Week 5 – Forecasting Techniques

A forecast is simply a prediction of what will happen in the future. Managers must
learn to accept the fact that, regardless of the technique used, they will not be able to
develop perfect forecasts. The purpose of forecasting is only to help managers
develop appropriate strategies for the future.

Quantitative forecasting methods include time series methods and causal methods. A
time series method is appropriate when the historical data are restricted to past values
of the variable being forecast. The three time series methods discussed here are
smoothing (moving averages, weighted moving averages, and exponential
smoothing), trend projection and trend projection adjusted for seasonal influence.

Smoothing methods are appropriate for a stable time series; that is, one that exhibits
no significant trend, cyclical or seasonal effects. The moving averages approach
consists of computing an average of past values and then using this average as the
forecast for the next period. The weighted moving averages method allows for the
possibility of unequal weights for the data; thus, the moving averages method is a
special case of the weighted moving averages method in which all the weights are
equal. Exponential smoothing also is a special case of the weighted moving averages
method involving only on e parameter; the weight for the most recent observation.

When a time series consists of random fluctuations around a long-term trend line, a
linear equation may be used to estimate the trend. When seasonal effects are present,
seasonal indexes can be computed and used to deseasonalize the data and to develop
forecasts. When both seasonal and long-term trend effects are present, a trend line is
fitted to the deseasonalized data; the seasonal indexes are then used to adjust the trend
projection.

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A. Components of a Time Series

The usual assumption is that four separate components – trend, cyclical, seasonal and
irregular – combine to provide specific values for the time series.

• The trend component accounts for the gradual shifting of the time series over a
long period of time.

• Any regular pattern of sequences of values above and below the trend line is
attributable to the cyclical component of the series.

• The seasonal component of the series accounts for regular patterns of

variability within certain time periods, such as over a year.

• The irregular component of the series is caused by short-term, unanticipated

and non-recurring factors that affect the values of the time series. One cannot
attempt to predict its impact on the time series in advance.

B. Smoothing Methods

Many business management activities require forecasts for thousands of alternatives

proposals. Thus, in choosing a forecasting technique, simplicity and ease of use are
important criteria. In cases in which the time series is fairly stable and has no
significant trend, seasonal, or cyclical effects, one can use smoothing methods to
average out the irregular components of the time series.

Four common smoothing methods are:

•Moving averages
•Centered moving averages
•Weighted moving averages
•Exponential smoothing

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1. Moving Average Method

The moving average method consists of computing an average of the most recent n
data values for the series and using this average for forecasting the value of the time
series for the next period.

2. Centered Moving Average Method

The centered moving average method consists of computing an average of n periods'

data and associating it with the midpoint of the periods. For example, the average for
periods 5, 6, and 7 is associated with period 6. This methodology is useful in the
process of computing season indexes.

3. Weighted Moving Average Method

In the weighted moving average method for computing the average of the most recent
n periods, the more recent observations are typically given more weight than older
observations. For convenience, the weights usually sum to 1.

4. Exponential Smoothing

Using exponential smoothing, the forecast for the next period is equal to the forecast
for the current period plus a proportion (a) of the forecast error in the current period.

Using exponential smoothing, the forecast is calculated by:

a[the actual value for the current period] +

(1- a)[the forecasted value for the current period],
where the smoothing constant, a , is a number between 0 and 1.

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When deciding on the better forecasting method, we need to consider their accuracy.
These are measured by:

a) Mean Squared Error

The average of the squared forecast errors for the historical data is calculated. The
forecasting method or parameter(s) which minimize this mean squared error is then
selected.

b) Mean Absolute Deviation

The mean of the absolute values of all forecast errors is calculated, and the forecasting
method or parameter(s) which minimize this measure is selected. The mean absolute
deviation measure is less sensitive to individual large forecast errors than the mean
squared error measure.

Illustrated Problem 1

Corporate Triple A Bond interest rates for 12 consecutive months are 9.5, 9.3, 9.4, 9.6,
9.8, 9.7, 9.8, 10.5, 9.9, 9.7, 9.6 and 9.6.

a) Develop three- and four-month moving averages for this time series.
Which moving average provides the better forecasts? Explain.

b) What is the moving average forecast for the next month?

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Solution

a.
Time- 3-Month Moving 4-Month Moving
Month Series Average Forecast (Error)2 Average (Error)2
Value Forecast
1 9.5
2 9.3
3 9.4
4 9.6 9.40 0.04
5 9.8 9.43 0.14 9.45 0.12
6 9.7 9.60 0.01 9.53 0.03
7 9.8 9.70 0.01 9.63 0.03
8 10.5 9.77 0.53 9.73 0.59
9 9.9 10.00 0.01 9.95 0.00
10 9.7 10.07 0.14 9.98 0.08
11 9.6 10.03 0.18 9.97 0.14
12 9.6 9.73 0.02 9.92 0.10
1.08 1.09

MSE(3-Month) = 1.08 / 9 = .12

MSE(4-Month) = 1.09 / 8 = .14

Use 3-Month moving averages because of the lower MSE.

b. forecast = (9.7 + 9.6 + 9.6) / 3 = 9.63

Illustrated Problem 2

For the Hawkins Company, the monthly percentages of all shipments that were
received on time over the past 12 months are 80, 82, 84, 83, 83, 84, 85, 84, 82, 83, 84
and 83.

a) Compare a three-month moving average forecast with an exponential

smoothing forecast for α - 0.2. Which provides the better forecasts?

b) What is the forecast for next month?

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Solution

a.
3-Month α =2
Month Yt Moving (Error)2 Forecast (Error)2
Averages
Forecast
1 80
2 82 80.00 4.00
3 84 80.40 12.96
4 83 82.00 1.00 81.12 3.53
5 83 83.00 0.00 81.50 2.25
6 84 83.33 0.45 81.80 4.84
7 85 83.33 2.79 82.24 7.62
8 84 84.00 0.00 82.79 1.46
9 82 84.33 5.43 83.03 1.06
10 83 83.67 0.45 82.83 0.03
11 84 83.00 1.00 82.86 1.30
12 83 83.00 0.00 83.09 0.01
11.12 39.06

MSE(3-Month) = 11.12 / 9 = 1.24

MSE(α = .2) = 39.06 / 11 = 3.55

Use 3-month moving averages.

b. (83 + 84 + 83) / 3 = 83.3

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Activity 3.1 (Answer at end of chapter)

Moving averages often are used to identify movements in stock prices. Daily closing
prices (in dollars per share) for SanDisk for August 16, 2002, through September 3,
2002, follow:

Day Price ($) Day Price ($)

August 16 14.45 August 26 16.45
August 19 15.75 August 27 15.60
August 20 16.45 August 28 15.09
August 21 17.40 August 29 16.42
August 22 17.32 August 30 16.21
August 23 15.96 September 3 15.22

a) Use a five-day moving average to smooth the time series. Forecast the
closing price for September 4, 2002.

b) Use a four-day weighted moving average to smooth the time series. Use a
weight of 0.4 for the most recent period, 0.3 for the next period back, 0.2
for the third period back, and 0.1 for the fourth period back. Forecast the
closing price for September 4, 2002.

c) Use exponential smoothing with a smoothing constant of α = 0.7 to

smooth the time series. Forecast the closing price for September 4, 2002.

d) Which of the three methods do you prefer? Why?

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C. Trend Projection

If a time series exhibits a linear trend, the method of least squares may be used to
determine a trend line (projection) for future forecasts. Least squares, also used in
regression analysis, determines the unique trend line forecast which minimizes the
mean square error between the trend line forecasts and the actual observed values for
the time series. The independent variable is the time period and the dependent
variable is the actual observed value in the time series.

Using the method of least squares, the formula for the trend projection is:

Tt = b0 + b1t.

where: Tt = trend forecast for time period t

b1 = slope of the trend line
b0 = trend line projection for time 0

b1 = nStYt - St SYt

nSt 2 - (St )2

b0 = Y - b1 t

where: Yt = observed value of the time series at time period t

Y = average of the observed values for Yt
t = average time period for the n observations

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Illustrated Problem 3

The enrolment data (figures in thousands) for a state college for the past six years are
shown.

Year 1 2 3 4 5 6
Enrollment 20.5 20.2 19.5 19.0 19.1 18.8

Develop the equation for the linear trend component for this time series. Comment on
what is happening to enrolment at this institution.

Solution

The following values are needed to compute the slope and intercept:

∑ t = 21 ∑t 2
= 91 ∑Y t = 117.1 ∑ tY t = 403.7

Computation of slope:

b1 =
∑ tYt − d∑ t ∑ Y i / n t
=
4 0 3 . 7 − ( 2 1 ) ( 1 1 7 .1 ) / 6
= − 0 .3 5 1 4
− d∑ ti / n
2
9 1 − ( 2 1) 2 / 6
∑ t 2

Computation of intercept:

b0 = Y − b1 t = 19.5167 − (−0.3514)(3.5) = 20.7466

Equation for linear trend: Tt = 20.7466 - 0.3514t

Conclusion: enrollment appears to be decreasing by an average of approximately 351

students per year.

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Illustrated Problem 4

Hudson Marine has been an authorised dealer for C&D marine radios for the past
seven years. The number of radios sold each year is shown.

Year 1 2 3 4 5 6 7
Number Sold 35 50 75 90 105 110 130

a) Graph this time series. Does a linear trend appear?

b) Develop the equation for the linear trend component for the time series.

c) Use the linear trend developed in part (b) to prepare a forecast for sales in year 8.

Solution

a. Yes, a linear trend appears to exist.

b. The following values are needed to compute the slope and intercept:

2
∑t = 28 ∑t = 140 ∑ Yt = 595 ∑ t Y t = 2815

Computation of slope:

b1 =
∑ tY − d
t ∑ t ∑ Y i / n = 2815 − (28)(595) / 7 = 155357
t
.
∑ ∑t − d
2
t i2
/ n
2
140 − (28) / 7

Computation of intercept:

b0 = Y - b1 t = 85 - 15.5357(4) = 22.857

Equation for linear trend: Tt = 22.857 + 15.536t

c. Forecast: T8 = 22.857 + 15.536(8) = 147.15

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Activity 2 (Answer at end of chapter)

The Garden Avenue Seven sells tapes of its musical performances. The following
data show sales for the past 18 months. The group’s manager wants an accurate
method for forecasting future sales.

Month Sales Month Sales Month Sales

1 293 7 381 13 549
2 283 8 431 14 544
3 322 9 424 15 601
4 355 10 433 16 587
5 346 11 470 17 644
6 379 12 481 18 660

a) Use exponential smoothing, with α = 0.3, 0.4 and 0.5. Which value of α
provides the best forecasts?

b) Use trend projection to provide a forecast. What is the value of MSE?

c) Which method of forecasting would you recommend to the manager? Why?

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D. Trend and Seasonal Components

Steps of Multiplicative Time Series Model:

1. Calculate the centered moving averages (CMAs).

2. Center the CMAs on integer-valued periods.

3. Determine the seasonal and irregular factors (StIt ).

4. Determine the average seasonal factors.

5. Scale the seasonal factors (St ).

6. Determine the deseasonalized data.

7. Determine a trend line of the deseasonalized data.

8. Determine the deseasonalized predictions.

9. Take into account the seasonality.

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Illustrated Problem 5

Identify the monthly seasonal indexes for the following three years of expenses for a
six-unit apartment house in Changi. Use a 12-month moving average calculation.

Month Year 1 Year 2 Year 3

January 170 180 195
February 180 205 210
March 205 215 230
April 230 245 280
May 240 265 290
June 315 330 390
July 360 400 420
August 290 335 330
September 240 260 290
October 240 270 295
November 230 255 280
December 195 220 250

Solution

Seasonal-Irregular
Month Component Values Seasonal Adjusted Seasonal Index
Index
1 0.72 0.70 0.71 0.707
2 0.80 0.75 0.78 0.777
3 0.83 0.82 0.83 0.827
4 0.94 0.99 0.97 0.966
5 1.01 1.02 1.02 1.016
6 1.25 1.36 1.31 1.305
7 1.49 1.51 1.50 1.494
8 1.19 1.26 1.23 1.225
9 0.98 0.97 0.98 0.976
10 0.98 1.00 0.99 0.986
11 0.93 0.94 0.94 0.936
12 0.78 0.80 0.79 0.787
12.05

Notes:

1. Adjustment for seasonal index = 12 / 12.05 = 0.996

2. The adjustment is really not necessary in this problem since it implies more

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accuracy than is warranted. That is, the seasonal component values and the seasonal
index were rounded to two decimal places.

Illustrated Problem 6

Consider the Costello Music Company scenario presented below:

Year Q1 Q2 Q3 Q4 Total Yearly Sales

1 4 2 1 5 12
2 6 4 4 14 28
3 10 3 5 16 34
4 12 9 7 22 50
5 18 10 13 35 76

a) Compute the seasonal indexes for the four quarters.

b) When does Castello Music experience the largest seasonal effect? Does this
result appear to be reasonable? Explain.

c) Deseasonalise the data and use the deseasonalised time series to identify the
trend.

d) Use the results of part (c) to develop a quarterly forecast for next year based on
trend.

e) Use the seasonal indexes developed in (a) to adjust the forecasts developed in
part (d) to account for seasonal effects.

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 Solution

a)

Seasonal-Irregular Seasonal
Component Values Index
Quarter
1
1.371, 1.270, 1.116, 1.200 1.239
2 0.681, 0.364, 0.776, 0.576 0.597
3 0.308, 0.533, 0.571, 0.528 0.485
4 1.333, 1.778, 1.641, 1.558 1.578
Total 3.899

Centered Seasonal-Irregular
t Sales Moving Average Component
1 4
2 2
3 1 3.250 0.308
4 5 3.750 1.333
5 6 4.375 1.371
6 4 5.875 0.681
7 4 7.500 0.533
8 14 7.875 1.778
9 10 7.875 1.270
10 3 8.250 0.364
11 5 8.750 0.571
12 16 9.750 1.641
13 12 10.750 1.116
14 9 11.750 0.766
15 7 13.250 0.528
16 22 14.125 1.558
17 18 15.000 1.200
18 10 17.375 0.576
19 13
20 35

Quarter Adjusted
Seasonal Index
1 1.271
2 0.613
3 0.498
4 1.619

Note: Adjustment for seasonal index = 4 / 3.899 = 1.026

b. The largest effect is in quarter 4; this seems reasonable since retail sales are
generally higher during October, November, and December.

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c. Note: To simplify the calculations the seasonal indexes in problem 29 have been
round to two decimal places.

Seasonal Factor Deseasonalized Sales

Year Quarter Sales Yt St Yt / St = TtIt
1 1 4 1.27 3.15
2 2 0.61 3.28
3 1 0.50 2.00
4 5 1.62 3.09
2 1 6 1.27 4.72
2 4 0.61 6.56
3 4 0.50 8.00
4 14 1.62 8.64
3 1 10 1.27 7.87
2 3 0.61 4.92
3 5 0.50 10.00
4 16 1.62 9.88
4 1 12 1.27 9.45
2 9 0.61 14.75
3 7 0.50 14.00
4 22 1.62 13.58
5 1 18 1.27 14.17
2 10 0.61 16.39
3 13 0.50 26.00
4 35 1.62 21.60

Yt
t (deseasonalized) tYt t2
1 3.15 3.15 1
2 3.28 6.56 4
3 2.00 6.00 9
4 3.09 12.36 16
5 4.72 23.60 25
6 6.56 39.36 36
7 8.00 56.00 49
8 8.64 69.12 64
9 7.87 70.83 81
10 4.92 49.20 100
11 10.00 110.00 121
12 9.88 118.56 144
13 9.45 122.85 169
14 14.75 206.50 196
15 14.00 210.00 225
16 13.58 217.28 256
17 14.17 240.89 289
18 16.39 295.02 324
19 26.00 494.00 361
20 21.60 432.00 400
210 202.05 2783.28 2870

t = 10.5 Y = 10.1025 b1 = .995 b0 = - .345 T t = - .345 + .995 t

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d.
y Trend Forecast
21 20.55
22 21.55
23 22.54
24 23.54

e.
Trend Seasonal Quarterly
Year Quarter Forecast Index Forecast
6 1 20.55 1.27 26.10
2 21.55 0.61 13.15
3 22.54 0.50 11.27
4 23.54 1.62 38.13

Activity 3 (Answer at end of chapter)

Air pollution control specialists in Singapore monitor the amount of ozone, carbon
dioxide and nitrogen dioxide in the air on an hourly basis. The hourly time series data
exhibit seasonality, with the levels of pollutants showing similar patterns over the
hours in the day. On July 15, 16 and 17, the observed levels of nitrogen dioxide in
Orchard Road for the 12 hours from 6 a.m. to 6 p.m. were as follows:

July 15 25 28 35 50 60 60 40 35 30 25 25 20
July 16 28 30 35 48 60 65 50 40 35 25 20 20
July 17 35 42 45 70 72 75 60 45 40 25 25 25

a) Identify the hourly seasonal indexes for the 12 hourly daily readings.

b) Based on the seasonal indexes in part (a), the trend equation developed for the
deseasonalised data is Tt = 32.983 + 0.3922t. Using only the trend equation,
develop forecasts for the 12 hours for July 18.

c) Use the seasonal indexes from part (a) to adjust the trend forecasts in part (b).

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 Solutions to Activities

Activity 1

a.
5-Day Moving Forecast
Day Time-Series Average Forecast Error (Error)2
Value
1 14.45
2 15.75
3 16.45
4 17.40
5 17.32
6 15.96 16.27 -0.31 0.10
7 16.45 16.58 -0.13 0.02
8 15.60 16.72 -1.12 1.25
9 15.09 16.55 -1.46 2.12
10 16.42 16.08 0.34 0.11
11 16.21 15.90 0.31 0.09
12 15.22 15.95 -0.73 0.54

Note: MSE = 4.23/7 = 0.60

Forecast for September 4 is (15.60 + 15.09 + 16.42 + 16.21 + 15.22)/5 = 15.71

b. The weighted moving average forecasts for days 5-12 are 16.49, 17.01, 16.71,
16.57, 16.10, 15.60, 15.09, 16.42, 16.21 and 15.22

Note: MSE = 5.21/8 = 0.65

Forecast for September 4 is 0.1(15.09) + 0.2(16.42) + 0.3(16.21) + 0.4(15.22) =

15.74

c. The exponential smoothing forecasts for days 2-12 are 14.45, 15.36, 16.12, 17.02,
17.23, 16.34, 16.42, 15.85, 15.32, 16.09 and 16.17

Note: MSE = 9.57/11 = 0.87

Forecast for September 4 is 0.7(15.22) + 0.3(16.17) = 15.51

d.
Method MSE
Moving Averages 0.60
Weighted Moving Average 0.65
Exponential Smoothing 0.87

Moving Averages is the best of the three approaches because it has the smallest
MSE.

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Activity 2

Note: Results were obtained using the Forecasting module of The Management
Scientist.

a.
Smoothing Constant MSE
α = 0.3 4,492.37
α = 0.4 2,964.67
α = 0.5 2,160.31

The α = 0.5 smoothing constant is better because it has the smallest MSE.

b. Tt = 244.778 + 22.088t

MSE = 357.81

c. Trend projection provides much better forecasts because it has the smallest
MSE. The reason MSE is smaller for trend projection is that sales are
increasing over time; as a result, exponential smoothing continuously
underestimates the value of sales. If you look at the forecast errors for
exponential smoothing you will see that the forecast errors are positive for
periods 2 through 18.

Activity 3

a. Use a twelve period moving averages. After centering the moving averages, you
should obtain the following seasonal indexes:
Hour Seasonal Index Hour Seasonal Index
1 0.771 7 1.207
2 0.864 8 0.994
3 0.954 9 0.850
4 1.392 10 0.647
5 1.571 11 0.579
6 1.667 12 0.504

b. The hours of July 18 are number 37 to 48 in the time series. Thus the trend
component for 7:00 a.m. on July 18 (period 37) would be

T37 = 32.983 + .3922(37) = 47.49

A summary of the trend components for the twelve hours on July 18 is as

follows:

Hour Trend Component Hour Trend Component

1 47.49 7 49.85
2 47.89 8 50.24
3 48.28 9 50.63
4 48.67 10 51.02

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 5 49.06 11 51.42
6 49.46 12 51.81

c. Multiply the trend component in part b by the seasonal indexes in part a to

obtain the twelve hourly forecasts for July 18. For example, 47.49 x (.771) =
36.6 or rounded to 37, would be the forecast for 7:00 a.m. on July 18th.

The seasonally adjusted hourly forecasts for July 18 are as follows:

Hour Forecast Hour Forecast

1 37 7 60
2 41 8 50
3 46 9 43
4 68 10 33
5 77 11 30
6 82 12 26

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