Principles of Forecasting

Principles of Forecasting:
Applications in Revenue and
Expenditure Forecasting
Michael L. Hand, Ph.D
Professor of Applied Statistics and Information Systems
Atkinson Graduate School of Management
Willamette University, 900 State Street, Salem, OR 97301
mhand@willamette.edu, 503.370.6056

Principles of Forecasting

Presentation Overview
Philosophy/Perspective

Taxonomy of Methods
Forecasting Process (with Special Attention

to Selected Dimensions of Knowledge

Acquisition)

Data Understanding
Model Interpretation
Model Assessment

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

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Data/Forecasts/Level

Principles of Forecasting

Example: Project Oregon Personal Income Tax Revenue

Oregon Personal Income Tax Revenues (in $ Millions)

1600

1500

1400

1300

1200

1100

1000

900

800

700
Data
Forecast
Level

600

Time

Michael L. Hand
Professor of Applied Statistics
and Information Systems
Atkinson Graduate School of Management
Willamette University

Principles of Forecasting

Challenges
Prediction is very difficult, especially if it's about
the future.
Nils Bohr, Nobel laureate in physics
(though this sounds a lot more like Yogi Berra)

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Why Forecast?
The effectiveness of almost every human

endeavor, every public initiative, depends in

part upon unknown and uncertain future
outcomes the demand for services, the
revenues to fund them.
The quality of decisions about whether or not
to engage and at what level improves with the
reliability of supporting forecasts.

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Why Forecast?
For every level of demand, there is a best level of service capacity.
140

Service Capacity

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100
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0.0

5.0

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Demand

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

25.0

Principles of Forecasting

Why Forecast?
In short, we forecast because we have little choice. A
forecast is implied by essentially every decision that
we make, every action that we take.
It is far better to foresee even without certainty than not
to foresee at all.
Henri Poincare in The Foundations of Science

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Forecast Risks/Costs
Prophesy is a good line of business, but it is full of
risks.
Mark Twain in Following the Equator

Forecast high

Cost of excess capacity, misallocations

Forecast low

Kicker

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Forecast Objective
Perfection? Forecasts that are without error? Thats a nave
and unproductive view in terms of the reasonable
management of expectations for the forecasting process.
Preoccupation with being right can be unhealthy and only
serves to stifle the process.

Objective: Minimize (the cost of) forecast errors

It is sufficient to develop forecasts that systematically reduce
uncertainty (and thereby reduce the risks and costs
associated with forecast errors.)

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

1996:01
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Data/Forecasts/Level

Principles of Forecasting

Example: Project Oregon Personal Income Tax Revenue

Oregon Personal Income Tax Revenues (in $ Millions)

1600

1500

1400

1300

1200

1100

1000

900

800

700
Data
Forecast
Level

600

Time

Michael L. Hand
Professor of Applied Statistics
and Information Systems
Atkinson Graduate School of Management
Willamette University

Principles of Forecasting

A Brief Taxonomy of Forecasting Methods

Subjective

Objective/Data-Based

Expert Opinion
Survey Research
Historical Analogy

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Associative
Multiple Regression
Econometric Models
Projective
Decomposition
Smoothing
Time-Series Regrn
Box-Jenkins/ARIMA

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Subjective Methods
Judgment/expert opinion based methods with (little or)

no direct data on the process to be forecast.

Generally no data/supporting forecast requirement
May rely upon data from related process for historical
analogy
Best for long-range forecasts
More than two years out

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Data-Based Forecasting
In God we trust, all others bring data.
W. Edwards Deming

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Associative Methods
Causal, multiple regression models relating response

to a general set of predictors

Data/supporting forecast requirement
Increased model complexity and development effort
Assumes relationships among response and predictors

are stable over time

Best for intermediate-term forecasts
One- to two-year forecast time horizon

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Associative Models
Oregon Personal Income Tax versus Unemployment

Personal Income Tax (in $Millions)

1500
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600
3.5

4.0

4.5

5.0

Unemployment Rate (%)

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

5.5

6.0

Principles of Forecasting

Econometric Models
http://egov.oregon.gov/DAS/OEA/docs/revenue/pit_forecastmethod.pdf
LOG(GIwages) = 20.7 + 0.93*LOG(PIwages + PIother_lab) + [AR(1)=0.85]
LOG(GIdividends) = 16.7 + 0.49*LOG(PIdir) + 0.30*LOG(MKTw5000)
LOG(GIinterest) = 19.6 + 0.34*LOG(PIwages) + 0.04* IR3mo_tbill + 0.039* IR3mo_tbill (-1) + [AR(1)=0.65]
LOG(GIcapgains) = 11.5 + 1.14*LOG(MKTw5000) + [MA(4) = -0.86]
LOG(GIretirement) = -0.12 + 1.24*LOG(POP_OR65+) + 0.97*LOG(PItotal PIwages) + 0.32*LOG(MKTw5000) +
[AR(1)=-0.50]
LOG(GIproprietors) = -304.7 + 0.72*LOG(PIproprietors) + 2.10*LOG(EMPretail) + [AR(1)=1.0]
LOG(GIschedule_e) = 14.4 + 1.1*LOG(CORP_PROFIT) + [AR(1)=0.78]
LOG(GIother) = -2.1 + 4.14*LOG(EMPretail)
Eff_tax_rate = 0.05 + 0.005* DMYtax_rate + 0.053* FDIST1mil + 0.04*(( GIschedule_e + GIproprietors)/ GIwages) +
[AR(1)=0.58]
GI - Gross Income from the source indicated
PItotal Total Oregon Personal Income
PIwages Wage and Salary Component of Personal Income
PIother_lab Other labor component of Personal Income
PIdir Dividends, Interest and Rent component of Personal Income
PIproprietors Proprietors Income component of Personal Income
Personal Income Tax Model
MKTw5000 Wilshire 5000 stock index
EMPretail Oregon Retail Employment
Office of Economic Analysis
CORP_PROFIT U.S. Corporate Profits
DAS
POP_OR65+ Oregon 65 and older population
IR3mo_tbill Discount rate of 3 month Treasury Bill
FDIST1mil - Filer Distribution Model, Ratio of $1 million-plus filers to Total filers
DMYtax_rate Dummy variable for 1982 through 1984 tax rate increase
Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Projection/Extrapolation
I have seen the future and it is very much like
the present, only longer.
Dan Quisenberry

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Projective Methods
Simple extrapolation in time
Predictors are time and functions of time
Trend, seasonal, cyclical factors
Minimal data/supporting forecast requirement
Assumes current conditions will persist
Best for short-term forecasts
One year out (two if we stretch) or less

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

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Data/Forecasts/Level

Principles of Forecasting

Projective Models
Winters Seasonal Exponential Smoothing
Oregon Personal Income Tax Revenues (in $ Millions)

1600

1500

1400

1300

1200

1100

1000

900

800

700
Data
Forecast
Level

600

Time

Michael L. Hand
Professor of Applied Statistics
and Information Systems
Atkinson Graduate School of Management
Willamette University

Principles of Forecasting

Forecasting Process

Enterprise Understanding
Data Understanding
Alternative Model Identification
Model Estimation
Model Assessment Adequacy, Quality
Model Selection
Model Interpretation
Forecasting

Important (oft overlooked) knowledge acquisition stages

(see Class_Tools:Hand_Outs:Examples:0.Introduction:NNG_Paper.pdf)
Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Oregon Personal Income Taxes,

1996 2005
Oregon Personal Income Tax Revenues (in $ Millions)

1500
1400

Data Understanding

Note dramatic shift in

level and nature of
seasonal variation

1300

Data/Forecast

1200
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700

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Period

(see Class Tools > Sitewide > Hand Outs > Public Finance > MultDecompPITFull.xls)
Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Oregon Personal Income Taxes,

1996 2001
Oregon Personal Income Tax Revenues (in $ Millions)
1500
1400

For simplicity, we restrict

our initial view to the
fairly stable period from
1996 2001

Data Understanding

Data/Forecasts

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(see Class Tools > Sitewide > Hand Outs > Public Finance > MultDecompPIT.xls)
Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Classical Multiplicative

Decomposition
Conceptual Decomposition:
Trend:
Cycle:
Seasonal:
Irregular:

Long-term growth/decline
Long-term slow, irregular oscillation
Regular, periodic variation w/in calendar year
Short-term, erratic variation

Conceptual Forecast:

Forecasting Model:

Michael L. Hand
Professor of Applied Statistics
and Information Systems

yt Trendt Cyclet Seasonalt Irregulart

y t Trendt Seasonalt
s1
s
y t b0 b1t 2

sL

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Classical Multiplicative

Decomposition
Conceptual Decomposition: yt Trend t Cyclet Seasonalt Irregulart
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Period

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Classical Multiplicative

Visual Representation
Decomposition
1.25

1600

1200
1000

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Seasonal

Trend

1400

0.95

800
600

0.85

1.25

1.25

1.15

1.15

1.05

Irregular

Cyclical

1.05

1.05

0.95

0.95

0.85

0.85

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Classical Multiplicative

Decomposition, Model Interpretation
s1
s
y t b0 b1t 2 ,

sL

0.9794
0.9236

y t 731.9291 18.5017t
0.8913

1
.
2057

Model Interpretation
Initial, time-zero (1995:Q4) level is $731.92 million
Increasing at $18.5 million per quarter
Seasonal pattern
Peak in Q4 21% over trend
Trough in Q3 11% below trend
Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Classical Multiplicative

Decomposition, Forecasts
s1
s
y t b0 b1t 2 ,

sL

0.9794
0.9236

y t 731.9291 18.5017t
0.8913

1.2057

Forecasts
1996 : Q1 t 1

y t 731.9291 18.5017( 1) 0.9794 750.4309 0.9794 735.00

2002 : Q1 t 25

y t 731.9291 18.5017(25) 0.9794 1194.4727 0.9794 1169.90

2002 : Q 2 t 26

y t 731.9291 18.5017(26) 0.9236 1212.9744 0.9236 1120.32

2002 : Q3 t 27

y t 731.9291 18.5017(27) 0.8913 1231.4762 0.8913 1097.60

2002 : Q 4 t 28

y t 731.9291 18.5017(28) 1.2057 1249.9779 1.2057 1507.07

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Forecast Model Assessment

Residual analysis: A somewhat scatological endeavor,
whereby we assess forecast quality through an analysis
of residuals or what the forecast process leaves
unexplained.
Residual (Error) = Actual Forecast
Assessment possible for any type of forecasting process
statistical, organizational, ad hoc, arbitrary.

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Classical Multiplicative

Decomposition, Residuals/Errors
Time
1
2
3
4

Year
1996
1996
1996
1996

Qtr
1
2
3
4

Period
1996:01
1996:02
1996:03
1996:04

Tax
700.38
694.46
731.49
933.63

Forecast
735.00
710.19
701.83
971.70

Error
-34.62
-15.74
29.66
-38.07

2001
2001
2001
2001
2002
2002
2002
2002

1
2
3
4
1
2
3
4

2001:01
2001:02
2001:03
2001:04
2002:01
2002:02
2002:03
2002:04

1075.97
1011.88
1063.42
1399.33

1097.42
1051.96
1031.64
1417.84
1169.90
1120.32
1097.60
1507.07

-21.45
-40.08
31.79
-18.50

21
22
23
24
25
26
27
28

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Classical Multiplicative

Decomposition, Time Series Plot of Residuals
Oregon Personal Income Tax Revenues (in $ Millions)
100

60
40
20

-40
-60
Period

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

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0
1996:01

Prediction Errors (in $ Millions)

80

Principles of Forecasting

Desirable Properties of Residuals

Small aggregate error measure
Independent/random
No remaining pattern
Mean zero, Unbiased
Constant variance
Normality
Required for many statistical assessments

These properties can be tested with a variety of charts

and graphs too numerous to mention here.

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Measures of Forecast Accuracy

Error Summary Measures

Mean Squared Error, MSE

Mean Absolute Deviation, MAD
Mean Absolute Percentage Error, MAPE
Mean Percentage Error, MPE (Bias)

R2 = (SSTO SSE)/SSTO

Percent of variation explained

Prediction Intervals
Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Example: Classical Multiplicative

Decomposition, Measures of Forecast Accuracy
Error Summary Measures

Summaries
Mean Squared Error, MSD
SSTO
870280
Std Deviation of Residuals, s MSD SSE
32390
Mean Absolute Deviation, MAD
Mean Absolute Pct Error, MAPE
Mean Pct Error, MPE (Bias)

R2 = (SSTO SSE)/SSTO

Michael L. Hand
Professor of Applied Statistics
and Information Systems

MSD
s
MAD
MAPE
MPE

1349.60
36.74
30.08
3.07%
-0.15%

R2

96.28%

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Conclusion
Forecasting process can be about far more

than mere forecasts, it can also provide for

essential Knowledge Acquisition/Key Insights

Data Understanding
Model Interpretation
Model Assessment

Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University

Principles of Forecasting

Basic Forecasting References

Armstrong. Long-Range Forecasting: From Crystal Ball to
Computer. Wiley-Interscience, 1985.
(Also available in .pdf form at:
http://www-marketing.wharton.upenn.edu/forecast/Long-Range%20Forecasting/contents.html

Bowerman, O'Connell, Hand. Business Statistics in Practice,

2nd Edition. McGraw-Hill/Irwin, 2001.
Bowerman, O'Connell, Koehler. Forecasting, Time Series
and Regression, Fourth Edition. Duxbury Press, 2005.
Hanke and Wichern. Business Forecasting, 8th Edition.
Prentice-Hall, 2005.
Makridakis, Wheelwright, Hyndman. Forecasting Methods
and Applications, 3rd Edition. John Wiley and Sons, 1998
Michael L. Hand
Professor of Applied Statistics
and Information Systems

Atkinson Graduate School of Management

Willamette University