Slides Prepared by

JOHN S. LOUCKS
St. Edward’s University

© 2002 South-Western/Thomson Learning Slide 1

 Chapter 18
Forecasting
 Time Series and Time Series Methods
 Components of a Time Series
 Smoothing Methods
 Trend Projection
 Trend and Seasonal Components
 Regression Analysis
 Qualitative Approaches to Forecasting

Slide 2
 Time Series and Time Series Methods

 By reviewing historical data over time, we can better

understand the pattern of past behavior of a variable
and better predict the future behavior.
 A time series is a set of observations on a variable
measured over successive points in time or over
successive periods of time.
 The objective of time series methods is to discover a
pattern in the historical data and then extrapolate the
pattern into the future.
 The forecast is based solely on past values of the
variable and/or past forecast errors.

Slide 3
 The Components of a Time Series

 Trend Component
• It represents a gradual shifting of a time series to
relatively higher or lower values over time.
• Trend is usually the result of changes in the
population, demographics, technology, and/or
consumer preferences.
 Cyclical Component
• It represents any recurring sequence of points
above and below the trend line lasting more than
one year.
• We assume that this component represents
multiyear cyclical movements in the economy.

Slide 4
 The Components of a Time Series

 Seasonal Component
• It represents any repeating pattern, less than one
year in duration, in the time series.
• The pattern duration can be as short as an hour, or
even less.
 Irregular Component
• It is the “catch-all” factor that accounts for the
deviation of the actual time series value from what
we would expect based on the other components.
• It is caused by the short-term, unanticipated, and
nonrecurring factors that affect the time series.

Slide 5
 Forecast Accuracy

 Mean Squared Error (MSE)

• It is the average of the sum of all the squared
forecast errors.
 Mean Absolute Deviation (MAD)
• It is the average of the absolute values of all the
forecast errors.

One major difference between MSE and MAD is that

the MSE measure is influenced much more by large
forecast errors than by small errors.

Slide 6
 Using Smoothing Methods in Forecasting

 Moving Averages
• We use the average of the most recent n data
values in the time series as the forecast for the next
period.
• The average changes, or moves, as new
observations become available.
• The moving average calculation is

Moving Average = (most recent n data values)/n

Slide 7
 Using Smoothing Methods in Forecasting

 Weighted Moving Averages

• This method involves selecting weights for each of
the data values and then computing a weighted
mean as the forecast.
• For example, a 3-period weighted moving average
would be computed as follows.

Ft + 1 = w1(Yt - 2) + w2(Yt - 1) + w3(Yt)

where the sum of the weights (w values) is 1.

Slide 8
 Using Smoothing Methods in Forecasting

 Exponential Smoothing
• It is a special case of the weighted moving
averages method in which we select only the
weight for the most recent observation.
• The weight placed on the most recent observation
is the value of the smoothing constant, a.
• The weights for the other data values are
computed automatically and become smaller at an
exponential rate as the observations become older.

Slide 9
 Using Smoothing Methods in Forecasting

 Exponential Smoothing

Ft + 1 = aYt + (1 - a)Ft

where Ft + 1 = forecast value for period t + 1

Yt = actual value for period t + 1
Ft = forecast value for period t
a = smoothing constant (0 < a < 1)

Slide 10
 Example: Executive Seminars, Inc.

Executive Seminars specializes in conducting

management development seminars. In order to better
plan future revenues and costs, management would like
to develop a forecasting model for their “Time
Management” seminar.
Enrollments for the past ten “TM” seminars are:

(oldest) (newest)
Seminar 1 2 3 4 5 6 7 8 9 10
Enroll. 34 40 35 39 41 36 33 38 43 40

Slide 11
 Example: Executive Seminars, Inc.

 Exponential Smoothing
Let a = .2, F1 = Y1 = 34
F2 = aY1 + (1 - a)F1
= .2(34) + .8(34)
= 34
F3 = aY2 + (1 - a)F2
= .2(40) + .8(34)
= 35.20
F4 = aY3 + (1 - a)F3
= .2(35) + .8(35.20)
= 35.16
. . . and so on

Slide 12
 Example: Executive Seminars, Inc.

Seminar Actual Enrollment Exp. Sm. Forecast

1 34 34.00
2 40 34.00
3 35 35.20
4 39 35.16
5 41 35.93
6 36 36.94
7 33 36.76
8 38 36.00
9 43 36.40
10 40 37.72
11 Forecast for the next seminar = 38.18

Slide 13
 Using Trend Projection in Forecasting

 Equation for Linear Trend

Tt = b0 + b1t

where
Tt = trend value in period t
b0 = intercept of the trend line
b1 = slope of the trend line
t = time
Note: t is the independent variable.

Slide 14
 Using Trend Projection in Forecasting

 Computing the Slope (b1) and Intercept (b0)

b1 = tYt - (t Yt)/n

t 2 - (t )2/n

b0 = (Yt/n) - b1t/n = Y - b1t

where
Yt = actual value in period t
n = number of periods in time series

Slide 15
 Example: Sailboat Sales, Inc.

Sailboat Sales is a major marine dealer in Chicago.

The firm has experienced tremendous sales growth in
the past several years. Management would like to
develop a forecasting method that would enable
them to better control inventories.
The annual sales, in number of boats, for one
particular sailboat model for the past five years are:

Year 1 2 3 4 5
Sales 11 14 20 26 34

Slide 16
 Example: Sailboat Sales, Inc.

 Linear Trend Equation

t Yt tYt t2
1 11 11 1
2 14 28 4
3 20 60 9
4 26 104 16
5 34 170 25
Total 15 105 373 55

Slide 17
 Example: Sailboat Sales, Inc.

 Trend Projection

b1 = 373 - (15)(105)/5 = 5.8

55 - (15)2/5

b0 = 105/5 - 5.8(15/5) = 3.6

Tt = 3.6 + 5.8t

T6 = 3.6 + 5.8(6) = 38.4

Slide 18
 Trend and Seasonal Components
in Forecasting
 Multiplicative Model
 Calculating the Seasonal Indexes
 Deseasonalizing the Time Series
 Using the Deseasonalizing Time Series
to Identify Trend
 Seasonal Adjustments
 Cyclical Component

Slide 19
 Multiplicative Model

 Using Tt , St , and It to identify the trend, seasonal,

and irregular components at time t, we describe the
time series value Yt by the following multiplicative
time series model:

Yt = Tt x St x It

 Tt is measured in units of the item being forecast.

 St and It are measured in relative terms, with values
above 1.00 indicating effects above the trend and
values below 1.00 indicating effects below the trend.

Slide 20
 Calculating the Seasonal Indexes

1. Compute a series of n -period centered moving

averages, where n is the number of seasons in the
time series.
2. If n is an even number, compute a series of 2-period
centered moving averages.
3. Divide each time series observation by the
corresponding centered moving average to identify
the seasonal-irregular effect in the time series.
4. For each of the n seasons, average all the computed
seasonal-irregular values for that season to eliminate
the irregular influence and obtain an estimate of the
seasonal influence, called the seasonal index, for that
season.

Slide 21
 Deseasonalizing the Time Series

 The purpose of finding seasonal indexes is to remove

the seasonal effects from the time series.
 This process is called deseasonalizing the time series.
 By dividing each time series observation by the
corresponding seasonal index, the result is a
deseasonalized time series.
 With deseasonalized data, relevant comparisons can
be made between observations in successive periods.

Slide 22
 Using the Deseasonalizing Time Series
to Identify Trend
 To identify the linear trend, we use the linear
regression procedure covered earlier; in this case, the
data are the deseasonalized time series values.
 In other words, Yt now refers to the deseasonalized
time series value at time t and not to the actual value
of the time series.
 The resulting line equation is used to make trend
projections, as it was earlier.

Slide 23
 Seasonal Adjustments

 The final step in developing the forecast is to use the

seasonal index to adjust the trend projection.
 The forecast for period t, season s, is obtained by
multiplying the trend projection for period t by the
seasonal index for season s.

Yt,s = Is[b0 + b1(t )]

Slide 24
 Example: Eastern Athletic Supplies

Management of EAS would like to develop a

quarterly sales forecast for one of their tennis
rackets.
Sales of tennis rackets is highly seasonal and hence
an
accurate quarterly forecast could aid substantially
in
ordering raw material used in manufacturing.
The quarterly sales data (000 units) for the
previous
three years is shown on the next slide.

Slide 25
Example: Eastern Athletic Supplies
Year Quarter Sales
1 1 3
2 9
3 6
4 2
2 1 4
2 11
3 8
4 3
3 1 5
2 15
3 11
4 3
Slide 26
Example: Eastern Athletic Supplies
Year Quarter Sales 4-CMA 2-CMA
1 1 3
2 9
5.00
3 6 5.13
5.25
4 2 5.50
5.75
2 1 4 6.00
6.25
2 11 6.38
6.50
3 8 6.63
6.75
4 3 7.25
7.75
3 1 5 8.13
8.50
2 15 8.50
8.50
3 11
4 3
Slide 27
Example: Eastern Athletic Supplies
Year Quarter Sales 2-CMA Seas-Irreg
1 1 3
2 9
3 6 5.13 1.17
4 2 5.50 0.36
2 1 4 6.00 0.67
2 11 6.38 1.72
3 8 6.63 1.21
4 3 7.25 0.41
3 1 5 8.13 0.62
2 15 8.50 1.76
3 11
4 3

Slide 28
 Example: Eastern Athletic Supplies

Quarter Seas-Irreg Values Seas. Index

1 0.67, 0.62 0.65
2 1.72, 1.76 1.74
3 1.17, 1.21 1.19
4 0.36, 0.41 0.39
Total = 3.97
Seas.Index Adj. Factor Adj.Seas.Index
0.65 4/3.97 .655
1.74 4/3.97 1.753
1.19 4/3.97 1.199
0.39 4/3.97 .393
Total = 4.000

Slide 29
 Example: Eastern Athletic Supplies
Year Quarter Sales Seas.Index Deseas.Sales
1 1 3 .655 4.58
2 9 1.753 5.13
3 6 1.199 5.00
4 2 .393 5.09
2 1 4 .655 6.11
2 11 1.753 6.27
3 8 1.199 6.67
4 3 .393 7.63
3 1 5 .655 7.63
2 15 1.753 8.56
3 11 1.199 9.17
4 3 .393 7.63

Slide 30
 Example: Eastern Athletic Supplies

 Trend Projection

Tt = 4.066 + .3933t
T13 = 4.066 + .3993(13) = 9.1789

Using the trend component only, we would forecast

sales of 9,179 tennis rackets for period 13 (year 4,
quarter 1).

Slide 31
 Example: Eastern Athletic Supplies

 Seasonal Adjustments

Period Trend Seasonal Quarterly

t Forec. Index Forecast

13 9,179 .655 6,012

14 9,572 1.753 16,780
15 9,966 1.199 11,949
16 10,359 .393 4,071

Slide 32
 Models Based on Monthly Data

 Many businesses use monthly rather than quarterly

forecasts.
 The preceding procedures can be applied with minor
modifications:
• A 12-month moving average replaces the 4-
quarter moving average.
• 12 monthly, rather than 4 quarterly, seasonal
indexes must be computed.
• Otherwise, the procedures are identical.

Slide 33
 Cyclical Component

 The multiplicative model can be expanded to include

a cyclical component that is expressed as a
percentage of trend.

Yt  Tt  Ct  St  It
 However, there are difficulties in including a cyclical
component:
• A cycle can span several (many) years and enough
data must be obtained to estimate the cyclical
component.
• Cycles usually vary in length.

Slide 34
 Regression Analysis

 One or more independent variables can be used to

predict the value of a single dependent variable.
 The time series value that we want to forecast is the
dependent variable.
 The independent variable(s) might include any
combination of the following:
• Previous values of the time series variable itself
• Economic/demographic variables
• Time variables

Slide 35
 Regression Analysis

 An autoregressive model is a regression model in

which the independent variables are previous values
of the time series being forecast.
 A causal forecasting model uses other time series
related to the one being forecast in an effort to
explain the cause of a time series’ behavior.

Slide 36
 Regression Analysis

 For a function involving k independent variables, we

use the following notation:

Yt = value of the time series in period t

x1t = value of independent variable 1 in period t
x2t = value of independent variable 2 in period t

xkt = value of independent variable k in period t

Slide 37
 Regression Analysis

 In forecasting sales of refrigerators, we might select

the following five independent variables:

x1t = price of refrigerator in period t

x2t = total industry sales in period t - 1
x3t = number of new-house building permits
in period t - 1
x4t = population forecast for period t
x5t = advertising budget for period t

Slide 38
 Regression Analysis

 The n periods of data necessary to develop the

estimated regression equation would appear as:

Period Time Series Value of Independent Variables

(t) (Yt) (x1t) (x2t) (x3t) . . (xkt)
1 Y1 x11 x21 x31 . . xk1
2 Y2 x12 x22 x32 . . xk2
. . . . . . . .
. . . . . . . .
n Yn x1n x2n x3n . . xkn

Slide 39
 Qualitative Approaches to Forecasting

 Delphi Method
• It is an attempt to develop forecasts through
“group consensus.”
• The goal is to produce a relatively narrow spread
of opinions within which the majority of the panel
of experts concur.
 Expert Judgment
• Experts individually consider information that
they believe will influence the variable; then they
combine their conclusions into a forecast.
• No two experts are likely to consider the same
information in the same way.

Slide 40
 Qualitative Approaches to Forecasting

 Scenario Writing
• This procedure involves developing several
conceptual scenarios, each based on a well-defined
set of assumptions.
• The decision maker must decide how likely each
scenario is and then make decisions accordingly.
 Intuitive Approaches
• A committee or panel seeks to develop new ideas
or solve complex problems through a series of
“brainstorming sessions.”
• Individuals are free to present any idea without
being concerned about criticism or relevancy.

Slide 41
End of Chapter 18

Slide 42