is a 95% chance sales will lie

between 28 and 36 million next year.Density Forecast

Our forecast of sales is normal distributed with a mean of 32 million and s.d. 2 million

Forecast Horizon

How far into the future do you want to forecast and at what time interval Sales next month only Monthly sales for the next two years Annual sales over a ten year period

Information Set

What Information will be used for the forecast? Often determined by the budget for the

forecast. Should I use only lagged sales to

forecast? Will the boss buy other data for my

forecast? Can I spend two months gathering data?