Business Forecasting Analytics

Forecasting with Smoothing

Techniques
Akhter Mohiuddin
Woxsen School of Business

Chapter Topics

Introduction
Nave Model
Forecasting with Averaging Models:

Simple Average Model

Moving Average Model
Double Moving Average Model

Exponential Smoothing:

Double 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:

Introduction
1.

2.

3.

Time series are best when applied to shortterm forecasts.

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.
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.

Yt 1 Yt

The error associated with this model is

computed as:

et Yt Yt

Example of the Nave Model

Week
1
2
3
5
6
7
8
9

Sales (in $1,000)

9
8
9
12
9
12
11
?

Forecast
9
8
9
12
9
12
11

Example of the Nave Model

Week

Sales (in
$1,000)

1
2
3
5
6
7
8

9
8
9
12
9
12
11

Forecast

Error

Absolute
Error

Squared
Error

9
8
9
12
9
12
Sum
Mean

1
1
3
3
3
1
2
0.33

1
1
3
3
3
1
12
2

1
1
9
9
9
1
30
5

Example of 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.)

Example: Quarterly Operating Cost at the Home Depot

Corporation

Source: Annual Reports of the Home Depot Corporation. Various years.

Online, available <http://ir.homedepot.com/earnings.cfm>

Example: Quarterly Operating Cost at the Home Depot

Corporation

To account for the trend, we can adjust the model by

adding the difference between this period and the last
period as shown below:

For instance, forecast for period 13 is:

Check error for 13th period, is it reduced?

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.

Yt 1

Yt

t 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

In this methodology, we compute a set of moving averages (MAt),

and then a second set is computed as a moving average of the first
set (MAt ).

The difference between the two moving averages is computed as

follows and calculate slope:

Finally find forecast:

Example: Hero Bicycles

Hero Bicycles would like to expand its

operation. The manager has asked an analyst
to forecast sales based on monthly data for
the last 24 months (shown in Table).
The manager would like a forecast of sales for
the 25th month. The analyst recognizes that
there is an increasing trend in the monthly
sales of this bicycle factory as noted in the
data.

Example: Solution

Example: Solution

Compute first MA, for the 5th & 24th time periods.

Compute double moving average for periods 7 and 24.

Example: Solution

Browns Exponential Smoothing

Model

Browns 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.

Browns 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.

Browns Exponential Smoothing

Model

Exponential smoothing is used for routine

sales forecasting of inventory, production,
distribution, and retail planning.

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

Formulation of Holts Model:

Exercise 1
The following data show the return on a stock of a
company for the years 19922007.

Exercise 1

1.

Prepare a forecast for 1992 to 2007 using a simple twoperiod moving average.

2.
3.

What do the results in (a) show? Is this a good model?

Prepare a forecast for 1992 to 2007 using a double
moving average method.

Exercise 2

An airline has the following monthly data on the number

of passengers flying its most profitable route. They have
asked you to prepare a forecast for January 2008. Use
the Browns Exponential Smoothing method in your
forecast.