Chapter 10 10 -1

Business Forecasting
Chapter 5
Forecasting with Smoothing
Techniques
Chapter Topics
Introduction
Nave Model
Forecasting with Averaging Models:
Simple Average Model
Moving Average Model
Double Moving Average Model
Exponential Smoothing:
Double Exponential Smoothing
Exponential Smoothing
(Continued)

Holts Method

Triple Exponential Smoothing

Winters Seasonal Exponential Smoothing
Introduction
Elaborate statistical models are not always
required to develop accurate forecasts.
The principle of parsimony suggests that the
simpler the model the better.
The main advantage of simple models is that
they serve as a benchmark with which to
gauge applicability, reliability, and necessity of
the more sophisticated models.

Introduction
These time series models are good tools in
forecasting short-term events.
The cardinal premise underlying all time series
models is that the historical pattern of the
dependent variable can be used as the basis
for developing forecasts.
In these models, historical data for the
forecast variable are analyzed in an attempt
to discern any underlying pattern(s).

Introduction
Time series or autoregressive forecasting
models will be most useful when economic
conditions can be expected to remain
relatively stable.
Reliance of time series models on analysis and
extrapolation of historical patterns carries
several important implications with respect to
technique selection:

Chapter 10 10 -2
Introduction
1. Time series are best when applied to short-
term forecasts.
2. Time series models prove most satisfactory
when historical data contain either no
systematic data pattern or when the
changes are occurring very slowly or
consistently.
3. Data requirements and ease of
implementation are a function of the specific
time series technique selected.

Nave Model
Uses recent past as the best indicator of the
future.



The error associated with this model is
computed as:


t t
Y Y =
+1

t t t
Y Y e

=
Example for the Nave Model
Week Sales (in $1,000) Forecast
1 9 -
2 8 9
3 9 8
5 12 9
6 9 12
7 12 9
8 11 12
9 ? 11
Example for the Nave Model
Week Sales (in
$1,000)
Forecast Error Absolute
Error
Squared
Error
1 9
2 8 9 1 1 1
3 9 8 1 1 1
5 12 9 3 3 9
6 9 12 3 3 9
7 12 9 3 3 9
8 11 12 1 1 1
Sum 2 12 30
Mean 0.33 2 5
Example for the Nave Model
What you should keep in mind is that,
although MAD is often used as the
measurement of error in evaluating a
forecast, an alternative criterion is the MSE.

Note that the difference between MAD and
MSE is that the latter penalizes a forecast
much more for extreme deviations than it
does for small ones.

Example for the Nave Model
Whenever a manager evaluates alternative
forecasting techniques in terms of their
accuracy, it is necessary to go beyond the
computation of error.
Managers are generally concerned with two
forms of accuracy:
Accuracy of the technique in predicting the
underlying patterns or relationship of past data.
Accuracy of the changes in the pattern. That is,
how fast forecasting procedure can respond to that
basic change. (We will discuss this in later
chapters.)
Chapter 10 10 -3
Averaging Models
The basic premise of these models is that
a weighted-average of past observations
can be used to smooth the fluctuations in
the data in the short term.



Simple Average Model
Similar to the nave model, this model uses
part of the historical data to make a forecast.


n
Y
Y
n
t
t
t

=
=
+
1
1

Moving Average Model

Recent observations play an important
role in the forecast.
As new observations become available, a
new average is computed.
The choice of using a smaller or larger
number of observations has implications
for the forecast.

Double Moving Average Model
Used when we have a linear trend in the data.

Two different moving averages are computed
in this model.

The idea is to remove the trend.
Double Moving Average Model
Week Sales
(in $1,000)
Simple Moving
Average
Simple Moving
Average
Forecast
Double
Moving
Average
1 9
2 11 10
3 10 10.5 10 10.25
5 14 12 10.5 11.25
6 18 16 12 14
7 22 20 16 18
8 23 22.5 20 21.25
Exponential Smoothing Model
The model relies on the assumption that the
data are stationary.

Most recent observations play a more
important role than the distant past.


3
3
2
2
1 1
) 1 ( ) 1 ( ) 1 (
+
+ + + =
t t t t t
Y Y Y Y Y

o o o o o o o
Chapter 10 10 -4
Exponential Smoothing Model
The model depends on three pieces of data:
Most recent actual
Most recent forecast
Smoothing constant.

The value of alpha assigned as a smoothing
constant is critical to the forecast.
The best alpha should be chosen on the basis
of minimal sum of error squared.
Exponential Smoothing Model
Several approaches are followed in selecting
the smoothing constant.
If a great amount of smoothing is desired, a small
alpha should be chosen.
The choice of alpha is affected by the
characteristics of the time series. If sharp ups and
downs are noticed in the data, the best smoothing
constant is 0.1. That is alpha chosen should equal
0.1.
If the data show that the past is very different
from the present, then alpha of 0.9 is appropriate.
Exponential Smoothing Model
Exponential smoothing is used for routine
sales forecasting of inventory, production,
distribution, and retail planning.


Double Exponential Smoothing
Model
Similar to the double moving average model.
Also known as Browns double exponential
smoothing model.

x b a Y
t t x t
+ =
+

Double Exponential Smoothing

Model
The model is represented as:


x b a Y
t t x t
+ =
+

x t
Y
+

" A
= forecast value x periods in the future
t
a = the difference between the simple ' A
and the double smoothed values
t
b
= slope in a time series
X = number of periods ahead to be forecasted
Double Exponential Smoothing
Model
To compute the difference between simple and
double smoothed values:

'
1
'
) 1 (

+ =
t t t
A Y A o o
' '
1
' ' '
) 1 (

+ =
t t t
A A A o o
Chapter 10 10 -5
Double Exponential Smoothing
Model
Once we have computed the simple and double
smoothed values, we then compute the intercept
and the slope of the forecast line as follows:





The forecast equation is:

' ' '
2
t t t
A A a =
) (
1
' ' '
t t t
A A b

=
o
o
x b a Y
t t x t
+ =
+

Holts Exponential Smoothing Model

To handle linear trend, similar to the Browns
Method.
The difference is that in this method we smooth the
trend and the slope in the time series by using
different constants for each.
How do we find the best combination of smoothing
constant?
Low values of alpha and beta should be used when
there are frequent random fluctuations in the data.
High values of alpha and beta should be used when
there is a pattern such as trend in the data.
Holts Exponential Smoothing Model
The following equations are used when applying the
Holts method:


) )( 1 (
1 1
+ + =
t t t t
T A Y A o o
1 1
) 1 ( ) (

+ =
t t t t
T A A T | |
t t x t
xT A Y + =
+

Triple Exponential Smoothing Model

When faced with nonlinear pattern in the data, this
model provides a good forecast.
The life cycle model of products, and cost structures
are environments where the triple exponential
smoothing should be used.
The forecasting equation is:


2
) 2 / 1 (

x c x b a Y
t t t x t
+ + =
+
Triple Exponential Smoothing Model
In this model we have to compute three coefficients:
a, b, and c .

Each of the coefficients is computed as follows:

3 2 1
3 3
t t t t
A A A a + =
{ }
3 2 1
2
) 3 4 ( ) 8 10 ( ) 5 6 (
) 1 ( 2
t t t t
A A A b o o o
o
o
+

=
) 2 (
1
3 2 1
2
t t t t
A A A c +
(

)
`

=
o
o
Triple Exponential Smoothing Model
You will note that the estimation of the coefficients
(a, b, and c) requires us to compute three
smoothing values.



1
1
1
) 1 (

+ =
t t t
A Y A o o
2
1
1 2
) 1 (

+ =
t t t
A A A o o
3
1
2 3
) 1 (

+ =
t t t
A A A o o
Chapter 10 10 -6
Winters Seasonal Exponential
Smoothing
Allows for both trend and seasonal patterns to be
taken into account.
This is an extension of the Holts method of
smoothing.
In computing the forecast, we add an equation for
seasonality as an index.
The forecast model is:




x L t t t x t
I xT A Y
+ +
+ = ) (

Winters Seasonal Exponential

Smoothing
The Winters model has the following components:




) )( 1 (
1 1

+ + =
t t
L t
t
t
T A
I
Y
A o o
1 1
) 1 ( ) (

+ =
t t t t
T A A T | |
Smoothing value
Trend estimate
L t
t
t
t
I
A
Y
I

+ = ) 1 ( Seasonality estimate
Chapter Summary
Discussed how the nave model is used in
forecasting.
Elaborated on the moving averages model,
which included the simple moving average
and the double moving average.
Discussed the exponential smoothing models
of Brown, Holt, and Winters.
Identified the criteria for using the various
models.