Statistics for Business Slides by

and Economics, JOHN

11E LOUCKS
St. Edward’s
Anderson/Sweeney/Williams University

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

1
 Chapter 18
Forecasting
 Quantitative Approaches to Forecasting
 Components of a Time Series
 Measures of Forecast Accuracy
 Smoothing Methods
 Trend Projection
 Trend and Seasonal Components
 Regression Analysis
 Qualitative Approaches

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

2
 Forecasting Methods

Forecasting
Methods

Quantitative Qualitative

Causal Time Series

Trend Trend Projection

Smoothing Projection Adjusted for
Seasonal Influence

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

3
 Quantitative Approaches to Forecasting

 Quantitative methods are based on an analysis of

historical data concerning one or more time series.
 A time series is a set of observations measured at
successive points in time or over successive periods
of time.
 If the historical data used are restricted to past
values of the series that we are trying to forecast, the
procedure is called a time series method.
 If the historical data used involve other time series
that are believed to be related to the time series that
we are trying to forecast, the procedure is called a
causal method.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

4
 Time Series Methods

 Three time series methods are:

• smoothing
• trend projection
• trend projection adjusted for seasonal influence

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

5
 Components of a Time Series

 The pattern or behavior of the data in a time series

has several components.
 The four components we will study are:

Trend Cyclical Seasonal Irregular

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

6
 Components of a Time Series

 Trend Component
• The trend component accounts for the gradual
shifting of the time series to relatively higher or
lower values over a long period of time.
• Trend is usually the result of long-term factors
such as changes in the population, demographics,
technology, or consumer preferences.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

7
 Components of a Time Series

 Cyclical Component
• Any regular pattern of sequences of values above
and below the trend line lasting more than one year
can be attributed to the cyclical component.
• Usually, this component is due to multiyear cyclical
movements in the economy.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

8
 Components of a Time Series

 Seasonal Component
• The seasonal component accounts for regular
patterns of variability within certain time periods,
such as a year.
• The variability does not always correspond with the
seasons of the year (i.e. winter, spring, summer, fall).
• There can be, for example, within-week or within-
day “seasonal” behavior.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

9
 Components of a Time Series

 Irregular Component
• The irregular component is caused by short-term,
unanticipated and non-recurring factors that affect
the values of the time series.
• This component is the residual, or “catch-all,”
factor that accounts for unexpected data values.
• It is unpredictable.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

10
 Measures of Forecast Accuracy

 Mean Squared Error

The average of the squared forecast errors for the
historical data is calculated. The forecasting method or
parameter(s) that minimize this mean squared error is
then selected.
 Mean Absolute Deviation
The mean of the absolute values of all forecast errors is
calculated, and the forecasting method or parameter(s)
that minimize this measure is selected. (The mean
absolute deviation measure is less sensitive to large
forecast errors than the mean squared error measure.)

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

11
 Smoothing Methods

 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 component of the time series.
 Three common smoothing methods are:
Moving Averages

Weighted Moving Averages

Exponential Smoothing

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

12
 Smoothing Methods

 Moving Averages
The moving averages 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.

Moving Average =
 (most recent n data values)
n

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

13
 Smoothing Methods: Moving Averages

 Example: Rosco Drugs

Sales of Comfort brand headache medicine for
the past ten weeks at Rosco Drugs
are shown on the next slide. If
Rosco Drugs uses a 3-period
moving average to forecast sales,
what is the forecast for Week 11?

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

14
 Smoothing Methods: Moving Averages

 Example: Rosco Drugs

Week Sales Week Sales

1 110 6 120
2 115 7 130
3 125 8 115
4 120 9 110
5 125 10 130

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

15
 Smoothing Methods: Moving Averages

Week Sales 3MA Forecast

1 110 (110 + 115 + 125)/3
2 115
3 125 116.7
4 120 120.0 116.7
5 125 123.3 120.0
6 120 121.7 123.3
7 130 125.0 121.7
8 115 121.7 125.0
9 110 118.3 121.7
10 130 118.3 118.3
11 118.3

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

16
 Smoothing Methods

 Weighted Moving Averages

• To use this method we must first select the number
of data values to be included in the average.
• Next, we must choose the weight for each of the
data values.
• The more recent observations are typically
given more weight than older observations.
• For convenience, the weights usually sum to 1.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

17
 Smoothing Methods

 Weighted Moving Averages

• An example of a 3-period weighted moving
average (3WMA) is:

3WMA = .2(110) + .3(115) + .5(125) = 119

Weights (.2, .3, Most recent of the

and .5) sum to 1 three observations

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

18
 Smoothing Methods

 Exponential Smoothing
• This method is a special case of a weighted moving
averages method; we select only the weight for the
most recent observation.
• The weights for the other data values are computed
automatically and become smaller as the
observations grow older.
• The exponential smoothing forecast is a weighted
average of all the observations in the time series.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

19
 Smoothing Methods
To start the
 Exponential Smoothing Model calculations,
we let F11 = Y11
Ft+1 = Yt + (1 – )Ft

where
Ft+1 = forecast of the time series for period t + 1
Yt = actual value of the time series in period t
Ft = forecast of the time series for period t
 = smoothing constant (0 <  < 1)

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

20
 Smoothing Methods

 Exponential Smoothing Model

• With some algebraic manipulation, we can rewrite
Ft+1 = Yt + (1 – )Ft as:

Ft+1 = Ft + Yt – Ft)

• We see that the new forecast Ft+1 is equal to the

previous forecast Ft plus an adjustment, which is 
times the most recent forecast error, Yt – Ft.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

21
 Smoothing Methods: Exponential Smoothing

 Example: Rosco Drugs

Sales of Comfort brand headache medicine for
the past ten weeks at Rosco Drugs
are shown on the next slide. If
Rosco Drugs uses exponential
smoothing to forecast sales, which
value for the smoothing constant ,
.1 or .8, gives better forecasts?

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

22
 Smoothing Methods: Exponential Smoothing

 Example: Rosco Drugs

Week Sales Week Sales

1 110 6 120
2 115 7 130
3 125 8 115
4 120 9 110
5 125 10 130

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

23
 Smoothing Methods: Exponential Smoothing

 Exponential Smoothing ( = .1, 1 -  = .9)

F1 = 110
F2 = .1Y1 + .9F1 = .1(110) + .9(110) = 110
F3 = .1Y2 + .9F2 = .1(115) + .9(110) = 110.5
F4 = .1Y3 + .9F3 = .1(125) + .9(110.5) = 111.95
F5 = .1Y4 + .9F4 = .1(120) + .9(111.95) = 112.76
F6 = .1Y5 + .9F5 = .1(125) + .9(112.76) = 113.98
F7 = .1Y6 + .9F6 = .1(120) + .9(113.98) = 114.58
F8 = .1Y7 + .9F7 = .1(130) + .9(114.58) = 116.12
F9 = .1Y8 + .9F8 = .1(115) + .9(116.12) = 116.01
F10= .1Y9 + .9F9 = .1(110) + .9(116.01) = 115.41

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

24
 Smoothing Methods: Exponential Smoothing

 Exponential Smoothing ( = .8, 1 -  = .2)

F1 = 110
F2 = .8(110) + .2(110) = 110
F3 = .8(115) + .2(110) = 114
F4 = .8(125) + .2(114) = 122.80
F5 = .8(120) + .2(122.80) = 120.56
F6 = .8(125) + .2(120.56) = 124.11
F7 = .8(120) + .2(124.11) = 120.82
F8 = .8(130) + .2(120.82) = 128.16
F9 = .8(115) + .2(128.16) = 117.63
F10= .8(110) + .2(117.63) = 111.53

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

25
 Smoothing Methods: Exponential Smoothing

 Mean Squared Error

In order to determine which smoothing constant
gives the better performance, we calculate, for each,
the mean squared error for the nine weeks of
forecasts, weeks 2 through 10.

[(Y2-F2)2 + (Y3-F3)2 + (Y4-F4)2 + . . . + (Y10-F10)2]/9

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

26
 Smoothing Methods: Exponential Smoothing

 = .1  = .8
Week Yt Ft (Yt - Ft)2 Ft (Yt - Ft)2
2 115 110.00 25.00 110.00 25.00
3 125 110.50 210.25 114.00 121.00
4 120 111.95 64.80 122.80 7.84
5 125 112.76 149.94 120.56 19.71
6 120 113.98 36.25 124.11 16.91
7 130 114.58 237.73 120.82 84.23
8 115 116.12 1.26 128.16 173.30
9 110 116.01 36.12 117.63 58.26
10 130 115.41 212.87 111.53 341.27
Sum 974.22 Sum 847.52
MSE Sum/9 108.25 Sum/9 94.17
© 2011 South-Western/Cengage Learning. All Rights Reserved Slide
27
 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.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

28
 Trend Projection

 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

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

29
 Trend Projection

 For the trend projection equation Tt = b0 + b1t

b1 
 tY  (  t  Y )/ n
t t
b0  Y  b1 t
 t  ( t ) / n
2 2

where: Yt = observed value of the time series at

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

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

30
 Trend Projection

 Example: Auger’s Plumbing Service

The number of plumbing repair jobs performed
by Auger's Plumbing Service in each of the
last nine months is listed on the next
slide. Forecast the number of repair
jobs Auger's will perform in December
using the least squares method.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

31
 Trend Projection

 Example: Auger’s Plumbing Service

Month Jobs Month Jobs

March 353 August 409
April 387 September 399
May 342 October 412
June 374 November 408
July 396

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

32
 Trend Projection

(month) t Yt tYt t2
(Mar.) 1 353 353 1
(Apr.) 2 387 774 4
(May) 3 342 1026 9
(June) 4 374 1496 16
(July) 5 396 1980 25
(Aug.) 6 409 2454 36
(Sep.) 7 399 2793 49
(Oct.) 8 412 3296 64
(Nov.) 9 408 3672 81
Sum 45 3480 17844 285

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

33
 Trend Projection

t  45 /9  5 Y  3480 /9  386.667

b1 
 tY  (  t  Y )/ n (9)(17844)  (45)(3480)
t t
  7.4
 t  ( t ) / n
2 2
(9)(285)  (45) 2

b0  Y  b1 t  386.667  7.4(5)  349.667

T10 = 349.667 + (7.4)(10) = 423.667

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

34
 Trend Projection

 Example: Auger’s Plumbing Service

Forecast for December (Month 10) using a
three-period (n = 3) weighted moving
average with weights of .6, .3, and .1
for the newest to oldest data, respec-
tively. Then, compare this Month 10
weighted moving average forecast with
the Month 10 trend projection forecast.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

35
 Trend Projection

 Three-Month Weighted Moving Average

The forecast for December will be the weighted
average of the preceding three months: September,
October, and November.
F10 = .1YSep. + .3YOct. + .6YNov.
= .1(399) + .3(412) + .6(408)
= 408.3
 Trend Projection
F10 = 423.7 (from earlier slide)

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

36
 Trend Projection

 Conclusion
Due to the positive trend component in the time
series, the trend projection produced a forecast that is
more in tune with the trend that exists. The weighted
moving average, even with heavy (.6) weight placed
on the current period, produced a forecast that is
lagging behind the changing data.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

37
Forecasting with 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.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

38
Forecasting with Trend and Seasonal Components

 Example: Terry’s Tie Shop

Business at Terry's Tie Shop can be
viewed as falling into three distinct
seasons: (1) Christmas (November and
December); (2) Father's Day (late May to
mid June); and (3) all other times.
Average weekly sales ($) during each of the three
seasons during the past four years are shown on
the next slide.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

39
Forecasting with Trend and Seasonal Components

 Example: Terry’s Tie Shop

Season
Year 1 2 3
1 1856 2012 985
2 1995 2168 1072
3 2241 2306 1105
4 2280 2408 1120

Determine a forecast for the average weekly

sales in year 5 for each of the three seasons.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

40
Forecasting with Trend and Seasonal Components

Step 1. Calculate the centered moving averages.

There are three distinct seasons in each year.
Hence, take a three-season moving average to
eliminate seasonal and irregular factors. For
example:

1st CMA = (1856 + 2012 + 985)/3 = 1617.67

2nd CMA = (2012 + 985 + 1995)/3 = 1664.00
Etc.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

41
Forecasting with Trend and Seasonal Components

Step 2. Center the CMAs on integer-valued periods.

The first centered moving average computed
in step 1 (1617.67) will be centered on season 2 of
year 1. Note that the moving averages from step
1 center themselves on integer-valued periods
because n is an odd number.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

42
Forecasting with Trend and Seasonal Components

Dollar Moving
Year Season Sales (Yt) Average
(1856 + 2012 + 985)/3
1 1 1856
2 2012 1617.67
3 985 1664.00
2 1 1995 1716.00
2 2168 1745.00
3 1072 1827.00
3 1 2241 1873.00
2 2306 1884.00
3 1105 1897.00
4 1 2280 1931.00
2 2408 1936.00
3 1120

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

43
Forecasting with Trend and Seasonal Components

Step 3. Determine the seasonal & irregular factors (St It ).

Isolate the trend and cyclical components. For
each period t, this is given by:

St It = Yt /(Moving Average for period t )

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

44
Forecasting with Trend and Seasonal Components

Dollar Moving
Year Season Sales (Yt) Average StIt
2012/1617.67
1 1 1856
2 2012 1617.67 1.244
3 985 1664.00 .592
2 1 1995 1716.00 1.163
2 2168 1745.00 1.242
3 1072 1827.00 .587
3 1 2241 1873.00 1.196
2 2306 1884.00 1.224
3 1105 1897.00 .582
4 1 2280 1931.00 1.181
2 2408 1936.00 1.244
3 1120

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

45
Forecasting with Trend and Seasonal Components

Step 4. Determine the average seasonal factors.

Averaging all St It values corresponding to that
season:

Season 1: (1.163 + 1.196 + 1.181) /3 = 1.180

Season 2: (1.244 + 1.242 + 1.224 + 1.244) /4 = 1.238
Season 3: (.592 + .587 + .582) /3 = .587

3.005

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

46
Forecasting with Trend and Seasonal Components

Step 5. Scale the seasonal factors (St ).

Average the seasonal factors = (1.180 + 1.238 + .
587)/3 = 1.002. Then, divide each seasonal factor
by the average of the seasonal factors.

Season 1: 1.180/1.002 = 1.178

Season 2: 1.238/1.002 = 1.236
Season 3: .587/1.002 = .586

3.000

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

47
Forecasting with Trend and Seasonal Components

Dollar Moving Scaled

Year Season Sales (Yt) Average StIt St
1 1 1856 1.178
2 2012 1617.67 1.244 1.236
3 985 1664.00 .592 .586
2 1 1995 1716.00 1.163 1.178
2 2168 1745.00 1.242 1.236
3 1072 1827.00 .587 .586
3 1 2241 1873.00 1.196 1.178
2 2306 1884.00 1.224 1.236
3 1105 1897.00 .582 .586
4 1 2280 1931.00 1.181 1.178
2 2408 1936.00 1.244 1.236
3 1120 .586

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

48
Forecasting with Trend and Seasonal Components

Step 6. Determine the deseasonalized data.

Divide the data point values, Yt , by St .

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

49
Forecasting with Trend and Seasonal Components
1856/1.178
Dollar Moving Scaled
Year Season Sales (Yt) Average StIt St Yt/St
1 1 1856 1.178 1576
2 2012 1617.67 1.244 1.236 1628
3 985 1664.00 .592 .586 1681
2 1 1995 1716.00 1.163 1.178 1694
2 2168 1745.00 1.242 1.236 1754
3 1072 1827.00 .587 .586 1829
3 1 2241 1873.00 1.196 1.178 1902
2 2306 1884.00 1.224 1.236 1866
3 1105 1897.00 .582 .586 1886
4 1 2280 1931.00 1.181 1.178 1935
2 2408 1936.00 1.244 1.236 1948
3 1120 .586 1911

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

50
Forecasting with Trend and Seasonal Components

Step 7. Determine a trend line of the deseasonalized data.

Using the least squares method for t = 1, 2, ..., 12,
gives:
Tt = 1580.11 + 33.96t

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

51
Forecasting with Trend and Seasonal Components

Step 8. Determine the deseasonalized predictions.

Substitute t = 13, 14, and 15 into the least
squares equation:

T13 = 1580.11 + (33.96)(13) = 2022

T14 = 1580.11 + (33.96)(14) = 2056
T15 = 1580.11 + (33.96)(15) = 2090

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

52
Forecasting with Trend and Seasonal Components

Step 9. Take into account the seasonality.

Multiply each deseasonalized prediction by its
seasonal factor to give the following forecasts for
year 5:

Season 1: (1.178)(2022) = 2382

Season 2: (1.236)(2056) = 2541
Season 3: ( .586)(2090) = 1225

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

53
 Qualitative Approaches to Forecasting

 Delphi Approach
• A panel of experts, each of whom is physically
separated from the others and is anonymous, is
asked to respond to a sequential series of
questionnaires.
• After each questionnaire, the responses are
tabulated and the information and opinions of the
entire group are made known to each of the other
panel members so that they may revise their
previous forecast response.
• The process continues until some degree of
consensus is achieved.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

54
 Qualitative Approaches to Forecasting

 Scenario Writing
• Scenario writing consists of developing a
conceptual scenario of the future based on a well
defined set of assumptions.
• After several different scenarios have been
developed, the decision maker determines which
is most likely to occur in the future and makes
decisions accordingly.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

55
 Qualitative Approaches to Forecasting

 Subjective or Interactive Approaches

• These techniques are often used by committees or
panels seeking to develop new ideas or solve
complex problems.
• They often involve "brainstorming sessions".
• It is important in such sessions that any ideas or
opinions be permitted to be presented without
regard to its relevancy and without fear of
criticism.

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

56
 End of Chapter 18

© 2011 South-Western/Cengage Learning. All Rights Reserved Slide

57