3-2 Business Forecasting with Accompanying Excel-Based ForecastX Software

Time-Series Smoothing Methods

1. Moving Averages
2. Simple Exponential Smoothing
3. Holts exponential Smoothing
4. Winters exponential smoothing
5. Adaptive-response-rate Single exponential smoothing
All of these methods use:
Weighted average of past observations to smooth up-and-down
movements, AND
All are based on the concept that:
There is some underling pattern to the data.

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3-3 Business Forecasting with Accompanying Excel-Based ForecastX Software

Moving Averages

A simple but popular forecasting method.

Appropriate to use for forecasting stationary time series.
A moving average of order N is simply the arithmetic
average of the most recent N observations.
Figure 3.1 shows the exchange rate between the
Japanese yen and the U.S. Dollar from 1983Q1
through 1998Q4.
Do we observe any data pattern in these data?
No, we just observe irregular up-and-down movements.

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Figure 3-1
Figure 3-1
Table 3-1 (continued)
Table 3-1 (continued)
Figure 3-2
Figure 3-3
3-10 Business Forecasting with Accompanying Excel-Based ForecastX Software

Moving Averages

Selecting the interval for moving average:

-- depends on the length of the underlying cycle or pattern in the
original data. If a cycle occurs every four period, then we can
calculate a four-period moving average in order to smooth
out the short-run fluctuation.
Note that the simplest naive model in Chapter 1 is a one-period
moving average.
The shortcomings of moving-average models are:
1. May not be successful in predicting peaks and troughs.
2. May not be successful when there is a trend in the series.
3. May exhibit a cycle, in fact, no cycle was present in the
actual data.

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3-11 Business Forecasting with Accompanying Excel-Based ForecastX Software

Simple Exponential Smoothing

Like moving averages, this method is

appropriate to use when there is no trend or
seasonality present in the data
In exponential smoothing, the current forecast
is the weighted average of the last forecast and
the actual value in that period.
Ft+1 = Xt + (1- )Ft
: smoothing constant 0 < < 1

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3-12 Business Forecasting with Accompanying Excel-Based ForecastX Software

Simple Exponential Smoothing

Note that moving averages give equal weights

to past values included in each average.
Whereas exponential smoothing gives more
weight to recent obsevations. The justification
for this is that the most recent observations
contain the most relevant information so that
these observations with higher weights will
have more influence on forecast value.

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3-13 Business Forecasting with Accompanying Excel-Based ForecastX Software

Simple Exponential Smoothing

If we rearrange the following equation:

Ft+1 = Xt + (1- )Ft we obtain this:
Ft+1 = Ft + (Xt - Ft) error= Xt - Ft
This equation says that the exponential smoothing
model learns from past errors. If we forecast low in
period t, then the error term will be positive and an
adjustment will be made to incerese the current
forecast. If we forecast high in period t, then the error
term will be negative and an adjustment will be made
to lower the current forecast.

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3-14 Business Forecasting with Accompanying Excel-Based ForecastX Software

Simple Exponential Smoothing

As mentioned earlier, the weights of past

observations decline geometrically with the
age of observation:
Ft+1=Xt+(1- )Xt-1+(1- )2Xt-2+ (1- )3Ft-2
0<<1
If is chosen close to 1, in calculating forecast
values, the recent values of time series will be
weighted heavily relative to the distant past.

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3-15 Business Forecasting with Accompanying Excel-Based ForecastX Software

Simple Exponential Smoothing

If is chosen close to 0, then the weights of the

distant time series will be comparable to those given
the recent values. (see pg. 105 and 106)
Note that the sum of weights will be eventually 1.
In choosing an appropriate value of smoothing
constant, , usually the RMSE is used as a criterion.
In calculating forecast values, this method requires a
limited quantity of data, so this can be considered as
an advantage. However, this method does not have
ability to adjust data when there is any trend or
seasonality in data. (see example given on pg.107)

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Table 3-2
Table 3-2 (continued)
Figure 3-4
3-19 Business Forecasting with Accompanying Excel-Based ForecastX Software

Holts Exponential Smoothing

This method adjusts the smoothing model for

any trend in the data by adding a growth factor
(or trend factor) to the smoothing equation. It
uses three equations to calculate forecast
value:
1) Ft+1 =Xt + (1- )(Ft +Tt) this equation
adjusts Ft+1 by adding a growth factor(Tt) to
the smoothed value of earlier period, Ft.

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3-20 Business Forecasting with Accompanying Excel-Based ForecastX Software

Holts Exponential Smoothing

2) Tt+1 = (Ft+1 Ft) + (1 )Tt this equation

estimates the smoothed trend value by multiplying
the most recent trend (Ft+1 Ft) by and the last
previous smoothed trend by (1 ).
3) Ht+m = Ft+1 + mTt+1 this equation forecasts m
periods into the future, in other words, it calculates
Holts forecast value for period t+m.
With these three equations, this method accurately
accounts for any linear trend in the data. This
method is also called as linear-trend smoothing.
(see example given on pg. 110)

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Table 3-3
Figure 3-5
3-23 Business Forecasting with Accompanying Excel-Based ForecastX Software

Winters Exponential Smoothing

This method is used when data exhibit both

trend and seasonality. To account for
seasonality, this method adds a third parameter
to the Holts model. (see equations given on
pg.112)
Winters exponential smoothing has been
implemented using data for the production of
light trucks in the United States by quarter.
(see Fig. 3.6 and Table 3.4)

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Figure 3-6
Table 3-4
3-26 Business Forecasting with Accompanying Excel-Based ForecastX Software

Adaptive-Response-Rate Single
Exponential Smoothing (ADRES)
This method is the same as simple exponential
smoothing except that it uses a different value
(smoothing factor) for each period.
The value of is determined in such a way that it
adapts to the changes in the basic pattern of the data.
Other than its ability to adapt to changing
circumstances, this method is the same as simple
smoothing model, so it is applied to data which have
little trend or seasonality.

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3-27 Business Forecasting with Accompanying Excel-Based ForecastX Software

Adaptive-Response-Rate Single Exponential

Smoothing (ADRES)

Ft+1 = tXt + (1- t)Ft As you see in the formula,

there may be a different value for each period.
1) et = Xt Ft
2) St = et + (1 )St-1 (Smoothed error)
3) At=|et| + (1 )At- (Absolute smoothed error)
4) t = |St/At|
In most cases is assigned a value of either 0.1
or 0.2. (See Table 3.5 on pg.116)

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Table 3-5
3-29 Business Forecasting with Accompanying Excel-Based ForecastX Software

Using Single, Holts or ADRES Smoothing to

Forecast a Seasonal Data Series

When we observe seasonal pattern in the data,

we can either use Winters smoothing model
or apply the following steps:
1. Calculate seasonal indices
2. Deseasonalize the data
3. Apply a forecasting method
4. Reseasonalize the data (See Table 3.6 and
Figure 3.7)

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Table 3-6
Figure 3-7
3-32 Business Forecasting with Accompanying Excel-Based ForecastX Software

Event Modeling

This technique helps to improve forecast accuracy by

taking into consideration special events such as
promotions, natural disasters.
The logic of event models is similar to seasonal
models: just as each period (i.e., month or a quarter)
is assigned its own index for seasonality, so, too, each
event type is assigned its own index for a specific
promotional activity.
See the event values used by a condiment manufacturer
on pg. 121.

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Figure 3-8
Table 3-7
Table 3-7 (continued)
Figure 3-9
Table 3-8