Business Forecasting

John E. Hanke Dean Wichern

Ninth Edition
 P E A R S O N C U S T O M L I B R A R Y

Table of Contents

1. Introduction to Forecasting
John E. Hanke/Dean Wichern 1
2. Exploring Data Patterns and an Introduction to Forecasting Techniques
John E. Hanke/Dean Wichern 15
3. Moving Averages and Smoothing Methods
John E. Hanke/Dean Wichern 61
4. Time Series and Their Components
John E. Hanke/Dean Wichern 119
5. Simple Linear Regression
John E. Hanke/Dean Wichern 175
6. Multiple Regression Analysis
John E. Hanke/Dean Wichern 235
7. Regression with Time Series Data
John E. Hanke/Dean Wichern 295
8. The Box-Jenkins (ARIMA) Methodology
John E. Hanke/Dean Wichern 355
9. Judgmental Forecasting and Forecast Adjustments
John E. Hanke/Dean Wichern 437
10. Managing the Forecasting Process
John E. Hanke/Dean Wichern 459
Appendix: Tables
John E. Hanke/Dean Wichern 477
Appendix: Data Sets and Databases
John E. Hanke/Dean Wichern 487
Index 501

I
 EXPLORING DATA PATTERNS
AND AN INTRODUCTION TO
FORECASTING TECHNIQUES
One of the most time-consuming and difficult parts of forecasting is the collection of
valid and reliable data. Data processing personnel are fond of using the expression
“garbage in, garbage out” (GIGO). This expression also applies to forecasting. A fore-
cast can be no more accurate than the data on which it is based. The most sophisticated
forecasting model will fail if it is applied to unreliable data.
Modern computer power and capacity have led to an accumulation of an incred-
ible amount of data on almost all subjects. The difficult task facing most forecasters
is how to find relevant data that will help solve their specific decision-making
problems.
Four criteria can be applied when determining whether data will be useful:
1. Data should be reliable and accurate. Proper care must be taken that data are col-
lected from a reliable source with proper attention given to accuracy.
2. Data should be relevant. The data must be representative of the circumstances for
which they are being used.
3. Data should be consistent. When definitions concerning data collection change,
adjustments need to be made to retain consistency in historical patterns. This
can be a problem, for example, when government agencies change the mix or
“market basket” used in determining a cost-of-living index. Years ago personal
computers were not part of the mix of products being purchased by consumers;
now they are.
4. Data should be timely. Data collected, summarized, and published on a timely
basis will be of greatest value to the forecaster. There can be too little data (not
enough history on which to base future outcomes) or too much data (data from
irrelevant historical periods far in the past).
Generally, two types of data are of interest to the forecaster. The first is data col-
lected at a single point in time, be it an hour, a day, a week, a month, or a quarter. The
second is observations of data made over time. When all observations are from the
same time period, we call them cross-sectional data. The objective is to examine such
data and then to extrapolate or extend the revealed relationships to the larger popu-
lation. Drawing a random sample of personnel files to study the circumstances of the
employees of a company is one example. Gathering data on the age and current
maintenance cost of nine Spokane Transit Authority buses is another. A scatter dia-
gram such as Figure 1 helps us visualize the relationship and suggests age might be
used to help in forecasting the annual maintenance budget.

From Chapter 3 of Business Forecasting, Ninth Edition. John E. Hanke, Dean W. Wichern.
Copyright © 2009 by Pearson Education, Inc. All rights reserved.
 Exploring Data Patterns and an Introduction to Forecasting Techniques

FIGURE 1 Scatter Diagram of Age and Maintenance Cost for

Nine Spokane Transit Authority Buses

Cross-sectional data are observations collected at a single point in time.

Any variable that consists of data that are collected, recorded, or observed over
successive increments of time is called a time series. Monthly U.S. beer production is an
example of a time series.

A time series consists of data that are collected, recorded, or observed over suc-
cessive increments of time.

EXPLORING TIME SERIES DATA PATTERNS

One of the most important steps in selecting an appropriate forecasting method for
time series data is to consider the different types of data patterns. There are typically
four general types of patterns: horizontal, trend, seasonal, and cyclical.
When data collected over time fluctuate around a constant level or mean, a
horizontal pattern exists. This type of series is said to be stationary in its mean. Monthly
sales for a food product that do not increase or decrease consistently over an extended
period would be considered to have a horizontal pattern.
When data grow or decline over several time periods, a trend pattern exists. Figure 2
shows the long-term growth (trend) of a time series variable (such as housing costs)
with data points one year apart. A linear trend line has been drawn to illustrate this
growth. Although the variable housing costs have not increased every year, the move-
ment of the variable has been generally upward between periods 1 and 20. Examples of
the basic forces that affect and help explain the trend of a series are population growth,
price inflation, technological change, consumer preferences, and productivity increases.
Exploring Data Patterns and an Introduction to Forecasting Techniques

25

Cyclical Peak

20

Cost

15
Cyclical Valley
Trend Line

10

0 10 20
Year

FIGURE 2 Trend and Cyclical Components of an Annual

Time Series Such as Housing Costs

Many macroeconomic variables, like the U.S. gross national product (GNP),
employment, and industrial production exhibit trendlike behavior. Figure 10 contains
another example of a time series with a prevailing trend. This figure shows the growth
of operating revenue for Sears from 1955 to 2004.

The trend is the long-term component that represents the growth or decline in
the time series over an extended period of time.

When observations exhibit rises and falls that are not of a fixed period, a cyclical
pattern exists. The cyclical component is the wavelike fluctuation around the trend that
is usually affected by general economic conditions. A cyclical component, if it exists,
typically completes one cycle over several years. Cyclical fluctuations are often influ-
enced by changes in economic expansions and contractions, commonly referred to as
the business cycle. Figure 2 also shows a time series with a cyclical component. The
cyclical peak at year 9 illustrates an economic expansion and the cyclical valley at year
12 an economic contraction.

The cyclical component is the wavelike fluctuation around the trend.

When observations are influenced by seasonal factors, a seasonal pattern exists.

The seasonal component refers to a pattern of change that repeats itself year after year.
For a monthly series, the seasonal component measures the variability of the series
each January, each February, and so on. For a quarterly series, there are four seasonal
elements, one for each quarter. Figure 3 shows that electrical usage for Washington
 Exploring Data Patterns and an Introduction to Forecasting Techniques

Electrical Usage for Washington Water Power: 1980 –1991

1,100

1,000

Kilowatts 900

800

700

600

500

1980 1982 1984 1986 1988 1990

Year

FIGURE 3 Electrical Usage for Washington Water Power

Company, 1980–1991

Water Power residential customers is highest in the first quarter (winter months) of
each year. Figure 14 shows that the quarterly sales for Coastal Marine are typically low
in the first quarter of each year. Seasonal variation may reflect weather conditions,
school schedules, holidays, or length of calendar months.

The seasonal component is a pattern of change that repeats itself year after year.

EXPLORING DATA PATTERNS WITH AUTOCORRELATION ANALYSIS

When a variable is measured over time, observations in different time periods are fre-
quently related or correlated. This correlation is measured using the autocorrelation
coefficient.

Autocorrelation is the correlation between a variable lagged one or more time

periods and itself.

Data patterns, including components such as trend and seasonality, can be studied
using autocorrelations. The patterns can be identified by examining the autocorrela-
tion coefficients at different time lags of a variable.
The concept of autocorrelation is illustrated by the data presented in Table 1. Note
that variables Yt - 1 and Yt - 2 are actually the Y values that have been lagged by one and
two time periods, respectively. The values for March, which are shown on the row for
time period 3, are March sales, Yt = 125; February sales, Yt - 1 = 130; and January sales,
Yt - 2 = 123.
Exploring Data Patterns and an Introduction to Forecasting Techniques

TABLE 1 VCR Data for Example 1

Time Original Data Y Lagged One Y Lagged Two

t Month Yt Period Yt-1 Periods Yt-2

1 January 123
2 February 130 123
3 March 125 130 123
4 April 138 125 130
5 May 145 138 125
6 June 142 145 138
7 July 141 142 145
8 August 146 141 142
9 September 147 146 141
10 October 157 147 146
11 November 150 157 147
12 December 160 150 157

Equation 1 is the formula for computing the lag k autocorrelation coefficient (rk)
between observations, Yt and Yt - k that are k periods apart.

a 1Yt - Y 21Yt - k - Y 2
n

t=k+1
rk = k = 0, 1, 2, Á (1)
a 1Yt - Y 2
n
2
t=1

where
rk = the autocorrelation coefficient for a lag of k periods
Y = the mean of the values of the series
Yt = the observation in time period t
Yt - k = the observation k time periods earlier or at time period t - k

Example 1
Harry Vernon has collected data on the number of VCRs sold last year by Vernon’s Music
Store. The data are presented in Table 1. Table 2 shows the computations that lead to the cal-
culation of the lag 1 autocorrelation coefficient. Figure 4 contains a scatter diagram of the
pairs of observations (Yt, Yt - 1). It is clear from the scatter diagram that the lag 1 correlation
will be positive.
The lag 1 autocorrelation coefficient (r1), or the autocorrelation between Yt and Yt-1 ,
is computed using the totals from Table 2 and Equation 1. Thus,

a 1Yt-1 - Y 21Yt - Y2
n

t=1+1 843
r1 = = = .572
a 1Yt - Y2
n
2 1,474
t=1

As suggested by the plot in Figure 4, positive lag 1 autocorrelation exists in this time
series. The correlation between Yt and Yt-1 or the autocorrelation for time lag 1, is .572. This
means that the successive monthly sales of VCRs are somewhat correlated with each other.
This information may give Harry valuable insights about his time series, may help him pre-
pare to use an advanced forecasting method, and may warn him about using regression
analysis with his data.
 Exploring Data Patterns and an Introduction to Forecasting Techniques

TABLE 2 Computation of the Lag 1 Autocorrelation Coefficient

for the Data in Table 1
—
Time t Yt Yt - 1 1Yt - Y 2 1Yt - 1 - Y 2 1Y - Y 22 (Yt - Y 2 (Yt–1 — Y )
1 123 — –19 — 361 —
2 130 123 -12 -19 144 228
3 125 130 -17 -12 289 204
4 138 125 -4 -17 16 68
5 145 138 3 -4 9 -12
6 142 145 0 3 0 0
7 141 142 -1 0 1 0
8 146 141 4 -1 16 -4
9 147 146 5 4 25 20
10 157 147 15 5 225 75
11 150 157 8 15 64 120
12 160 150 18 8 324 144
Total 1,704 0 1,474 843
1,704
Y = = 142
12
843
r1 = = .572
1,474

The second-order autocorrelation coefficient (r2), or the correlation between Yt and

Yt-2 for Harry’s data, is also computed using Equation 1.

a 1Yt - Y21Yt - 2 - Y2
n

t=2+1 682
r2 = = = .463
a 1Yt - Y2
n
2 1,474
t=1
Yt

Yt!1

FIGURE 4 Scatter Diagram for Vernon’s Music Store Data for

Example 1
Exploring Data Patterns and an Introduction to Forecasting Techniques

It appears that moderate autocorrelation exists in this time series lagged two time peri-
ods. The correlation between Yt and Yt - 2, or the autocorrelation for time lag 2, is .463. Notice
that the autocorrelation coefficient at time lag 2 (.463) is less than the autocorrelation coef-
ficient at time lag 1 (.572). Generally, as the number of time lags (k) increases, the magni-
tudes of the autocorrelation coefficients decrease.

Figure 5 shows a plot of the autocorrelations versus time lags for the Harry Vernon
data used in Example 1. The horizontal scale on the bottom of the graph shows each time
lag of interest: 1, 2, 3, and so on.The vertical scale on the left shows the possible range of an
autocorrelation coefficient, -1 to 1. The horizontal line in the middle of the graph repre-
sents autocorrelations of zero.The vertical line that extends upward above time lag 1 shows
an autocorrelation coefficient of .57, or r1 = .57. The vertical line that extends upward
above time lag 2 shows an autocorrelation coefficient of .46, or r2 = .46. The dotted lines
and the T (test) and LBQ (Ljung-Box Q) statistics displayed in the Session window will be
discussed in Examples 2 and 3. Patterns in a correlogram are used to analyze key features
of the data, a concept demonstrated in the next section. The Minitab computer package
(see the Minitab Applications section at the end of the chapter for specific instructions) can
be used to compute autocorrelations and develop correlograms.

The correlogram or autocorrelation function is a graph of the autocorrelations for

various lags of a time series.

FIGURE 5 Correlogram or Autocorrelation Function for the Data

Used in Example 1
Exploring Data Patterns and an Introduction to Forecasting Techniques

With a display such as that in Figure 5, the data patterns, including trend and sea-
sonality, can be studied. Autocorrelation coefficients for different time lags for a vari-
able can be used to answer the following questions about a time series:
1. Are the data random?
2. Do the data have a trend (are they nonstationary)?
3. Are the data stationary?
4. Are the data seasonal?
If a series is random, the autocorrelations between Yt and Yt - k for any time lag k
are close to zero. The successive values of a time series are not related to each other.
If a series has a trend, successive observations are highly correlated, and the auto-
correlation coefficients typically are significantly different from zero for the first sev-
eral time lags and then gradually drop toward zero as the number of lags increases.
The autocorrelation coefficient for time lag 1 will often be very large (close to 1). The
autocorrelation coefficient for time lag 2 will also be large. However, it will not be as
large as for time lag 1.
If a series has a seasonal pattern, a significant autocorrelation coefficient will occur
at the seasonal time lag or multiples of the seasonal lag. The seasonal lag is 4 for quar-
terly data and 12 for monthly data.
How does an analyst determine whether an autocorrelation coefficient is signifi-
cantly different from zero for the data of Table 1? Quenouille (1949) and others have
demonstrated that the autocorrelation coefficients of random data have a sampling dis-
tribution that can be approximated by a normal curve with a mean of zero and an
approximate standard deviation of 1> 1n. Knowing this, the analyst can compare the
sample autocorrelation coefficients with this theoretical sampling distribution and deter-
mine whether, for given time lags, they come from a population whose mean is zero.
Actually, some software packages use a slightly different formula, as shown in
Equation 2, to compute the standard deviations (or standard errors) of the autocorre-
lation coefficients. This formula assumes that any autocorrelation before time lag k is
different from zero and any autocorrelation at time lags greater than or equal to k is
zero. For an autocorrelation at time lag 1, the standard error 1> 1n is used.

1 + 2 a r 2i
k-1

i=1
SE1rk2 = (2)
T n

where
SE1rk2 = the standard error 1estimated standard deviation2
of the autocorrelation at time lag k
ri = the autocorrelation at time lag i
k = the time lag
n = the number of observations in the time series
This computation will be demonstrated in Example 2. If the series is truly random,
almost all of the sample autocorrelation coefficients should lie within a range specified
by zero, plus or minus a certain number of standard errors. At a specified confidence
level, a series can be considered random if each of the calculated autocorrelation coef-
ficients is within the interval about 0 given by 0 ± t × SE(rk), where the multiplier t is an
appropriate percentage point of a t distribution.
Exploring Data Patterns and an Introduction to Forecasting Techniques

Although testing each rk to see if it is individually significantly different from 0 is

useful, it is also good practice to examine a set of consecutive rk’s as a group. We can
use a portmanteau test to see whether the set, say, of the first 10 rk values, is signifi-
cantly different from a set in which all 10 values are zero.
One common portmanteau test is based on the Ljung-Box Q statistic (Equation
3). This test is usually applied to the residuals of a forecast model. If the autocorre-
lations are computed from a random (white noise) process, the statistic Q has a chi-
square distribution with m (the number of time lags to be tested) degrees of free-
dom. For the residuals of a forecast model, however, the statistic Q has a chi-square
distribution with the degrees of freedom equal to m minus the number of parame-
ters estimated in the model. The value of the Q statistic can be compared with the
chi-square table (Table 4 in Appendix: Tables) to determine if it is larger than we
would expect it to be under the null hypothesis that all the autocorrelations in the
set are zero. Alternatively, the p-value generated by the test statistic Q can be com-
puted and interpreted. The Q statistic is given in Equation 3. It will be demonstrated
in Example 3.

Q = n1n + 22 a
m
r 2k
(3)
k=1 n - k

where
n = the number of observations in the time series
k = the time lag
m = the number of time lags to be tested
rk = the sample autocorrelation function of the residuals lagged k time periods

Are the Data Random?

A simple random model, often called a white noise model, is displayed in Equation 4.
Observation Yt is composed of two parts: c, the overall level, and "t, which is the ran-
dom error component. It is important to note that the "t component is assumed to be
uncorrelated from period to period.

Yt = c + "t (4)

Are the data in Table 1 consistent with this model? This issue will be explored in
Examples 2 and 3.

Example 2
A hypothesis test is developed to determine whether a particular autocorrelation coefficient
is significantly different from zero for the correlogram shown in Figure 5. The null and alter-
native hypotheses for testing the significance of the lag 1 population autocorrelation coeffi-
cient are

H0 : r1 = 0
H1 : r1 Z 0

If the null hypothesis is true, the test statistic

r1 - r1 r1 - 0 r1
t = = = (5)
SE1r12 SE1r12 SE1r12
Exploring Data Patterns and an Introduction to Forecasting Techniques

has a t distribution with df = n - 1. Here, n - 1 = 12 - 1 = 11, so for a 5% significance

level, the decision rule is as follows:

If t 6 2.2 or t 7 2.2, reject H0 and conclude the lag 1 autocorrelation is significantly

different from 0.

The critical values #2.2 are the upper and lower .025 points of a t distribution with 11
degrees of freedom. The standard error of r1 is SE1r12 = 11>12 = 1.083 = .289, and the
value of the test statistic becomes

r1 .572
t = = = 1.98
SE1r12 .289

Using the decision rule above, H0 : r1 = 0 cannot be rejected, since -2.2 < 1.98 < 2.2.
Notice the value of our test statistic, t = 1.98, is the same as the quantity in the Lag 1 row
under the heading T in the Minitab output in Figure 5. The T values in the Minitab out-
put are simply the values of the test statistic for testing for zero autocorrelation at the
various lags.
To test for zero autocorrelation at time lag 2, we consider

H0 : r2 = 0
H1 : r2 Z 0

and the test statistic

r2 - r2 r2 - 0 r2
t = = =
SE1r22 SE122 SE1r22

Using Equation 2,

1 + 2 a r 2i 1 + 2 a r 2i
k-1 2-1

i=1 i=1 1 + 21.57222 1.6544

SE1r22 = T = T = = = 1.138 = .371
n n Q 12 A 12

and

.463
t = = 1.25
.371

This result agrees with the T value for Lag 2 in the Minitab output in Figure 5.
Using the decision rule above, H0 : r1 = 0 cannot be rejected at the .05 level, since
-2.2 $ 1.25 $ 2.2. An alternative way to check for significant autocorrelation is to construct,
say, 95% confidence limits centered at 0. These limits for time lags 1 and 2 are as follows:

lag 1: 0 ; t.025 * SE1r12 or 0 ; 2.21.2892 : 1-.636, .6362

lag 2: 0 ; t.025 * SE1r22 or 0 ; 2.21.3712 : 1-.816, .8162

Autocorrelation significantly different from 0 is indicated whenever a value for rk falls out-
side the corresponding confidence limits. The 95% confidence limits are shown in Figure 5 by
the dashed lines in the graphical display of the autocorrelation function.

Example 3
Minitab was used to generate the time series of 40 pseudo-random three-digit numbers
shown in Table 3. Figure 6 shows a time series graph of these data. Because these data are
random (independent of one another and all from the same population), autocorrelations for
Exploring Data Patterns and an Introduction to Forecasting Techniques

TABLE 3 Time Series of 40 Random Numbers for Example 3

t Yt t Yt t Yt t Yt

1 343 11 946 21 704 31 555

2 574 12 142 22 291 32 476
3 879 13 477 23 43 33 612
4 728 14 452 24 118 34 574
5 37 15 727 25 682 35 518
6 227 16 147 26 577 36 296
7 613 17 199 27 834 37 970
8 157 18 744 28 981 38 204
9 571 19 627 29 263 39 616
10 72 20 122 30 424 40 97

all time lags should theoretically be equal to zero. Of course, the 40 values in Table 3 are only
one set of a large number of possible samples of size 40. Each sample will produce different
autocorrelations. Most of these samples will produce sample autocorrelation coefficients that
are close to zero. However, it is possible that a sample will produce an autocorrelation coef-
ficient that is significantly different from zero just by chance.
Next, the autocorrelation function shown in Figure 7 is constructed using Minitab. Note
that the two dashed lines show the 95% confidence limits. Ten time lags are examined, and all
the individual autocorrelation coefficients lie within these limits. There is no reason to doubt
that each of the autocorrelations for the first 10 lags is zero. However, even though the individ-
ual sample autocorrelations are not significantly different from zero, are the magnitudes of
the first 10 rk’s as a group larger than one would expect under the hypothesis of no autocorre-
lation at any lag? This question is answered by the Ljung-Box Q (LBQ in Minitab) statistic.
If there is no autocorrelation at any lag, the Q statistic has a chi-square distribution
with, in this case, df = 10. Consequently, a large value for Q (in the tail of the chi-square dis-
tribution) is evidence against the null hypothesis. From Figure 7, the value of Q (LBQ) for
10 time lags is 7.75. From Table 4 in Appendix: Tables, the upper .05 point of a chi-square
distribution with 10 degrees of freedom is 18.31. Since 7.75 < 18.31, the null hypothesis can-
not be rejected at the 5% significance level. These data are uncorrelated at any time lag, a
result consistent with the model in Equation 4.
Yt

FIGURE 6 Time Series Plot of 40 Random Numbers Used

in Example 3
Exploring Data Patterns and an Introduction to Forecasting Techniques

FIGURE 7 Autocorrelation Function for the Data Used in Example 3

Do the Data Have a Trend?

If a series has a trend, a significant relationship exists between successive time series
values. The autocorrelation coefficients are typically large for the first several time lags
and then gradually drop toward zero as the number of lags increases.
A stationary time series is one whose basic statistical properties, such as the mean
and variance, remain constant over time. Consequently, a series that varies about a fixed
level (no growth or decline) over time is said to be stationary. A series that contains a
trend is said to be nonstationary. The autocorrelation coefficients for a stationary series
decline to zero fairly rapidly, generally after the second or third time lag. On the other
hand, sample autocorrelations for a nonstationary series remain fairly large for several
time periods. Often, to analyze nonstationary series, the trend is removed before addi-
tional modeling occurs.
A method called differencing can often be used to remove the trend from a nonsta-
tionary series. The VCR data originally presented in Table 1 are shown again in
Figure 8, column A. The Yt values lagged one period, Yt - 1, are shown in column B.
The differences, Yt - Yt - 1 (column A - column B), are shown in column C. For
example, the first value for the differences is Y2 - Y1 = 130 - 123 = 7 . Note the
upward growth or trend of the VCR data shown in Figure 9, plot A. Now observe
the stationary pattern of the differenced data in Figure 9, plot B. Differencing the
data has removed the trend.
Example 4
Maggie Trymane, an analyst for Sears, is assigned the task of forecasting operating revenue
for 2005. She gathers the data for the years 1955 to 2004, shown in Table 4. The data
are plotted as a time series in Figure 10. Notice that, although Sears operating revenues
were declining over the 2000–2004 period, the general trend over the entire 1955–2004 time
frame is up. First, Maggie computes a 95% confidence interval for the autocorrelation coef-
ficients at time lag 1 using 0 ; Z.02511> 1n2 where, for large samples, the standard normal
.025 point has replaced the corresponding t distribution percentage point:
0 ; 1.96111>502
0 ; .277
Next, Maggie runs the data on Minitab and produces the autocorrelation function
shown in Figure 11. Upon examination, she notices that the autocorrelations for the first
FIGURE 8 Excel Results for Differencing the VCR Data of Example 1
Yt

FIGURE 9 Time Series Plots of the VCR Data and the

Differenced VCR Data of Example 1
Exploring Data Patterns and an Introduction to Forecasting Techniques

TABLE 4 Yearly Operating Revenue for Sears, 1955–2004, for Example 4

Year Yt Year Yt Year Yt Year Yt Year Yt

1955 3,307 1967 7,296 1979 17,514 1991 57,242 2003 23,253
1956 3,556 1968 8,178 1980 25,195 1992 52,345 2004 19,701
1957 3,601 1969 8,844 1981 27,357 1993 50,838
1958 3,721 1970 9,251 1982 30,020 1994 54,559
1959 4,036 1971 10,006 1983 35,883 1995 34,925
1960 4,134 1972 10,991 1984 38,828 1996 38,236
1961 4,268 1973 12,306 1985 40,715 1997 41,296
1962 4,578 1974 13,101 1986 44,282 1998 41,322
1963 5,093 1975 13,639 1987 48,440 1999 41,071
1964 5,716 1976 14,950 1988 50,251 2000 40,937
1965 6,357 1977 17,224 1989 53,794 2001 36,151
1966 6,769 1978 17,946 1990 55,972 2002 30,762

Source: Industry Surveys, various years.

FIGURE 10 Time Series Plot of Sears Operating Revenue

for Example 4

four time lags are significantly different from zero (.96, .92, .87, and .81) and that the values
then gradually drop to zero. As a final check, Maggie looks at the Q statistic for 10 time lags.
The LBQ is 300.56, which is greater than the chi-square value 18.3 (the upper .05 point of a
chi-square distribution with 10 degrees of freedom). This result indicates the autocorrela-
tions for the first 10 lags as a group are significantly different from zero. She decides that the
data are highly autocorrelated and exhibit trendlike behavior.
Maggie suspects that the series can be differenced to remove the trend and to create a
stationary series. She differences the data (see the Minitab Applications section at the end
of the chapter), and the results are shown in Figure 12. The differenced series shows no evi-
dence of a trend, and the autocorrelation function, shown in Figure 13, appears to support
this conclusion. Examining Figure 13, Maggie notes that the autocorrelation coefficient at
time lag 3, .32, is significantly different from zero (tested at the .05 significance level). The
autocorrelations at lags other than lag 3 are small, and the LBQ statistic for 10 lags is also
relatively small, so there is little evidence to suggest the differenced data are autocorrelated.
Yet Maggie wonders whether there is some pattern in these data that can be modeled by
one of the more advanced forecasting techniques.
Exploring Data Patterns and an Introduction to Forecasting Techniques

FIGURE 11 Autocorrelation Function for Sears Operating

Revenue for Example 4

FIGURE 12 Time Series Plot of the First Differences of the

Sears Operating Revenue for Example 4

FIGURE 13 Autocorrelation Function for the First Differences of

the Sears Operating Revenue for Example 4
 Exploring Data Patterns and an Introduction to Forecasting Techniques

TABLE 5 Quarterly Sales for Coastal Marine,

1994–2006, for Example 5

Fiscal Year December 31 March 31 June 30 September 30

1994 147.6 251.8 273.1 249.1

1995 139.3 221.2 260.2 259.5
1996 140.5 245.5 298.8 287.0
1997 168.8 322.6 393.5 404.3
1998 259.7 401.1 464.6 479.7
1999 264.4 402.6 411.3 385.9
2000 232.7 309.2 310.7 293.0
2001 205.1 234.4 285.4 258.7
2002 193.2 263.7 292.5 315.2
2003 178.3 274.5 295.4 286.4
2004 190.8 263.5 318.8 305.5
2005 242.6 318.8 329.6 338.2
2006 232.1 285.6 291.0 281.4

Are the Data Seasonal?

If a series is seasonal, a pattern related to the calendar repeats itself over a particular
interval of time (usually a year). Observations in the same position for different sea-
sonal periods tend to be related. If quarterly data with a seasonal pattern are analyzed,
first quarters tend to look alike, second quarters tend to look alike, and so forth, and a
significant autocorrelation coefficient will appear at time lag 4. If monthly data are
analyzed, a significant autocorrelation coefficient will appear at time lag 12. That is,
January will correlate with other Januarys, February will correlate with other
Februarys, and so on. Example 5 discusses a series that is seasonal.
Example 5
Perkin Kendell is an analyst for the Coastal Marine Corporation. He has always felt that
sales were seasonal. Perkin gathers the data shown in Table 5 for the quarterly sales of the
Coastal Marine Corporation from 1994 to 2006 and plots them as the time series graph
shown in Figure 14. Next, he computes a large-sample 95% confidence interval for the auto-
correlation coefficient at time lag 1:

0 ; 1.96 11>52
0 ; .272

Then Perkin computes the autocorrelation coefficients shown in Figure 15. He notes
that the autocorrelation coefficients at time lags 1 and 4 are significantly different from zero
(r1 = .39 7 .272 and r4 = .74 7 .333). He concludes that Coastal Marine sales are seasonal
on a quarterly basis.

CHOOSING A FORECASTING TECHNIQUE

This text is devoted mostly to explaining various forecasting techniques and demon-
strating their usefulness. First, the important job of choosing among several forecasting
techniques is addressed.
Some of the questions that must be considered before deciding on the most appro-
priate forecasting technique for a particular problem follow:
• Why is a forecast needed?
• Who will use the forecast?
Exploring Data Patterns and an Introduction to Forecasting Techniques

FIGURE 14 Time Series Plot of Quarterly Sales for Coastal

Marine for Example 5

FIGURE 15 Autocorrelation Function for Quarterly Sales for

Coastal Marine for Example 5

• What are the characteristics of the available data?

• What time period is to be forecast?
• What are the minimum data requirements?
• How much accuracy is desired?
• What will the forecast cost?
To select the appropriate forecasting technique properly, the forecaster must be
able to accomplish the following:
• Define the nature of the forecasting problem.
• Explain the nature of the data under investigation.
• Describe the capabilities and limitations of potentially useful forecasting techniques.
• Develop some predetermined criteria on which the selection decision can be made.
A major factor influencing the selection of a forecasting technique is the identifica-
tion and understanding of historical patterns in the data. If trend, cyclical, or seasonal
Exploring Data Patterns and an Introduction to Forecasting Techniques

patterns can be recognized, then techniques that are capable of effectively extrapolating
these patterns can be selected.
Forecasting Techniques for Stationary Data
A stationary series was defined earlier as one whose mean value is not changing over
time. Such situations arise when the demand patterns influencing the series are rela-
tively stable. It is important to recognize that stationary data do not necessarily vary
randomly about a mean level. Stationary series can be autocorrelated, but the nature
of the association is such that the data do not wander away from the mean for any
extended period of time. In its simplest form, forecasting a stationary series involves
using the available history of the series to estimate its mean value, which then becomes
the forecast for future periods. More-sophisticated techniques allow the first few fore-
casts to be somewhat different from the estimated mean but then revert to the mean
for additional future periods. Forecasts can be updated as new information becomes
available. Updating is useful when initial estimates are unreliable or when the stability
of the average is in question. In the latter case, updating provides some degree of
responsiveness to a potential change in the underlying level of the series.
Stationary forecasting techniques are used in the following circumstances:
• The forces generating a series have stabilized, and the environment in which the
series exists is relatively unchanging. Examples are the number of breakdowns per
week on an assembly line having a uniform production rate, the unit sales of a
product or service in the maturation stage of its life cycle, and the number of sales
resulting from a constant level of effort.
• A very simple model is needed because of a lack of data or for ease of explanation or
implementation. An example is when a business or organization is new and very
few historical data are available.
• Stability may be obtained by making simple corrections for factors such as popula-
tion growth or inflation. Examples are changing income to per capita income and
changing dollar sales to constant dollar amounts.
• The series may be transformed into a stable one. Examples are transforming a
series by taking logarithms, square roots, or differences.
• The series is a set of forecast errors from a forecasting technique that is considered
adequate. (See Example 7.)
Techniques that should be considered when forecasting stationary series include
naive methods, simple averaging methods, moving averages, and autoregressive mov-
ing average (ARMA) models (Box-Jenkins methods).

Forecasting Techniques for Data with a Trend

Simply stated, a trend in a time series is a persistent, long-term growth or decline. For a
trending time series, the level of the series is not constant. It is common for economic
time series to contain a trend.
Forecasting techniques for trending data are used in the following circumstances:
• Increased productivity and new technology lead to changes in lifestyle. Examples
are the demands for electronic components, which increased with the advent of the
computer, and railroad usage, which decreased with the advent of the airplane.
• Increasing population causes increases in demand for goods and services. Examples
are the sales revenues of consumer goods, demand for energy consumption, and use
of raw materials.
• The purchasing power of the dollar affects economic variables due to inflation.
Examples are salaries, production costs, and prices.
Exploring Data Patterns and an Introduction to Forecasting Techniques

• Market acceptance increases. An example is the growth period in the life cycle of a
new product.
Techniques that should be considered when forecasting trending series include
moving averages, Holt’s linear exponential smoothing, simple regression, growth
curves, exponential models, and autoregressive integrated moving average (ARIMA)
models (Box-Jenkins methods).

Forecasting Techniques for Seasonal Data

A seasonal series was defined earlier as a time series with a pattern of change that
repeats itself year after year. One way to develop seasonal forecasts is to estimate sea-
sonal indexes from the history of the series. For example, with monthly data, there is an
index for January, an index for February, and so forth. These indexes are then used to
include seasonality in forecasts or to remove such effects from the observed values. The
latter process is referred to as seasonally adjusting the data.
Forecasting techniques for seasonal data are used in the following circumstances:
• Weather influences the variable of interest. Examples are electrical consumption,
summer and winter activities (e.g., sports such as skiing), clothing, and agricultural
growing seasons.
• The annual calendar influences the variable of interest. Examples are retail sales
influenced by holidays, three-day weekends, and school calendars.
Techniques that should be considered when forecasting seasonal series include
classical decomposition, Census X-12, Winter’s exponential smoothing, multiple
regression, and ARIMA models (Box-Jenkins methods).

Forecasting Techniques for Cyclical Series

The cyclical effect was defined earlier as the wavelike fluctuation around the trend.
Cyclical patterns are difficult to model because their patterns are typically not stable.
The up-down wavelike fluctuations around the trend rarely repeat at fixed intervals of
time, and the magnitude of the fluctuations also tends to vary. Decomposition methods
can be extended to analyze cyclical data. However, because of the irregular behavior of
cycles, analyzing the cyclical component of a series, if it exists, often requires finding
coincident or leading economic indicators.
Forecasting techniques for cyclical data are used in the following circumstances:
• The business cycle influences the variable of interest. Examples are economic, mar-
ket, and competition factors.
• Shifts in popular tastes occur. Examples are fashions, music, and food.
• Shifts in population occur. Examples are wars, famines, epidemics, and natural
disasters.
• Shifts in product life cycle occur. Examples are introduction, growth, maturation
and market saturation, and decline.
Techniques that should be considered when forecasting cyclical series include clas-
sical decomposition, economic indicators, econometric models, multiple regression,
and ARIMA models (Box-Jenkins methods).

Other Factors to Consider When Choosing a Forecasting Technique

The time horizon for a forecast has a direct bearing on the selection of a forecasting
technique. For short- and intermediate-term forecasts, a variety of quantitative tech-
niques can be applied. As the forecasting horizon increases, however, a number of
Exploring Data Patterns and an Introduction to Forecasting Techniques

these techniques become less applicable. For instance, moving averages, exponential
smoothing, and ARIMA models are poor predictors of economic turning points,
whereas econometric models are more useful. Regression models are appropriate for
the short, intermediate, and long terms. Means, moving averages, classical decomposi-
tion, and trend projections are quantitative techniques that are appropriate for the
short and intermediate time horizons. The more complex Box-Jenkins and economet-
ric techniques are also appropriate for short- and intermediate-term forecasts.
Qualitative methods are frequently used for longer time horizons.
The applicability of forecasting techniques is generally something a forecaster
bases on experience. Managers frequently need forecasts in a relatively short time.
Exponential smoothing, trend projection, regression models, and classical decomposi-
tion methods have an advantage in this situation. (See Table 6.)
Computer costs are no longer a significant part of technique selection. Desktop
computers (microprocessors) and forecasting software packages are becoming com-
monplace for many organizations. Due to these developments, other criteria will likely
overshadow computer cost considerations.
Ultimately, a forecast will be presented to management for approval and use in the
planning process. Therefore, ease of understanding and interpreting the results is an
important consideration. Regression models, trend projections, classical decomposi-
tion, and exponential smoothing techniques all rate highly on this criterion.
It is important to point out that the information displayed in Table 6 should be
used as a guide for the selection of a forecasting technique. It is good practice to try

TABLE 6 Choosing a Forecasting Technique

Minimal Data Requirements

Pattern of Time Type of
Method Data Horizon Model Nonseasonal Seasonal

Naive ST, T, S S TS 1
Simple averages ST S TS 30
Moving averages ST S TS 4–20
Exponential smoothing ST S TS 2
Linear exponential smoothing T S TS 3
Quadratic exponential smoothing T S TS 4
Seasonal exponential smoothing S S TS 2×s
Adaptive filtering S S TS 5×s
Simple regression T I C 10
Multiple regression C, S I C 10 × V
Classical decomposition S S TS 5×s
Exponential trend models T I, L TS 10
S-curve fitting T I, L TS 10
Gompertz models T I, L TS 10
Growth curves T I, L TS 10
Census X-12 S S TS 6×s
Box-Jenkins ST, T, C, S S TS 24 3×s
Leading indicators C S C 24
Econometric models C S C 30
Time series multiple regression T, S I, L C 6×s
Pattern of the data: ST, stationary; T, trending; S, seasonal; C, cyclical
Time horizon: S, short term (less than three months); I, intermediate term; L, long term
Type of model: TS, time series; C, causal
Seasonal: s, length of seasonality
Variable: V, number of variables
 Exploring Data Patterns and an Introduction to Forecasting Techniques

more than one forecasting method for a particular problem, holding out some recent
data, and then to compute forecasts of these holdout observations using the different
methods. The performance of the methods for these holdout test cases can be
determined using one or more of the accuracy measures defined in Equations 7
through 11, discussed below. Assuming an adequate fit to the data, the most accurate
method (the one with the smallest forecast error) is a reasonable choice for the “best”
method. It may not be the best method in the next situation.
Empirical Evaluation of Forecasting Methods
Empirical research has found that the forecast accuracy of simple methods is often as
good as that of complex or statistically sophisticated techniques (see Fildes et al., 1997;
Makridakis et al., 1993; and Makridakis and Hibon, 2000). Results of the M3–IJF
Competition, where different experts using their favorite forecasting methodology
each generated forecasts for 3,003 different time series, tended to support this finding
(Makridakis and Hibon, 2000). It would seem that the more statistically complex a
technique is, the better it should predict time series patterns. Unfortunately, estab-
lished time series patterns can and do change in the future. Thus, having a model that
best represents the historical data (the thing complex methods do well) does not neces-
sarily guarantee more accuracy in future predictions. Of course, the ability of the fore-
caster also plays an important role in the development of a good forecast.
The M3–IJF Competition was held in 1997. The forecasts produced by the various
forecasting techniques were compared across the sample of 3,003 time series, with the
accuracy assessed using a range of measures on a holdout set. The aim of the 1997
study was to check the four major conclusions of the original M-Competition on a
larger data set (see Makridakis et al., 1982). Makridakis and Hibon (2000) summarized
the latest competition as follows:
1. As discussed previously, statistically sophisticated or complex methods do not nec-
essarily produce more accurate forecasts than simpler methods.
2. Various accuracy measures produce consistent results when used to evaluate dif-
ferent forecasting methods.
3. The combination of three exponential smoothing methods outperforms, on aver-
age, the individual methods being combined and does well in comparison with
other methods.
4. The performance of the various forecasting methods depends on the length of the
forecasting horizon and the kind of data (yearly, quarterly, monthly) analyzed.
Some methods perform more accurately for short horizons, whereas others are
more appropriate for longer ones. Some methods work better with yearly data, and
others are more appropriate for quarterly and monthly data.
As part of the final selection, each technique must be evaluated in terms of its reli-
ability and applicability to the problem at hand, its cost effectiveness and accuracy
compared with competing techniques, and its acceptance by management. Table 6 sum-
marizes forecasting techniques appropriate for particular data patterns. As we have
pointed out, this table represents a place to start—that is, methods to consider for data
with certain characteristics. Ultimately, any chosen method should be continuously
monitored to be sure it is adequately doing the job for which it was intended.

MEASURING FORECAST ERROR

Because quantitative forecasting techniques frequently involve time series data, a
mathematical notation is developed to refer to each specific time period. The letter Y
will be used to denote a time series variable unless there is more than one variable
Exploring Data Patterns and an Introduction to Forecasting Techniques

involved. The time period associated with an observation is shown as a subscript.

Thus, Yt refers to the value of the time series at time period t. The quarterly data for
the Coastal Marine Corporation presented in Example 5 would be denoted
Y1 = 147.6, Y2 = 251.8, Y3 = 273.1, . . . , Y52 = 281.4.
Mathematical notation must also be developed to distinguish between an actual
value of the time series and the forecast value. A ^ (hat) will be placed above a value to
indicate that it is being forecast. The forecast value for Yt is YN t. The accuracy of a fore-
casting technique is frequently judged by comparing the original series, Y1, Y2, . . . . , to
the series of forecast values, YN1, YN2, . . . .
Basic forecasting notation is summarized as follows:
Yt = the value of a time series at period t
YNt = the forecast value of Yt
et = Yt - YNt = the residual or forecast error
Several methods have been devised to summarize the errors generated by a partic-
ular forecasting technique. Most of these measures involve averaging some function of
the difference between an actual value and its forecast value. These differences
between observed values and forecast values are often referred to as residuals.

A residual is the difference between an actual observed value and its forecast
value.

Equation 6 is used to compute the error or residual for each forecast period.
et = Yt - YNt (6)
where
et = the forecast error in time period t
Yt = the actual value in time period t
YNt = the forecast value for time period t
One method for evaluating a forecasting technique uses the sum of the absolute
errors. The mean absolute deviation (MAD) measures forecast accuracy by averaging
the magnitudes of the forecast errors (the absolute values of the errors). The MAD is
in the same units as the original series and provides an average size of the “miss”
regardless of direction. Equation 7 shows how the MAD is computed.

n ta
1 n
MAD = ƒ Yt - YNt ƒ (7)
=1

The mean squared error (MSE) is another method for evaluating a forecasting
technique. Each error or residual is squared; these are then summed and divided by the
number of observations. This approach penalizes large forecasting errors, since the
errors are squared. This is important because a technique that produces moderate
errors may well be preferable to one that usually has small errors but occasionally
yields extremely large ones. The MSE is given by Equation 8.

n ta
1 n
MSE = 1Yt - YNt 22 (8)
=1

The square root of the MSE, or the root mean squared error (RMSE), is also used
to evaluate forecasting methods. The RMSE, like the MSE, penalizes large errors but
Exploring Data Patterns and an Introduction to Forecasting Techniques

has the same units as the series being forecast so its magnitude is more easily inter-
preted. The RMSE is displayed below.

A n ta
1 n
RMSE = 1Yt - YNt22 (9)
=1

Sometimes it is more useful to compute the forecast errors in terms of percentages

rather than amounts. The mean absolute percentage error (MAPE) is computed by
finding the absolute error in each period, dividing this by the actual observed value for
that period, and averaging these absolute percentage errors. The final result is then
multiplied by 100 and expressed as a percentage. This approach is useful when the
error relative to the respective size of the time series value is important in evaluating
the accuracy of the forecast. The MAPE is especially useful when the Yt values are
large. The MAPE has no units of measurement (it is a percentage) and can be used to
compare the accuracy of the same or different techniques on two entirely different
series. Equation 10 shows how MAPE is computed.

n ta
1 n ƒ Yt - YNt ƒ
MAPE = (10)
=1 ƒ Yt ƒ
Notice that MAPE cannot be calculated if any of the Yt are zero.
Sometimes it is necessary to determine whether a forecasting method is biased (con-
sistently forecasting low or high). The mean percentage error (MPE) is used in these
cases. It is computed by finding the error in each period, dividing this by the actual value
for that period, and then averaging these percentage errors. The result is typically multi-
plied by 100 and expressed as a percentage. If the forecasting approach is unbiased, the
MPE will produce a number that is close to zero. If the result is a large negative percent-
age, the forecasting method is consistently overestimating. If the result is a large positive
percentage, the forecasting method is consistently underestimating. The MPE is given by

n ta
1 n 1Yt - YNt 2
MPE = (11)
=1 Yt

The decision to use a particular forecasting technique is based, in part, on the

determination of whether the technique will produce forecast errors that are judged to
be sufficiently small. It is certainly realistic to expect a good forecasting technique to
produce relatively small forecast errors on a consistent basis.
The five measures of forecast accuracy just described are used
• To compare the accuracy of two (or more) different techniques.
• To measure a particular technique’s usefulness or reliability.
• To help search for an optimal technique.

Example 6 will illustrate how each of these error measurements is computed.

Example 6
Table 7 shows the data for the daily number of customers requiring repair work, Yt, and a
forecast of these data, YNt, for Gary’s Chevron station. The forecasting technique used the
number of customers serviced in the previous period as the forecast for the current period.
The following computations were employed to evaluate this model using the MAD, MSE,
RMSE, MAPE, and MPE.

n ta
1 n 34
MAD = ƒ Yt - YNt ƒ = = 4.3
=1 8
 Exploring Data Patterns and an Introduction to Forecasting Techniques

n ta
1 n 188
MSE = 1Yt - YNt22 = = 23.5
=1 8

RMSE = 1MSE = 123.5 = 4.8

n ta
1 n ƒ Yt - YNt ƒ .556
MAPE = = = .0695 16.95%2
=1 Yt 8

n ta
1 n 1Yt - YNt 2 .162
MPE = = = .0203 12.03%2
=1 Yt 8

TABLE 7 Data Used in Computations to Measure Forecast

Error for Example 6
Forecast
Time t Customers Yt YN Error et |et| et2 |et|/Yt et /Yt
t

1 58 — — — — — —
2 54 58 -4 4 16 .074 -.074
3 60 54 6 6 36 .100 .100
4 55 60 -5 5 25 .091 -.091
5 62 55 7 7 49 .113 .113
6 62 62 0 0 0 .000 .000
7 65 62 3 3 9 .046 .046
8 63 65 -2 2 4 .032 -.032
9 70 63 7 7 49 .100 .100
Totals 12 34 188 .556 .162

The MAD indicates that each forecast deviated by an average of 4.3 customers. The
MSE of 23.5 (or the RMSE of 4.8) and the MAPE of 6.95% would be compared to the MSE
(RMSE) and the MAPE for any other method used to forecast these data. Finally, the small
MPE of 2.03% indicates that the technique is not biased: Since the value is close to zero, the
technique does not consistently over- or underestimate the number of customers serviced
daily.

DETERMINING THE ADEQUACY OF A FORECASTING TECHNIQUE

Before forecasting with a selected technique, the adequacy of the choice should be
evaluated. The forecaster should answer the following questions:
• Are the autocorrelation coefficients of the residuals indicative of a random series?
This question can be answered by examining the autocorrelation function for the
residuals, such as the one to be demonstrated in Example 7.
• Are the residuals approximately normally distributed? This question can be
answered by analyzing a histogram of the residuals or a normal probability plot.
• Do all parameter estimates have significant t ratios? Applications of t ratios are
demonstrated in Example 2.
• Is the technique simple to use, and can planners and policy makers understand it?
The basic requirement that the residual pattern be random is verified by examining
the autocorrelation coefficients of the residuals. There should be no significant autocor-
relation coefficients. Example 2 illustrated how the autocorrelation coefficients can be
used to determine whether a series is random. The Ljung-Box Q statistic is also used to
Exploring Data Patterns and an Introduction to Forecasting Techniques

test that the autocorrelations for all lags up to a given lag K equal zero. Example 7 illus-
trates this procedure with the residuals from two fitted models.
Example 7
Maggie Trymane, the analyst for Sears, has been asked to forecast sales for 2005. The data
are shown in Table 4 for 1955 to 2004. First, Maggie tries to forecast the data using a five-
month moving average. The residuals, the differences between the actual values and the
predicted values, are computed and stored. The autocorrelation coefficients for these resid-
uals are shown in Figure 16. An examination of these autocorrelation coefficients indicates
that two are significantly different from zero, r1 = .77 and r2 = .58. Significant autocorre-
lation coefficients indicate some association or pattern in the residuals. Furthermore, the
autocorrelation function itself has a pattern of smoothly declining coefficients. Examining
the first 10 autocorrelations as a group, the Q statistic for 10 lags is 73.90, much greater
than the upper .05 value of a chi-square variable with 10 degrees of freedom, 18.3. The
hypothesis that the first 10 autocorrelations are consistent with those for a random series is
clearly rejected at the 5% level. Since one of the basic requirements for a good forecasting
technique is that it give a residual or error series that is essentially random, Maggie judges
the five-month moving average technique to be inadequate.
Maggie now tries Holt’s linear exponential smoothing. The autocorrelation function
for the residual series generated by this technique is shown in Figure 17. An examination
of these autocorrelation coefficients indicates that none is significantly different from

FIGURE 16 Autocorrelation Function for Residuals with a Pattern

for Example 7

FIGURE 17 Autocorrelation Function for Residuals

That Are Essentially Random for Example 7
 Exploring Data Patterns and an Introduction to Forecasting Techniques

zero (at the 5% level). The Q statistic for 10 time lags is also examined. The LBQ value
of 7.40 in the Minitab output is less than the upper .05 value of a chi-square variable
with eight degrees of freedom, 15.5. (In this case, the degrees of freedom are equal to the
number of lags to be tested minus the number of parameters in the linear exponential
smoothing model that have been fitted to the data.) As a group, the first 10 residual
autocorrelations are not unlike those for a completely random series. Maggie decides to
consider Holt’s linear exponential smoothing technique as a possible model to forecast
2005 operating revenue for Sears.

APPLICATION TO MANAGEMENT

The concepts in this chapter provide a basis for selecting a proper forecasting tech-
nique in a given situation. It is important to note that in many practical situations,
more than one forecasting method or model may produce acceptable and nearly
indistinguishable forecasts. In fact, it is good practice to try several reasonable fore-
casting techniques. Often judgment, based on ease of use, cost, external environmen-
tal conditions, and so forth, must be used to select a particular set of forecasts from,
say, two sets of nearly indistinguishable values.
The following are a few examples of situations constantly arising in the busi-
ness world where a sound forecasting technique would help the decision-making
process:

• A soft-drink company wants to project the demand for its major product over the
next two years, by month.
• A major telecommunications company wants to forecast the quarterly dividend
payments of its chief rival for the next three years.
• A university needs to forecast student credit hours by quarter for the next four
years in order to develop budget projections for the state legislature.
• A public accounting firm needs monthly forecasts of dollar billings so it can plan
for additional accounting positions and begin recruiting.
• The quality control manager of a factory that makes aluminum ingots needs a
weekly forecast of production defects for top management of the company.
• A banker wants to see the projected monthly revenue of a small bicycle manufac-
turer that is seeking a large loan to triple its output capacity.
• A federal government agency needs annual projections of average miles per gallon
of American-made cars over the next 10 years in order to make regulatory
recommendations.
• A personnel manager needs a monthly forecast of absent days for the company
workforce in order to plan overtime expenditures.
• A savings and loan company needs a forecast of delinquent loans over the next
two years in an attempt to avoid bankruptcy.
• A company that makes computer chips needs an industry forecast for the number
of personal computers sold over the next 5 years in order to plan its research and
development budget.
• An Internet company needs forecasts of requests for service over the next six
months in order to develop staffing plans for its call centers.
 Exploring Data Patterns and an Introduction to Forecasting Techniques

Glossary
Autocorrelation. Autocorrelation is the correla- Seasonal component. The seasonal component is a
tion between a variable lagged one or more peri- pattern of change that repeats itself year after
ods and itself. year.
Correlogram or autocorrelation function. The cor- Stationary series. A stationary series is one whose
relogram (autocorrelation function) is a graph of basic statistical properties, such as the mean and
the autocorrelations for various lags of a time series. variance, remain constant over time.
Cross-sectional. Cross-sectional data are observa- Time series. A time series consists of data that are
tions collected at a single point in time. collected, recorded, or observed over successive
Cyclical component. The cyclical component is the increments of time.
wavelike fluctuation around the trend. Trend. The trend is the long-term component that
Residual. A residual is the difference between an represents the growth or decline in the time series
actual observed value and its forecast value. over an extended period of time.

Key Formulas

kth-order autocorrelation coefficient

a 1Yt - Y21Yt - k - Y 2
n

t=k+1
rk = (1)
a 1Yt - Y 2
n
2
t=1

Standard error of autocorrelation coefficient

1 + 2 a r 2i
k-1

i=1
SE1rk2 = (2)
T n

Ljung-Box Q statistic

Q = n1n + 22 a
m
r k2
(3)
k = 1n - k

Random model

Yt = c + "t (4)

t statistic for testing the significance of lag 1 autocorrelation

r1
t = (5)
SE1r12

Forecast error or residual

et = Yt - YNt (6)
 Exploring Data Patterns and an Introduction to Forecasting Techniques

Mean absolute deviation

n ta
1 n
MAD = ƒ Yt - YNt ƒ (7)
=1

Mean squared error

n ta
1 n
MSE = 1Yt - YNt 22 (8)
=1

Root mean squared error

A n ta
1 n
RMSE = 1Yt - YN t22 (9)
=1

Mean absolute percentage error

n ta
1 n ƒ Yt - YNt ƒ
MAPE = (10)
=1 ƒ Yt ƒ
Mean percentage error

n ta
1 n 1Yt - YNt 2
MPE = (11)
=1 Yt

Problems

1. Explain the differences between qualitative and quantitative forecasting techniques.

2. What is a time series?
3. Describe each of the components in a time series.
4. What is autocorrelation?
5. What does an autocorrelation coefficient measure?
6. Describe how correlograms are used to analyze autocorrelations for various lags
of a time series.
7. Indicate whether each of the following statements describes a stationary or a non-
stationary series.
a. A series that has a trend
b. A series whose mean and variance remain constant over time
c. A series whose mean value is changing over time
d. A series that contains no growth or decline
8. Descriptions are provided for several types of series: random, stationary, trending,
and seasonal. Identify the type of series that each describes.
a. The series has basic statistical properties, such as the mean and variance, that
remain constant over time.
b. The successive values of a time series are not related to each other.
c. A high relationship exists between each successive value of a series.
Exploring Data Patterns and an Introduction to Forecasting Techniques

d. A significant autocorrelation coefficient appears at time lag 4 for quarterly

data.
e. The series contains no growth or decline.
f. The autocorrelation coefficients are typically significantly different from zero
for the first several time lags and then gradually decrease toward zero as the
number of lags increases.
9. List some of the forecasting techniques that should be considered when forecasting
a stationary series. Give examples of situations in which these techniques would be
applicable.
10. List some of the forecasting techniques that should be considered when forecasting
a trending series. Give examples of situations in which these techniques would be
applicable.
11. List some of the forecasting techniques that should be considered when forecasting
a seasonal series. Give examples of situations in which these techniques would be
applicable.
12. List some of the forecasting techniques that should be considered when forecasting
a cyclical series. Give examples of situations in which these techniques would be
applicable.
13. The number of marriages in the United States is given in Table P-13. Compute the
first differences for these data. Plot the original data and the difference data as a
time series. Is there a trend in either of these series? Discuss.
14. Compute the 95% confidence interval for the autocorrelation coefficient for time
lag 1 for a series that contains 80 terms.
15. Which measure of forecast accuracy should be used in each of the following
situations?
a. The analyst needs to determine whether a forecasting method is biased.
b. The analyst feels that the size or magnitude of the forecast variable is important
in evaluating the accuracy of the forecast.
c. The analyst needs to penalize large forecasting errors.

TABLE P-13

Year Marriages (1,000s) Year Marriages (1,000s)

1985 2,413 1995 2,336

1986 2,407 1996 2,344
1987 2,403 1997 2,384
1988 2,396 1998 2,244
1989 2,403 1999 2,358
1990 2,443 2000 2,329
1991 2,371 2001 2,345
1992 2,362 2002 2,254
1993 2,334 2003 2,245
1994 2,362 2004 2,279

Source: Based on Statistical Abstract of the United States, various years.

Exploring Data Patterns and an Introduction to Forecasting Techniques

16. Which of the following statements is true concerning the accuracy measures used
to evaluate forecasts?
a. The MAPE takes into consideration the magnitude of the values being forecast.
b. The MSE and RMSE penalize large errors.
c. The MPE is used to determine whether a model is systematically predicting too
high or too low.
d. The advantage of the MAD method is that it relates the size of the error to the
actual observation.
17. Allie White, the chief loan officer for the Dominion Bank, would like to ana-
lyze the bank’s loan portfolio for the years 2001 to 2006. The data are shown in
Table P-17.
a. Compute the autocorrelations for time lags 1 and 2. Test to determine whether
these autocorrelation coefficients are significantly different from zero at the
.05 significance level.
b. Use a computer program to plot the data and compute the autocorrelations for
the first six time lags. Is this time series stationary?

TABLE P-17 Quarterly Loans ($ millions) for

Dominion Bank, 2001–2006

Calendar Mar. 31 Jun. 30 Sep. 30 Dec. 31

2001 2,313 2,495 2,609 2,792

2002 2,860 3,099 3,202 3,161
2003 3,399 3,471 3,545 3,851
2004 4,458 4,850 5,093 5,318
2005 5,756 6,013 6,158 6,289
2006 6,369 6,568 6,646 6,861
Source: Based on Dominion Bank records.

18. This question refers to Problem 17. Compute the first differences of the quarterly
loan data for Dominion Bank.
a. Compute the autocorrelation coefficient for time lag 1 using the differenced
data.
b. Use a computer program to plot the differenced data and compute the autocor-
relations for the differenced data for the first six time lags. Is this time series
stationary?
19. Analyze the autocorrelation coefficients for the series shown in Figures 18 through
21. Briefly describe each series.
20. An analyst would like to determine whether there is a pattern to earnings per
share for the Price Company, which operated a wholesale/retail cash-and-carry
business in several states under the name Price Club. The data are shown in Table
P-20. Describe any patterns that exist in these data.
a. Find the forecast value of the quarterly earnings per share for Price Club for
each quarter by using the naive approach (i.e., the forecast for first-quarter 1987
is the value for fourth-quarter 1986, .32).
b. Evaluate the naive forecast using MAD.
Exploring Data Patterns and an Introduction to Forecasting Techniques

c. Evaluate the naive forecast using MSE and RMSE.

d. Evaluate the naive forecast using MAPE.
e. Evaluate the naive forecast using MPE.
f. Write a memo summarizing your findings.

Autocorrelation Function for Trade

1.0
0.8
0.6
Autocorrelation

0.4
0.2
0.0
−0.2
−0.4
−0.6
−0.8
−1.0

5 10 15

FIGURE 18 Autocorrelation Function for Problem 19

Autocorrelation Function for Acid

1.0
0.8
0.6
Autocorrelation

0.4
0.2
0.0
−0.2
−0.4
−0.6
−0.8
−1.0

2 7 12 17

FIGURE 19 Autocorrelation Function for Problem 19

Autocorrelation Function for Trade First Differenced

1.0
0.8
0.6
Autocorrelation

0.4
0.2
0.0
−0.2
−0.4
−0.6
−0.8
−1.0

5 15 25

FIGURE 20 Autocorrelation Function for Problem 19

Exploring Data Patterns and an Introduction to Forecasting Techniques

Autocorrelation Function for Fuel

1.0
0.8
0.6
Autocorrelation 0.4
0.2
0.0
−0.2
−0.4
−0.6
−0.8
−1.0

5 10 15

FIGURE 21 Autocorrelation Function for Problem 19

TABLE P-20 Quarterly Earnings per Share for

Price Club: 1986–1993 Quarter
Year 1st 2nd 3rd 4th
1986 .40 .29 .24 .32
1987 .47 .34 .30 .39
1988 .63 .43 .38 .49
1989 .76 .51 .42 .61
1990 .86 .51 .47 .63
1991 .94 .56 .50 .65
1992 .95 .42 .57 .60
1993 .93 .38 .37 .57

Source: The Value Line Investment Survey (New York: Value Line,
1994), p. 1646.

TABLE P-21 Weekly Sales of a Food Item

(Read across)
2649.9 2898.7 2897.8 3054.3 3888.1 3963.6 3258.9 3199.6
3504.3 2445.9 1833.9 2185.4 3367.4 1374.1 497.5 1699.0
1425.4 1946.2 1809.9 2339.9 1717.9 2420.3 1396.5 1612.1
1367.9 2176.8 2725.0 3723.7 2016.0 862.2 1234.6 1166.5
1759.5 1039.4 2404.8 2047.8 4072.6 4600.5 2370.1 3542.3
2273.0 3596.6 2615.8 2253.3 1779.4 3917.9 3329.3 1864.4
3318.9 3342.6 2131.9 3003.2

21. Table P-21 contains the weekly sales for a food item for 52 consecutive weeks.
a. Plot the sales data as a time series.
b. Do you think this series is stationary or nonstationary?
c. Using Minitab or a similar program, compute the autocorrelations of the sales
series for the first 10 time lags. Is the behavior of the autocorrelations consistent
with your choice in part b? Explain.
Exploring Data Patterns and an Introduction to Forecasting Techniques

22. This question refers to Problem 21.

a. Fit the random model given by Equation 4 to the data in Table P-21 by estimat-
ing c with the sample mean Y so YNt = Y . Compute the residuals using
et = Yt - YNt = Yt - Y .
b. Using Minitab or a similar program, compute the autocorrelations of the resid-
uals from part c for the first 10 time lags. Is the random model adequate for the
sales data? Explain.
23. Table P-23 contains Southwest Airlines’ quarterly income before extraordinary
items ($MM) for the years 1988–1999.
a. Plot the income data as a time series and describe any patterns that exist.
b. Is this series stationary or nonstationary? Explain.
c. Using Minitab or a similar program, compute the autocorrelations of the
income series for the first 10 time lags. Is the behavior of the autocorrelations
consistent with your choice in part b? Explain.
24. This question refers to Problem 23.
a. Use Minitab or Excel to compute the fourth differences of the income data in
Table P-23. Fourth differences are computed by differencing observations four
time periods apart. With quarterly data, this procedure is sometimes useful for
creating a stationary series from a nonstationary series. Consequently, the
fourth differenced data will be Y5 - Y1 = 19.64 - .17 = 19.47, Y6 - Y2 =
19.24 - 15.13 = 4.11, . . . , and so forth.
b. Plot the time series of fourth differences. Does this time series appear to be sta-
tionary or nonstationary? Explain.
25. This question refers to Problem 23.
a. Consider a naive forecasting method where the first-quarter income is used to
forecast first-quarter income for the following year, second-quarter income is
used to forecast second-quarter income, and so forth. For example, a forecast of
first-quarter income for 1998 is provided by the first-quarter income for 1997,
50.87 (see Table P-23). Use this naive method to calculate forecasts of quarterly
income for the years 1998–1999.

TABLE P-23 Quarterly Income for Southwest Airlines ($MM)

Year 1st 2nd 3rd 4th
1988 0.17 15.13 26.59 16.07
1989 19.64 19.24 24.57 8.11
1990 5.09 23.53 23.04 -4.58
1991 -8.21 10.57 15.72 8.84
1992 13.48 23.48 26.89 27.17
1993 24.93 42.15 48.83 38.37
1994 41.85 58.52 58.62 20.34
1995 11.83 59.72 67.72 43.36
1996 33.00 85.32 60.86 28.16
1997 50.87 93.83 92.51 80.55
1998 70.01 133.39 129.64 100.38
1999 95.85 157.76 126.98 93.80
Source: Based on Compustat Industrial Quarterly Data Base.
 Exploring Data Patterns and an Introduction to Forecasting Techniques

b. Using the forecasts in part a, calculate the MAD, RMSE, and MAPE.
c. Given the results in part b and the nature of the patterns in the income series,
do you think this naive forecasting method is viable? Can you think of another
naive method that might be better?

CASES

CASE 1A MURPHY BROTHERS

FURNITURE

In 1958, the Murphy brothers established a furniture many federal publications. After looking through a
store in downtown Dallas. Over the years, they were recent copy of the Survey of Current Business, she
quite successful and extended their retail coverage found the history on monthly sales for all retail
throughout the West and Midwest. By 1996, their stores in the United States and decided to use this
chain of furniture stores had become well estab- variable as a substitute for her variable of interest,
lished in 36 states. Murphy Brothers sales dollars. She reasoned that,
Julie Murphy, the daughter of one of the if she could establish accurate forecasts for national
founders, had recently joined the firm. Her sales, she could relate these forecasts to Murphy’s
father and uncle were sophisticated in many ways own sales and come up with the forecasts she
but not in the area of quantitative skills. In particu- wanted.
lar, they both felt that they could not accu- Table 8 shows the data that Julie collected, and
rately forecast the future sales of Murphy Brothers Figure 22 shows a data plot provided by Julie’s com-
using modern computer techniques. For this rea- puter program. Julie began her analysis by using the
son, they appealed to Julie for help as part of her computer to develop a plot of the autocorrelation
new job. coefficients.
Julie first considered using Murphy sales dollars After examining the autocorrelation function
as her variable but found that several years of his- produced in Figure 23, it was obvious to Julie that
tory were missing. She asked her father, Glen, about her data contain a trend. The early autocorrelation
this, and he told her that at the time he “didn’t think coefficients are very large, and they drop toward
it was that important.” Julie explained the impor- zero very slowly with time. To make the series
tance of past data to Glen, and he indicated that he stationary so that various forecasting methods could
would save future data. be considered, Julie decided to first difference her
Julie decided that Murphy sales were probably data to see if the trend could be removed. The auto-
closely related to national sales figures and decided correlation function for the first differenced data is
to search for an appropriate variable in one of the shown in Figure 24.

QUESTIONS
1. What should Julie conclude about the retail 3. What forecasting techniques should Julie try?
sales series? 4. How will Julie know which technique works
2. Has Julie made good progress toward finding a best?
forecasting technique?
 TABLE 8 Monthly Sales ($ billions) for All Retail Stores, 1983–1995
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995
Jan. 81.3 93.1 98.8 105.6 106.4 113.6 122.5 132.6 130.9 142.1 148.4 154.6 167.0
Feb. 78.9 93.7 95.6 99.7 105.8 115.0 118.9 127.3 128.6 143.1 145.0 155.8 164.0
Mar. 93.8 103.3 110.2 114.2 120.4 131.6 141.3 148.3 149.3 154.7 164.6 184.2 192.1
Apr. 93.8 103.9 113.1 115.7 125.4 130.9 139.8 145.0 148.5 159.1 170.3 181.8 187.5
May 97.8 111.8 120.3 125.4 129.1 136.0 150.3 154.1 159.8 165.8 176.1 187.2 201.4
Jun. 100.6 112.3 115.0 120.4 129.0 137.5 149.0 153.5 153.9 164.6 175.7 190.1 202.6
Jul. 99.4 106.9 115.5 120.7 129.3 134.1 144.6 148.9 154.6 166.0 177.7 185.8 194.9
Aug. 100.1 111.2 121.1 124.1 131.5 138.7 153.0 157.4 159.9 166.3 177.1 193.8 204.2
Sep. 97.9 104.0 113.8 124.4 124.5 131.9 144.1 145.6 146.7 160.6 171.1 185.9 192.8
Oct. 100.7 109.6 115.8 123.8 128.3 133.8 142.3 151.5 152.1 168.7 176.4 189.7 194.0
Nov. 103.9 113.5 118.1 121.4 126.9 140.2 148.8 156.1 155.6 167.2 180.9 194.7 202.4
Dec. 125.8 132.3 138.6 152.1 157.2 171.0 176.5 179.7 181.0 204.1 218.3 233.3 238.0
Source: Based on Survey of Current Business, various years.

FIGURE 22 Time Series Graph of Monthly Sales

for All U.S. Retail Stores, 1983–1995

FIGURE 23 Autocorrelation Function for Monthly Sales

for All U.S. Retail Stores
 Exploring Data Patterns and an Introduction to Forecasting Techniques

FIGURE 24 Autocorrelation Function for Monthly Sales

for All U.S. Retail Stores First Differenced

TABLE 9 Monthly Sales for Murphy Brothers Furniture, 1992–1995

Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.

1992 4,906 5,068 4,710 4,792 4,638 4,670 4,574 4,477 4,571 4,370 4,293 3,911
1993 5,389 5,507 4,727 5,030 4,926 4,847 4,814 4,744 4,844 4,769 4,483 4,120
1994 5,270 5,835 5,147 5,354 5,290 5,271 5,328 5,164 5,372 5,313 4,924 4,552
1995 6,283 6,051 5,298 5,659 5,343 5,461 5,568 5,287 5,555 5,501 5,201 4,826

Source: Murphy Brothers sales records.

CASE 1B MURPHY BROTHERS FURNITURE

Glen Murphy was not happy to be chastised by his Table 9. He was surprised to find out that Julie did not
daughter. He decided to conduct an intensive search of share his enthusiasm. She knew that acquiring actual
Murphy Brothers’ records. Upon implementing an sales data for the past 4 years was a positive occur-
investigation, he was excited to discover sales data for rence. Julie’s problem was that she was not quite sure
the past four years, 1992 through 1995, as shown in what to do with the newly acquired data.

QUESTIONS
1. What should Julie conclude about Murphy 3. Which data should Julie use to develop a fore-
Brothers’ sales data? casting model?
2. How does the pattern of the actual sales data
compare to the pattern of the retail sales data
presented in Case 1A?
 Exploring Data Patterns and an Introduction to Forecasting Techniques

CASE 2 MR. TUX

John Mosby, owner of several Mr. Tux rental stores, is Finally, John uses another computer program to
beginning to forecast his most important business vari- calculate the percentage of the variance in the origi-
able, monthly dollar sales. One of his employees, nal data explained by the trend, seasonal, and ran-
Virginia Perot, has gathered the sales data. John decides dom components.
to use all 96 months of data he has collected. He runs The program calculates the percentage of the
the data on Minitab and obtains the autocorrelation variance in the original data explained by the factors
function shown in Figure 25. Since all the autocorrela- in the analysis:
tion coefficients are positive and they are trailing off
very slowly, John concludes that his data have a trend. FACTOR % EXPLAINED
Next, John asks the program to compute the
Data 100
first differences of the data. Figure 26 shows the
]

Trend 6
autocorrelation function for the differenced data. Seasonal 45
The autocorrelation coefficients for time lags 12 and Random 49
24, r12 = .68 and r24 = .42, respectively, are both sig-
nificantly different from zero.

QUESTIONS
1. Summarize the results of John’s analysis in one 3. How would you explain the line “Random 49%.”?
paragraph that a manager, not a forecaster, can 4. Consider the significant autocorrelations, r12 and
understand. r24, for the differenced data. Would you conclude
2. Describe the trend and seasonal effects that that the sales first differenced have a seasonal
appear to be present in the sales data for component? If so, what are the implications for
Mr. Tux. forecasting, say, the monthly changes in sales?

FIGURE 25 Autocorrelation Function for Mr. Tux Data

 Exploring Data Patterns and an Introduction to Forecasting Techniques

FIGURE 26 Autocorrelation Function for Mr. Tux Data First Differenced

CASE 3 CONSUMER CREDIT COUNSELING

Marv Harnishfeger, executive director, was con- various data exploration techniques, agreed to ana-
cerned about the size and scheduling of staff for lyze the problem. She asked Marv to provide
the remainder of 1993. He explained the problem monthly data for the number of new clients seen.
to Dorothy Mercer, recently elected president of Marv provided the monthly data shown in Table 10
the executive committee. Dorothy thought about for the number of new clients seen by CCC for the
the problem and concluded that Consumer Credit period January 1985 through March 1993. Dorothy
Counseling (CCC) needed to analyze the number then analyzed these data using a time series plot
of new clients it acquired each month. Dorothy, and autocorrelation analysis.
who worked for a local utility and was familiar with

TABLE 10 Number of New Clients Seen by CCC from January 1985

through March 1993
Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.

1985 182 136 99 77 75 63 87 73 83 82 74 75

1986 102 121 128 128 112 122 104 108 97 141 97 87
1987 145 103 113 150 100 131 96 92 88 118 102 98
1988 101 153 138 107 100 114 78 106 94 93 103 104
1989 150 102 151 100 100 98 97 120 98 135 141 67
1990 127 146 175 110 153 117 121 121 131 147 121 110
1991 171 185 172 168 142 152 151 141 128 151 121 126
1992 166 138 175 108 112 147 168 149 145 149 169 138
1993 152 151 199
 Exploring Data Patterns and an Introduction to Forecasting Techniques

QUESTIONS
1. Explain how Dorothy used autocorrelation 3. What type of forecasting technique did Dorothy
analysis to explore the data pattern for the num- recommend for this data set?
ber of new clients seen by CCC.
2. What did she conclude after she completed this
analysis?

CASE 4 ALOMEGA FOOD STORES

The president of Alomega, Julie Ruth, had collected which of the predictor variables was best for this
data from her company’s operations. She found sev- purpose.
eral months of sales data along with several possible Julie investigated the relationships between
predictor variables. While her analysis team was sales and the possible predictor variables. She now
working with the data in an attempt to forecast realizes that this step was premature because she
monthly sales, she became impatient and wondered doesn’t even know the data pattern of her sales. (See
Table 11.)

QUESTION
1. What did Julie conclude about the data pattern
of Alomega Sales?

TABLE 11 Monthly Sales for 27 Alomega

Food Stores, 2003–2006

Month 2003 2004 2005 2006

Jan. 425,075 629,404 655,748 455,136

Feb. 315,305 263,467 270,483 247,570
Mar. 432,101 468,612 429,480 732,005
Apr. 357,191 313,221 260,458 357,107
May 347,874 444,404 528,210 453,156
Jun. 435,529 386,986 379,856 320,103
Jul. 299,403 414,314 472,058 451,779
Aug. 296,505 253,493 254,516 249,482
Sep. 426,701 484,365 551,354 744,583
Oct. 329,722 305,989 335,826 421,186
Nov. 281,783 315,407 320,408 397,367
Dec. 166,391 182,784 276,901 269,096
 Exploring Data Patterns and an Introduction to Forecasting Techniques

CASE 5 SURTIDO COOKIES

GAMESA Company is the largest producer of Surtido is a mixture of different cookies in one
cookies, snacks, and pastry in Mexico and Latin presentation. Jame knows that this product is com-
America. monly served at meetings, parties, and reunions. It is
Jame Luna, an analyst for SINTEC, which is an also popular during the Christmas holidays. So Jame
important supply-chain consulting firm based in is pretty sure there will be a seasonal component in
Mexico, is working with GAMESA on an optimal the time series of monthly sales, but he is not sure if
vehicle routing and docking system for all the distri- there is a trend in sales. He decides to plot the sales
bution centers in Mexico. Forecasts of the demand series and use autocorrelation analysis to help him
for GAMESA products will help to produce a plan determine if these data have a trend and a seasonal
for the truck float and warehouse requirements component.
associated with the optimal vehicle routing and Karin, one of the members of Jame’s team, sug-
docking system. gests that forecasts of future monthly sales might be
As a starting point, Jame decides to focus on generated by simply using the average sales for each
one of the main products of the Cookies Division of month. Jame decides to test this suggestion by “hold-
GAMESA. He collects data on monthly aggregated ing out” the monthly sales for 2003 as test cases. Then
demand (in kilograms) for Surtido cookies from the average of the January sales for 2000–2002 will
January 2000 through May 2003. The results are be used to forecast January sales for 2003 and so
shown in Table 12. forth.

QUESTIONS
1. What should Jame conclude about the data 2. What did Jame learn about the forecast accu-
pattern of Surtido cookie sales? racy of Karin’s suggestion?

TABLE 12 Monthly Sales (in kgs) for Surtido Cookies,

January 2000–May 2003
Month 2000 2001 2002 2003
Jan. 666,922 802,365 574,064 1,072,617
Feb. 559,962 567,637 521,469 510,005
Mar. 441,071 527,987 522,118 579,541
Apr. 556,265 684,457 716,624 771,350
May 529,673 747,335 632,066 590,556
Jun. 564,722 658,036 633,984
Jul. 638,531 874,679 543,636
Aug. 478,899 793,355 596,131
Sep. 917,045 1,819,748 1,606,798
Oct. 1,515,695 1,600,287 1,774,832
Nov. 1,834,695 2,177,214 2,102,863
Dec. 1,874,515 1,759,703 1,819,749
 Exploring Data Patterns and an Introduction to Forecasting Techniques

Minitab Applications

The problem. In Example 4, Maggie Trymane, an analyst for Sears, wants to forecast
sales for 2005. She needs to determine the pattern for the sales data for the years from
1955 to 2004.
Minitab Solution

1. Enter the Sears data shown in Table 4 into column C1. Since the data are already
stored in a file called Tab4.MTW, click on

File>Open Worksheet

and double-click the Minitab Ch3 file. Click on Tab4.MTW and Open the file. The
Sears data will appear in C1.
2. To construct an autocorrelation function, click on the following menus, as shown in
Figure 27:

Stat>Time Series>Autocorrelation

3. The Autocorrelation Function dialog box shown in Figure 28 appears.

a. Double-click on the variable Revenue and it will appear to the right of Series.
b. Enter a Title in the appropriate space and click on OK. The resulting autocorre-
lation function is shown in Figure 11.
4. In order to difference the data, click on the following menus:
Stat>Time Series>Differences

FIGURE 27 Minitab Autocorrelation Menu

Exploring Data Patterns and an Introduction to Forecasting Techniques

FIGURE 28 Minitab Autocorrelation

Function Dialog Box

FIGURE 29 Minitab Differences Dialog Box

The Differences option is above the Autocorrelation option shown in Figure 27.
5. The Differences dialog box shown in Figure 29 appears.
a. Double-click on the variable Revenue and it will appear to the right of Series.
b. Tab to Store differences in: and enter C2. The differenced data will now appear
in the worksheet in column C2.
 Exploring Data Patterns and an Introduction to Forecasting Techniques

Excel Applications

The problem. Harry Vernon wants to use Excel to compute the autocorrelation coeffi-
cients and a correlogram for the data presented in Table 1.

Excel Solution
1. Create a new file by clicking on the following menus:

File>New

2. Position the mouse at A1. Notice that, whenever you position the mouse on a cell,
it is highlighted. Type the heading VERNON’S MUSIC STORE. Position the
mouse at A2 and type NUMBER OF VCRS SOLD.
3. Position the mouse at A4 and type Month. Press <enter> and the A5 cell is high-
lighted. Now enter each month, starting with January in A5 and ending with
December in A16.
4. Position the mouse at B4 and type Y. Enter the data from Table 1, beginning in cell
B5. Position the mouse at C4 and type Z.
5. Highlight cells B4:C16 and click on the following menus:

Insert>Name>Create

In the Create Names dialog box, click on the Top row check box, and click on OK.
This step creates the name Y for the range B5:B16 and the name Z for the range
C5:C16.
6. Highlight C5 and enter the formula

=(B5-AVERAGE(Y))/STDEV(Y)

Copy C5 to the rest of the column by highlighting it and then clicking on the Fill
handle in the lower right corner and dragging it down to cell C16. With cells
C5:C16 still highlighted, click the Decrease Decimal button (shown in Figure 30
toward the upper middle) until three decimal places are displayed. The Decrease
Decimal button is on the Formatting taskbar. This taskbar can be displayed by
right-clicking File and then left-clicking Formatting.
7. Enter the labels LAG and ACF in cells E4 and F4. In order to examine the first six
time lags, enter the digits 1 through 6 in cells E5:E10.
8. Highlight F5 and enter the formula

=SUMPRODUCT(OFFSET(Z,E5,0,12–E5),OFFSET(Z,0,0,12-E5))/11

Highlight F5, click the Fill handle in the lower right corner, and drag it down to cell
F10. With cells F5:F10 still highlighted, click the Decrease Decimal button until
three decimal places are displayed. The results are shown in Figure 30.
9. To develop the autocorrelation function, highlight cells F5:F10. Click on the
ChartWizard tool (shown in Figure 31 toward the upper middle).
10. The ChartWizard—Step 1 to 4 dialog box appears. In step 1, select a chart type by
clicking on Column and then on Next. In the dialog box for step 2, click on the Series
dialog box. In the blank next to Name, type Corr.. Click Next and the step 3 dialog
box appears. Under Chart title, delete Corr.. Under Category (X) axis, type Time
Lags. Now click on the Data Table dialog box and on the box next to Show data
table. Click on Next to obtain the step 4 dialog box and then on Finish to produce the
Exploring Data Patterns and an Introduction to Forecasting Techniques

FIGURE 30 Excel Spreadsheet for VCR Data

FIGURE 31 Excel Output for Autocorrelation Function

autocorrelation function shown in Figure 31. Click on one of the corners of the chart,
and move it outward in order to enlarge the autocorrelation function.
11. In order to save the data, click on

File>Save As

In the Save As dialog box, type Tab1 in the space to the right of File name. Click on
Save and the file will be saved as Tab1.xls.
 MOVING AVERAGES AND
SMOOTHING METHODS
This chapter will describe three simple approaches to forecasting a time series: naive,
averaging, and smoothing methods. Naive methods are used to develop simple models
that assume that very recent data provide the best predictors of the future. Averaging
methods generate forecasts based on an average of past observations. Smoothing
methods produce forecasts by averaging past values of a series with a decreasing
(exponential) series of weights.
Figure 1 outlines the forecasting methods discussed in this chapter. Visualize your-
self on a time scale. You are at point t in Figure 1 and can look backward over past
observations of the variable of interest 1Yt 2 or forward into the future. After you
select a forecasting technique, you adjust it to the known data and obtain forecast val-
ues 1YNt2. Once these forecast values are available, you compare them to the known
observations and calculate the forecast error 1e t2.
A good strategy for evaluating forecasting methods involves the following steps:

1. A forecasting method is selected based on the forecaster’s analysis of and intuition

about the nature of the data.
2. The data set is divided into two sections—an initialization or fitting section and a
test or forecasting section.
3. The selected forecasting technique is used to develop fitted values for the initial-
ization part of the data.
4. The technique is used to forecast the test part of the data, and the forecasting error
is determined and evaluated.
5. A decision is made. The decision might be to use the technique in its present form,
to modify the technique, or to develop a forecast using another technique and
compare the results.

FIGURE 1 Forecasting Outline

You are here

Past data t Periods to be forecast
^ ^ ^
. . . Yt−3, Yt−2, Yt−1, Yt , Yt+1, Yt+2, Yt+3, . . .
where Yt is the most recent observation of a variable
^
Yt+1 is the forecast for one period in the future

From Chapter 4 of Business Forecasting, Ninth Edition. John E. Hanke, Dean W. Wichern.
Copyright © 2009 by Pearson Education, Inc. All rights reserved.
 Moving Averages and Smoothing Methods

NAIVE MODELS
Often young businesses face the dilemma of trying to forecast with very small data sets.
This situation creates a real problem, since many forecasting techniques require large
amounts of data. Naive forecasts are one possible solution, since they are based solely
on the most recent information available.
Naive forecasts assume that recent periods are the best predictors of the future.
The simplest model is

YNt + 1 = Yt (1)

where YNt + 1 is the forecast made at time t (the forecast origin) for time t + 1.
The naive forecast for each period is the immediately preceding observation. One
hundred percent of the weight is given to the current value of the series. The naive
forecast is sometimes called the “no change” forecast. In short-term weather forecast-
ing, the “no change” forecast occurs often. Tomorrow’s weather will be much like
today’s weather.
Since the naive forecast (Equation 1) discards all other observations, this scheme
tracks changes very rapidly. The problem with this approach is that random fluctua-
tions are tracked as faithfully as other fundamental changes.

Example 1
Figure 2 shows the quarterly sales of saws from 2000 to 2006 for the Acme Tool Company.
The naive technique is used to forecast sales for the next quarter to be the same as for the
previous quarter. Table 1 shows the data from 2000 to 2006. If the data from 2000 to 2005 are
used as the initialization part and the data from 2006 as the test part, the forecast for the
first quarter of 2006 is

YN24 + 1 = Y24
YN25 = 650

FIGURE 2 Time Series Plot for Sales of Saws for Acme Tool
Company, 2000–2006, for Example 1
 Moving Averages and Smoothing Methods

TABLE 1 Sales of Saws for Acme Tool

Company, 2000–2006, for
Example 1

Year Quarter t Sales

2000 1 1 500
2 2 350
3 3 250
4 4 400
2001 1 5 450
2 6 350
3 7 200
4 8 300
2002 1 9 350
2 10 200
3 11 150
4 12 400
2003 1 13 550
2 14 350
3 15 250
4 16 550
2004 1 17 550
2 18 400
3 19 350
4 20 600
2005 1 21 750
2 22 500
3 23 400
4 24 650
2006 1 25 850
2 26 600
3 27 450
4 28 700

The forecasting error is determined using the following equation. The error for period 25 is

e25 = Y25 - YN25 = 850 - 650 = 200

In a similar fashion, the forecast for period 26 is 850, with an error of -250. Figure 2 shows
that these data have an upward trend and that there appears to be a seasonal pattern (the
first and fourth quarters are relatively high), so a decision is made to modify the naive model.

Examination of the data in Example 1 leads us to conclude that the values are
increasing over time. When data values increase over time, they are said to be
nonstationary in level or to have a trend. If Equation 1 is used, the projections will be
consistently low. However, the technique can be adjusted to take trend into considera-
tion by adding the difference between this period and the last period. The forecast
equation is

YNt + 1 = Yt + 1Yt - Yt - 12 (2)

Equation 2 takes into account the amount of change that occurred between quarters.
 Moving Averages and Smoothing Methods

Example 1 (cont.)
Using Equation 2, the forecast for the first quarter of 2006 is

YN24 + 1 = Y24 + (Y24 - Y24 - 1)

YN25 = Y24 + (Y24 - Y23)
YN = 650 + (650 - 400)
25

YN25 = 650 + 250 = 900

The forecast error with this model is

e25 = Y25 - YN = 850 - 900 = -50

For some purposes, the rate of change might be more appropriate than the
absolute amount of change. If this is the case, it is reasonable to generate forecasts
according to
Yt
YNt + 1 = Yt (3)
Yt - 1
Visual inspection of the data in Table 1 indicates that seasonal variation seems to
exist. Sales in the first and fourth quarters are typically larger than those in the second
and third quarters. If the seasonal pattern is strong, then an appropriate forecast equa-
tion for quarterly data might be
YNt + 1 = Yt - 3 (4)
Equation 4 says that in next quarter the variable will take on the same value that it
did in the corresponding quarter one year ago.
The major weakness of this approach is that it ignores everything that has occurred
since last year and also any trend. There are several ways of introducing more recent
information. For example, the analyst can combine seasonal and trend estimates and
forecast the next quarter using
(Yt - Yt - 1) + Á + 1Yt - 3 - Yt - 42 Yt - Yt - 4
YNt!1 = Yt - 3 + = Yt - 3 + (5)
4 4
where the Yt - 3 term forecasts the seasonal pattern and the remaining term averages
the amount of change for the past four quarters and provides an estimate of the trend.
The naive forecasting models in Equations 4 and 5 are given for quarterly data.
Adjustments can be made for data collected over different time periods. For monthly
data, for example, the seasonal period is 12, not 4, and the forecast for the next period
(month) given by Equation 4 is Y N t + 1 = Yt - 11.
It is apparent that the number and complexity of possible naive models are limited
only by the ingenuity of the analyst, but use of these techniques should be guided by
sound judgment.
Naive methods are also used as the basis for making comparisons against which
the performance of more sophisticated methods is judged.

Example 1 (cont.)
The forecasts for the first quarter of 2006 using Equations 3, 4, and 5 are

Y24 Y24
YN24 + 1 = Y24 = Y24
Y24 - 1 Y23
650 (Equation 3)
YN25 = 650 = 1,056
400
 Moving Averages and Smoothing Methods

YN24 + 1 = Y24 - 3 = Y21

(Equation 4)
YN25 = Y21 = 750
1Y24 - Y24 - 12 + # # # + 1Y24 - 3 - Y24 - 42 Y24 - Y2 - 4
YN24 + 1 = Y24 - 3 + = Y24 - 3 +
4 4
1Y24 - Y202 650 - 600
YN25 = Y21 + = 750 + (Equation 5)
4 4
YN 25 = 750 + 12.5 = 762.5

FORECASTING METHODS BASED ON AVERAGING

Frequently, management faces the situation in which forecasts need to be updated

daily, weekly, or monthly for inventories containing hundreds or thousands of items.
Often it is not possible to develop sophisticated forecasting techniques for each item.
Instead, some quick, inexpensive, very simple short-term forecasting tools are needed
to accomplish this task.
A manager facing such a situation is likely to use an averaging or smoothing tech-
nique. These types of techniques use a form of weighted average of past observations
to smooth short-term fluctuations. The assumption underlying these techniques is that
the fluctuations in past values represent random departures from some underlying
structure. Once this structure is identified, it can be projected into the future to pro-
duce a forecast.

Simple Averages
Historical data can be smoothed in many ways. The objective is to use past data to
develop a forecasting model for future periods. In this section, the method of simple
averages is considered. As with the naive methods, a decision is made to use the first t
data points as the initialization part and the remaining data points as the test part.
Next, Equation 6 is used to average (compute the mean of) the initialization part of the
data and to forecast the next period.

YNt + 1 = a Yi
1 t
(6)
t i=1
When a new observation becomes available, the forecast for the next period, YNt + 2, is the
average or the mean computed using Equation 6 and this new observation.
When forecasting a large number of series simultaneously (e.g., for inventory man-
agement), data storage may be an issue. Equation 7 solves this potential problem. Only
the most recent forecast and the most recent observation need be stored as time moves
forward.
tYNt + 1 + Yt + 1
YNt + 2 = (7)
t + 1
The method of simple averages is an appropriate technique when the forces gener-
ating the series to be forecast have stabilized and the environment in which the series
exists is generally unchanging. Examples of this type of series are the quantity of sales
resulting from a consistent level of salesperson effort; the quantity of sales of a product
in the mature stage of its life cycle; and the number of appointments per week
requested of a dentist, doctor, or lawyer whose patient or client base is fairly stable.
 Moving Averages and Smoothing Methods

A simple average uses the mean of all relevant historical observations as the
forecast for the next period.

Example 2
The Spokane Transit Authority operates a fleet of vans used to transport both persons with
disabilities and the elderly. A record of the gasoline purchased for this fleet of vans is shown
in Table 2. The actual amount of gasoline consumed by a van on a given day is determined
by the random nature of the calls and the destinations. Examination of the gasoline pur-
chases plotted in Figure 3 shows the data are very stable. Since the data seem stationary, the
method of simple averages is used for weeks 1 to 28 to forecast gasoline purchases for
weeks 29 and 30. The forecast for week 29 is

TABLE 2 Gasoline Purchases for the Spokane Transit

Authority for Example 2

Week Gallons Week Gallons Week Gallons

t Yt t Yt t Yt

1 275 11 302 21 310

2 291 12 287 22 299
3 307 13 290 23 285
4 281 14 311 24 250
5 295 15 277 25 260
6 268 16 245 26 245
7 252 17 282 27 271
8 279 18 277 28 282
9 264 19 298 29 302
10 288 20 303 30 285

FIGURE 3 Time Series Plot of Weekly Gasoline Purchases

for the Spokane Transit Authority for Example 2
 Moving Averages and Smoothing Methods

28 ia
1 28
YN28 + 1 = Yi
=1
7,874
YN29 = = 281.2
28
The forecast error is

e29 = Y29 - YN 29 = 302 - 281.2 = 20.8

The forecast for week 30 includes one more data point (302) added to the initialization
period. The forecast using Equation 7 is

28YN28 + 1 + Y28 + 1 28YN29 + Y29

YN28 + 2 = =
28 + 1 29
28(281.2) + 302
YN30 = = 281.9
29
The forecast error is

e30 = Y30 - YN30 = 285 - 281.9 = 3.1

Using the method of simple averages, the forecast of gallons of gasoline purchased for
week 31 is

30 ia
1 30 8,461
YN30 + 1 = Yi = = 282
=1 30

Moving Averages
The method of simple averages uses the mean of all the data to forecast. What if the
analyst is more concerned with recent observations? A constant number of data points
can be specified at the outset and a mean computed for the most recent observations.
The term moving average is used to describe this approach. As each new observation
becomes available, a new mean is computed by adding the newest value and dropping
the oldest. This moving average is then used to forecast the next period. Equation 8
gives the simple moving average forecast. A moving average of order k, MA(k), is
computed by

Yt + Yt - 1 + # # # + Yt - k + 1
YNt + 1 = (8)
k
where
YNt + 1 = the forecast value for the next period
Yt = the actual value at period t
k = the number of terms in the moving average
The moving average for time period t is the arithmetic mean of the k most recent
observations. In a moving average, equal weights are assigned to each observation.
Each new data point is included in the average as it becomes available, and the earliest
data point is discarded. The rate of response to changes in the underlying data pattern
depends on the number of periods, k, included in the moving average.
Note that the moving average technique deals only with the latest k periods of
known data; the number of data points in each average does not change as time
advances. The moving average model does not handle trend or seasonality very well,
although it does better than the simple average method.
 Moving Averages and Smoothing Methods

The analyst must choose the number of periods, k, in a moving average. A moving
average of order 1, MA(1), would take the current observation, Yt, and use it to forecast
Y for the next period. This is simply the naive forecasting approach of Equation 1.

A moving average of order k is the mean value of k consecutive observations. The

most recent moving average value provides a forecast for the next period.

Example 3
Table 3 demonstrates the moving average forecasting technique with the Spokane Transit
Authority data, using a five-week moving average.The moving average forecast for week 29 is

Y28 + Y28 - 1 + # # # + Y28 - 5 + 1

YN28 + 1 =
5

Y28 + Y27 + Y26 + Y25 + Y24

YN29 =
5

TABLE 3 Gasoline Purchases for the Spokane

Transit Authority for Example 3

t Gallons Ynt et

1 275 — —
2 291 — —
3 307 — —
4 281 — —
5 295 — —
6 268 289.8 -21.8
7 252 288.4 -36.4
8 279 280.6 -1.6
9 264 275.0 -11.0
10 288 271.6 16.4
11 302 270.2 31.8
12 287 277.0 10.0
13 290 284.0 6.0
14 311 286.2 24.8
15 277 295.6 -18.6
16 245 293.4 -48.4
17 282 282.0 0.0
18 277 281.0 -4.0
19 298 278.4 19.6
20 303 275.8 27.2
21 310 281.0 29.0
22 299 294.0 5.0
23 285 297.4 -12.4
24 250 299.0 -49.0
25 260 289.4 -29.4
26 245 280.8 -35.8
27 271 267.8 3.2
28 282 262.2 19.8
29 302 261.6 40.4
30 285 272.0 13.0
 Moving Averages and Smoothing Methods

282 + 271 + 245 + 260 + 250 1,308

YN29 = = = 261.6
5 5

When the actual value for week 29 is known, the forecast error is calculated:

e29 = Y29 - YN29 = 302 - 261.6 = 40.4

The forecast for week 31 is

Y30 + Y30 - 1 + Á + Y30 - 5 + 1
YN30 + 1 =
5
Y30 + Y29 + Y28 + Y27 + Y26
YN31 =
5
285 + 302 + 282 + 271 + 245 1,385
N
Y31 = = = 277
5 5

Minitab can be used to compute a five-week moving average (see the Minitab
Applications section at the end of the chapter for instructions). Figure 4 shows the five-
week moving average plotted against the actual data; the MAPE, MAD, and MSD; and the
basic Minitab instructions. Note that Minitab calls the mean squared error MSD (mean
squared deviation).
Figure 5 shows the autocorrelation function for the residuals from the five-week mov-
ing average method. Error limits for the individual autocorrelations centered at zero and
the Ljung-Box Q statistic (with six degrees of freedom, since no model parameters are esti-
mated) indicate that significant residual autocorrelation exists. That is, the residuals are not
random. The association contained in the residuals at certain time lags can be used to
improve the forecasting model.

The analyst must use judgment when determining how many days, weeks, months,
or quarters on which to base the moving average. The smaller the number, the larger
the weight given to recent periods. Conversely, the larger the number, the smaller the
weight given to more recent periods. A small number is most desirable when there are

FIGURE 4 Five-Week Moving Average Applied to Weekly

Gasoline Purchases for the Spokane
Transit Authority for Example 3
 Moving Averages and Smoothing Methods

FIGURE 5 Autocorrelation Function for the Residuals When a Five-Week

Moving Average Method Was Used with the Spokane Transit
Authority Data for Example 3

sudden shifts in the level of the series. A small number places heavy weight on recent
history, which enables the forecasts to catch up more rapidly to the current level.
A large number is desirable when there are wide, infrequent fluctuations in the series.
Moving averages are frequently used with quarterly or monthly data to help smooth
the components within a time series. For quarterly data, a four-quarter moving average,
MA(4), yields an average of the four quarters, and for monthly data, a 12-month moving
average, MA(12), eliminates or averages out the seasonal effects. The larger the order of
the moving average, the greater the smoothing effect.
In Example 3, the moving average technique was used with stationary data. In
Example 4, we show what happens when the moving average method is used with
trending data. The double moving average technique, which is designed to handle
trending data, is introduced next.

Double Moving Averages

One way of forecasting time series data that have a linear trend is to use double mov-
ing averages. This method does what the name implies: One set of moving averages is
computed, and then a second set is computed as a moving average of the first set.
Table 4 shows the weekly rentals data for the Movie Video Store along with the
results of using a three-week moving average to forecast future sales. Examination
of the error column in Table 4 shows that every entry is positive, signifying that the
forecasts do not catch up to the trend. The three-week moving average and the double
moving average for these data are shown in Figure 6. Note how the three-week moving
averages lag behind the actual values for comparable periods. This illustrates what hap-
pens when the moving average technique is used with trending data. Note also that the
double moving averages lag behind the first set about as much as the first set lags
behind the actual values. The difference between the two sets of moving averages is
added to the three-week moving average to forecast the actual values.
Equations 9 through 12 summarize double moving average construction. First,
Equation 8 is used to compute the moving average of order k.
Yt + Yt - 1 + Yt - 2 + Á + Yt - k + 1
Mt = YNt + 1 =
k
 Moving Averages and Smoothing Methods

TABLE 4 Weekly Rentals for the Movie Video Store for

Example 4

Weekly Units Three-Week Moving Average

t Rented Yt Moving Total Forecast YN t + 1 e

1 654 — — —
2 658 — — —
3 665 1,977 — —
4 672 1,995 659 13
5 673 2,010 665 8
6 671 2,016 670 1
7 693 2,037 672 21
8 694 2,058 679 15
9 701 2,088 686 15
10 703 2,098 696 7
11 702 2,106 699 3
12 710 2,115 702 8
13 712 2,124 705 7
14 711 2,133 708 3
15 728 2,151 711 17
16 — — 717 —

MSE " 133

730 Rentals

720
Moving
Average
710

700
Rentals

690 Double
Moving
680 Average

670

660

650
5 10 15
Week

FIGURE 6 Three-Week Single and Double Moving Averages for the

Movie Video Store Data for Example 4

Then Equation 9 is used to compute the second moving average.

Mt + Mt - 1 + Mt - 2 + Á + Mt - k + 1
M t¿ = (9)
k
Equation 10 is used to develop a forecast by adding to the single moving average the
difference between the single and the second moving averages.
at = Mt + 1Mt - M t¿2 = 2Mt - M t¿ (10)
 Moving Averages and Smoothing Methods

Equation 11 is an additional adjustment factor, which is similar to a slope measure that

can change over the series.
2
bt = 1Mt - M t¿2 (11)
k - 1
Finally, Equation 12 is used to make the forecast p periods into the future.

YNt+p = at + bt p (12)

where
k = the number of periods in the moving average
p = the number of periods ahead to be forecast

Example 4
The Movie Video Store operates several videotape rental outlets in Denver, Colorado. The
company is growing and needs to expand its inventory to accommodate the increasing
demand for its services. The president of the company assigns Jill Ottenbreit to forecast
rentals for the next month. Rental data for the last 15 weeks are available and are presented
in Table 5. At first, Jill attempts to develop a forecast using a three-week moving average.
The MSE for this model is 133 (see Table 4). Because the data are obviously trending, she
finds that her forecasts are consistently underestimating actual rentals. For this reason, she
decides to try a double moving average. The results are presented in Table 5. To understand
the forecast for week 16, the computations are presented next. Equation 8 is used to com-
pute the three-week moving average (column 3).
Y15 + Y15-1 + Y15-3+1
M15 = YN15+1 =
3
728 + 711 + 712
M15 = YN16 = = 717
3

TABLE 5 Double Moving Average Forecast for the Movie Video Store for
Example 4

(1) (2) (3) Three-Week (4) Double (5) (6) (7)

Time Weekly Moving Moving Average Value Value Forecast (8)
t Sales Yt Average Mt Mt ¿ of a of b a + bp (p = 1) et

1 654 — — — — — —
2 658 — — — — — —
3 665 659 — — — — —
4 672 665 — — — — —
5 673 670 665 675 5 — —
6 671 672 669 675 3 680 -9
7 693 679 674 684 5 678 15
8 694 686 679 693 7 689 5
9 701 696 687 705 9 700 1
10 703 699 694 704 5 714 -11
11 702 702 699 705 3 709 -7
12 710 705 702 708 3 708 2
13 712 708 705 711 3 711 1
14 711 711 708 714 3 714 -3
15 728 717 712 722 5 717 11
16 — — — — — 727 —

MSE " 63.7

 Moving Averages and Smoothing Methods

Then Equation 9 is used to compute the double moving average (column 4).

¿
M15 + M15-1 + M15-3+1
M 15 =
3
¿ 717 + 711 + 708
M 15 = = 712
3

Equation 10 is used to compute the difference between the two moving averages
(column 5).
¿
a15 = 2M15 - M 15 = 217172 - 712 = 722

Equation 11 is used to adjust the slope (column 6).

2 ¿ 2
b15 = 1M - M 15 2 = 1717 - 7122 = 5
3 - 1 15 2

Equation 12 is used to make the forecast one period into the future (column 7).

YN15+1 = a15 + b15 p = 722 + 5112 = 727

The forecast four weeks into the future is

YN15+4 = a15 + b15 p = 722 + 5142 = 742

Note that the MSE has been reduced from 133 to 63.7.

It seems reasonable that more-recent observations are likely to contain more-

important information. A procedure is introduced in the next section that gives more
emphasis to the most recent observations.

EXPONENTIAL SMOOTHING METHODS

Whereas the method of moving averages takes into account only the most recent
observations, simple exponential smoothing provides an exponentially weighted mov-
ing average of all previously observed values. The model is often appropriate for data
with no predictable upward or downward trend. The aim is to estimate the current
level. This level estimate is then used as the forecast of future values.
Exponential smoothing continually revises an estimate in the light of more-recent
experiences. This method is based on averaging (smoothing) past values of a series in
an exponentially decreasing manner. The most recent observation receives the largest
weight, a (where 0 6 a 6 1); the next most recent observation receives less weight,
a11 - a2; the observation two time periods in the past receives even less weight,
a11 - a22; and so forth.
In one representation of exponential smoothing, the new forecast (for time t + 1)
may be thought of as a weighted sum of the new observation (at time t) and the old
forecast (for time t). The weight a (0 6 a 6 1) is given to the newly observed value,
and the weight 11 - a2 is given to the old forecast. Thus,

New forecast = 3a * 1New observation24 + 311 - a2 * 1Old forecast24

More formally, the exponential smoothing equation is

YNt + 1 = aYt + 11 - a2YNt (13)

 Moving Averages and Smoothing Methods

where
YNt+1 = the new smoothed value or the forecast value for the next period
a = the smoothing constant 10 6 a 6 12
Yt = the new observation or the actual value of the series in period t
YNt = the old smoothed value or the forecast for period t
Equation 13 can be written as

YNt+1 = aYt + (1 -a)YNt = aYt + YNt - aYNt

YNt+1 = YNt + a(Yt - YNt)

In this form, the new forecast (YN t + 1) is the old forecast (YN t) adjusted by a times the
error Yt - YN t in the old forecast.
In Equation 13, the smoothing constant, a, serves as the weighting factor. The
value of a determines the extent to which the current observation influences the fore-
cast of the next observation. When a is close to 1, the new forecast will be essentially
the current observation. (Equivalently, the new forecast will be the old forecast plus a
substantial adjustment for any error that occurred in the preceding forecast.)
Conversely, when a is close to zero, the new forecast will be very similar to the old fore-
cast, and the current observation will have very little impact.

Exponential smoothing is a procedure for continually revising a forecast in the

light of more-recent experience.

Finally, Equation 13 implies, for time t, that YNt = #YNt - 1 + (1 - #)Yt - 1 , and substi-
tution for YNt in Equation 13 gives

YNt+1 = aYt + 11 - a2YNt = aYt + 11 - a23aYt-1 + 11 - a2YNt-14

YNt+1 = aYt + a11 - a2Yt-1 + 11 - a22YNt-1

Continued substitution (for YN t - 1 and so forth) shows YN t + 1 can be written as a sum of

current and previous Y’s with exponentially declining weights or

YNt+1 = aYt + a11 - a2Yt-1 + a11 - a22Yt-2 + a11 - a23Yt-3 + Á (14)

That is, YN t + 1 is an exponentially smoothed value. The speed at which past observations
lose their impact depends on the value of a, as demonstrated in Table 6.
Equations 13 and 14 are equivalent, but Equation 13 is typically used to calculate
the forecast YN t + 1 because it requires less data storage and is easily implemented.
The value assigned to a is the key to the analysis. If it is desired that predictions be
stable and random variations be smoothed, a small value of a is required. If a rapid
response to a real change in the pattern of observations is desired, a larger value of a is
appropriate. One method of estimating α is an iterative procedure that minimizes the
mean squared error (MSE ). Forecasts are computed for, say, α equal to .1, .2, . . . , .9,
and the sum of the squared forecast errors is computed for each.
 Moving Averages and Smoothing Methods

TABLE 6 Comparison of Smoothing Constants

# = .1 # = .6
Period Calculations Weight Calculations Weight

t .100 .600
t-1 .9 * .1 .090 .4 * .6 .240
t-2 .9 * .9 * .1 .081 .4 * .4 * .6 .096
t-3 .9 * .9 * .9 * .1 .073 .4 * .4 * .4 * .6 .038
t-4 .9 * .9 * .9 * .9 * .1 .066 .4 * .4 * .4 * .4 * .6 .015
All others .590 .011

Totals 1.000 1.000

The value of α producing the smallest error is chosen for use in generating future
forecasts.
To start the algorithm for Equation 13, an initial value for the old smoothed series
must be set. One approach is to set the first smoothed value equal to the first observa-
tion. Example 5 will illustrate this approach. Another method is to use the average of
the first five or six observations for the initial smoothed value.

Example 5
The exponential smoothing technique is demonstrated in Table 7 and Figure 7 for Acme
Tool Company for the years 2000 to 2006, using smoothing constants of .1 and .6. The data
for the first quarter of 2006 will be used as test data to help determine the best value of α
(among the two considered). The exponentially smoothed series is computed by initially set-
ting YN1 equal to 500. If earlier data are available, it might be possible to use them to develop
a smoothed series up to 2000 and then use this experience as the initial value for the
smoothed series. The computations leading to the forecast for periods 3 and 4 are demon-
strated next.
1. Using Equation 13, at time period 2, the forecast for period 3 with # = .1 is

YN2+1 = aY2 + 11 - a2YN2

YN3 = .113502 + .915002 = 485

2. The error in this forecast is

e3 = Y3 - YN3 = 250 - 485 = - 235

3. The forecast for period 4 is

YN3+1 = aY3 + 11 - a2YN3

YN4 = .112502 + .914852 = 461.5

From Table 7, when the smoothing constant is .1, the forecast for the first quarter of 2006
is 469, with a squared error of 145,161. When the smoothing constant is .6, the forecast for
the first quarter of 2006 is 576, with a squared error of 75,076. On the basis of this limited
evidence, exponential smoothing with a = .6 performs better than exponential smoothing
with a = .1.

In Figure 7, note how stable the smoothed values are for the .1 smoothing con-
stant. On the basis of minimizing the mean squared error, MSE (MSE is called MSD
on the Minitab output), over the first 24 quarters, the .6 smoothing constant is better.
 Moving Averages and Smoothing Methods

TABLE 7 Exponentially Smoothed Values for Acme Tool

Company Sales for Example 5
Actual Smoothed Forecast Smoothed Forecast
Time Value Value Error Value Error
Year Quarters Yt YN t(a = .1) et YN t(a = .6) et

2000 1 500 500.0 0.0 500.0 0.0

2 350 500.0 -150.0 500.0 -150.0
3 250 485.0 (1) -235.0 122 410.0 -160.0
4 400 461.5 (3) -61.5 314.0 86.0
2001 5 450 455.4 -5.4 365.6 84.4
6 350 454.8 -104.8 416.2 -66.2
7 200 444.3 -244.3 376.5 -176.5
8 300 419.9 -119.9 270.6 29.4
2002 9 350 407.9 -57.9 288.2 61.8
10 200 402.1 -202.1 325.3 -125.3
11 150 381.9 -231.9 250.1 -100.1
12 400 358.7 41.3 190.0 210.0
2003 13 550 362.8 187.2 316.0 234.0
14 350 381.6 -31.5 456.4 -106.4
15 250 378.4 -128.4 392.6 -142.6
16 550 365.6 184.4 307.0 243.0
2004 17 550 384.0 166.0 452.8 97.2
18 400 400.6 -0.6 511.1 -111.1
19 350 400.5 -50.5 444.5 -94.5
20 600 395.5 204.5 387.8 212.2
2005 21 750 415.9 334.1 515.1 234.9
22 500 449.3 -50.7 656.0 -156.0
23 400 454.4 -54.4 562.4 -162.4
24 650 449.0 201.0 465.0 185.0
2006 25 850 469.0 381.0 576.0 274.0

Note: The numbers in parentheses refer to the explanations given in the text in Example 5.

If the mean absolute percentage errors (MAPEs) are compared, the .6 smoothing
constant is also better. To summarize:

a = .1 MSE = 24,262 MAPE = 38.9%

a = .6 MSE = 22,248 MAPE = 36.5%

However, the MSE and MAPE are both large, and on the basis of these summary
statistics, it is apparent that exponential smoothing does not represent these data well.
As we shall see, a smoothing method that allows for seasonality does a better job of
predicting the Acme Tool Company saw sales.
A factor, other than the choice of α, that affects the values of subsequent forecasts
is the choice of the initial value, YN1 for the smoothed series. In Table 7 (see Example 5),
YN1 = Y1 was used as the initial smoothed value. This choice tends to give Y1 too much
weight in later forecasts. Fortunately, the influence of the initial forecast diminishes
greatly as t increases.
 Moving Averages and Smoothing Methods

FIGURE 7 Exponential Smoothing for Acme Tool Company Data from

Example 5: (Top) a = .1 and (Bottom) a = .6

Another approach to initializing the smoothing procedure is to average the first k

observations. The smoothing then begins with

YN1 = a Yt
1 k
k t=1
Often k is chosen to be a relatively small number. For example, the default approach in
Minitab is to set k = 6.
 Moving Averages and Smoothing Methods

Example 6
The computation of the initial value as an average for the Acme Tool Company data
presented in Example 5 is shown next. If k is chosen to equal 6, then the initial value is

YN1 = a Yt = 1500 + 350 + 250 + 400 + 450 + 3502 = 383.3

1 6 1
6 t=1 6

The MSE and MAPE for each α when an initial smoothed value of 383.3 is used are
shown next.
a = .1 MSE = 21,091 MAPE = 32.1%
a = .6 MSE = 22,152 MAPE = 36.7%

The initial value, YN1 = 383.3, led to a decrease in the MSE and MAPE for a = .1 but did
not have much effect when a = .6. Now the best model, based on the MSE and MAPE sum-
mary measures, appears to be one that uses a = .1 instead of .6.
Figure 8 shows results for Example 5 when the data are run on Minitab (see the
Minitab Applications section at the end of the chapter for instructions). The smoothing con-
stant of a = .266 was automatically selected by minimizing the MSE. The MSE is reduced
to 19,447, the MAPE equals 32.2%, and although not shown, the MPE equals –6.4%. The
forecast for the first quarter of 2006 is 534.
Figure 9 shows the autocorrelation function for the residuals of the exponential
smoothing method using an alpha of .266. When the Ljung-Box test is conducted for six
time lags, the large value of LBQ (33.86) shows that the first six residual autocorrelations as
a group are larger than would be expected if the residuals were random. In particular, the
significantly large residual autocorrelations at lags 2 and 4 indicate that the seasonal varia-
tion in the data is not accounted for by simple exponential smoothing.

Exponential smoothing is often a good forecasting procedure when a nonrandom

time series exhibits trending behavior. It is useful to develop a measure that can be
used to determine when the basic pattern of a time series has changed. A tracking sig-
nal is one way to monitor change. A tracking signal involves computing a measure of
the forecast errors over time and setting limits so that, when the errors go outside those
limits, the forecaster is alerted.

FIGURE 8 Exponential Smoothing with a = .266 for Acme

Tool Company Data for Example 6
 Moving Averages and Smoothing Methods

FIGURE 9 Autocorrelation Function for the Residuals When Exponential

Smoothing with a = .266 Is Used with Acme Tool Company Data
for Example 6

A tracking signal involves computing a measure of forecast errors over time and
setting limits so that, when the cumulative error goes outside those limits, the
forecaster is alerted.

For example, a tracking signal might be used to determine when the size of the
smoothing constant α should be changed. Since a large number of items are usually
being forecast, common practice is to continue with the same value of α for many peri-
ods before attempting to determine if a revision is necessary. Unfortunately, the sim-
plicity of using an established exponential smoothing model is a strong motivator for
not making a change. But at some point, it may be necessary to update α or abandon
exponential smoothing altogether. When the model produces forecasts containing a
great deal of error, a change is appropriate.
A tracking system is a method for monitoring the need for change. Such a system
contains a range of permissible deviations of the forecast from actual values. As long as
forecasts generated by exponential smoothing fall within this range, no change in α is
necessary. However, if a forecast falls outside the range, the system signals a need to
update α.
For instance, if things are going well, the forecasting technique should over-
and underestimate equally often. A tracking signal based on this rationale can be
developed.
Let U equal the number of underestimates out of the last n forecasts. In other
words, U is the number of errors out of the last k that are positive. If the process is in
control, the expected value of U is k/2, but sampling variability is involved, so values
close to k/2 would not be unusual. On the other hand, values that are not close to k/2
would indicate that the technique is producing biased forecasts.
Example 7
Suppose that Acme Tool Company has decided to use the exponential smoothing technique
with α equal to .1, as shown in Example 5. If the process is in control and the analyst decides
to monitor the last 10 error values, U has an expected value of 5. Actually,
 Moving Averages and Smoothing Methods

a U value of 2, 3, 4, 6, 7, or 8 would not be unduly alarming. However, a value of 0, 1, 9, or 10

would be of concern, since the probability of obtaining such a value by chance alone would
be .022 (based on the binomial distribution). With this information, a tracking system can be
developed based on the following rules:
If 2 … U … 8, then the process is in control.
If U 6 2 or U 7 8 then the process is out of control.
Assume that, out of the next 10 forecasts using this technique, only one has a positive error.
Since the probability of obtaining only one positive error out of 10 is quite low (.01), the
process is considered to be out of control (overestimating), and the value of α should be
changed.

Another way of tracking a forecasting technique is to determine a range that

should contain the forecasting errors. This can be accomplished by using the MSE that
was established when the optimally sized α was determined. If the exponential
smoothing technique is reasonably accurate, the forecast error should be approxi-
mately normally distributed about a mean of zero. Under this condition, there is about
a 95% chance that the actual observation will fall within approximately two standard
deviations of the forecast. Using the RMSE as an estimate of the standard deviation of
the forecast error, approximate 95% error limits can be determined. Forecast errors
falling within these limits indicate no cause for alarm. Errors (particularly a sequence
of errors) outside the limits suggest a change. Example 8 illustrates this approach.
Example 8
In Example 6, on the Acme Tool Company, the optimal α was determined to be a = .266,
with MSE = 19,447 . An estimate of the standard deviation of the forecast errors is
RMSE = 219,447 = 139.5. If the forecast errors are approximately normally distributed
about a mean of zero, there is about a 95% chance that the actual observation will fall
within two standard deviations of the forecast or within

;2RMSE = ;2219,477 = ;21139.52 = ;279

For this example, the permissible absolute error is 279. If for any future forecast the magni-
tude of the error is greater than 279, there is reason to believe that the optimal smoothing
constant α should be updated or a different forecasting method considered.

The preceding discussion on tracking signals also applies to the smoothing meth-
ods yet to be discussed in the rest of the chapter.
Simple exponential smoothing works well when the data vary about an infre-
quently changing level. Whenever a sustained trend exists, exponential smoothing will
lag behind the actual values over time. Holt’s linear exponential smoothing technique,
which is designed to handle data with a well-defined trend, addresses this problem and
is introduced next.

Exponential Smoothing Adjusted for Trend: Holt’s Method

In simple exponential smoothing, the level of the time series is assumed to be changing
occasionally, and an estimate of the current level is required. In some situations, the
observed data will be clearly trending and contain information that allows the anticipa-
tion of future upward movements.When this is the case, a linear trend forecast function is
needed. Since business and economic series rarely exhibit a fixed linear trend, we consider
the possibility of modeling evolving local linear trends over time. Holt (2004) developed
an exponential smoothing method, Holt’s linear exponential smoothing,1 that allows for
evolving local linear trends in a time series and can be used to generate forecasts.
1Holt’s linear exponential smoothing is sometimes called double exponential smoothing.
 Moving Averages and Smoothing Methods

When a trend in the time series is anticipated, an estimate of the current slope, as
well as the current level, is required. Holt’s technique smoothes the level and slope
directly by using different smoothing constants for each. These smoothing constants
provide estimates of level and slope that adapt over time as new observations become
available. One of the advantages of Holt’s technique is that it provides a great deal of
flexibility in selecting the rates at which the level and trend are tracked.
The three equations used in Holt’s method are
1. The exponentially smoothed series, or current level estimate
Lt = #Yt + 11 - #21Lt-1 + Tt-12 (15)
2. The trend estimate
Tt = $1Lt - Lt-12 + 11 - $)Tt-1 (16)
3. The forecast for p periods into the future
YNt+p = Lt + pTt (17)
where
Lt = the new smoothed value (estimate of current level)
a = 1 the smoothing constant for the level 10 6 a 6 12
Yt = the new observation or actual value of the series in period t
b = the smoothing constant for the trend estimate 10 6 b 6 12
Tt = the trend estimate
p = the periods to be forecast into the future
YNt+p " the forecast for p periods into the future

Equation 15 is very similar to the equation for simple exponential smoothing,

Equation 13, except that a term 1Tt-12 has been incorporated to properly update the level
when a trend exists. That is, the current level 1Lt2 is calculated by taking a weighted aver-
age of two estimates of level—one estimate is given by the current observation 1Yt2, and
the other estimate is given by adding the previous trend 1Tt-12 to the previously smoothed
level 1Lt-12. If there is no trend in the data, there is no need for the term Tt-1 in Equation
15, effectively reducing it to Equation 13. There is also no need for Equation 16.
A second smoothing constant, b, is used to create the trend estimate. Equation 16
shows that the current trend 1Tt2 is a weighted average (with weights b and 1 - b) of
two trend estimates—one estimate is given by the change in level from time t - 1 to t
1Lt - Lt-12, and the other estimate is the previously smoothed trend 1Tt-12 . Equation
16 is similar to Equation 15, except that the smoothing is done for the trend rather than
the actual data.
Equation 17 shows the forecast for p periods into the future. For a forecast made at
time t, the current trend estimate 1Tt2 is multiplied by the number of periods to be fore-
cast 1p2, and then the product is added to the current level 1Lt2. Note that the forecasts
for future periods lie along a straight line with slope Tt and intercept Lt.
As with simple exponential smoothing, the smoothing constants α and b can be
selected subjectively or generated by minimizing a measure of forecast error such as
the MSE. Large weights result in more rapid changes in the component; small weights
result in less rapid changes. Therefore, the larger the weights are, the more the
smoothed values follow the data; the smaller the weights are, the smoother the pattern
in the smoothed values is.
 Moving Averages and Smoothing Methods

We could develop a grid of values of α and b (e.g., each combination of

a = 0.1, 0.2, Á , 0.9 and b = 0.1, 0.2, Á , 0.9) and then select the combination that
provides the lowest MSE. Most forecasting software packages use an optimization
algorithm to minimize the MSE. We might insist that a = b , thus providing equal
amounts of smoothing for the level and the trend. In the special case where a = b ,
Holt’s approach is the same as Brown’s double exponential smoothing.
To get started, initial values for L and T in Equations 15 and 16 must be determined.
One approach is to set the first estimate of the smoothed level equal to the first observa-
tion. The trend is then estimated to be zero. A second approach is to use the average of
the first five or six observations as the initial smoothed value L. The trend is then esti-
mated using the slope of a line fit to these five or six observations. Minitab develops a
regression equation using the variable of interest as Y and time as the independent vari-
able X. The constant from this equation is the initial estimate of the level component, and
the slope or regression coefficient is the initial estimate of the trend component.

Example 9
In Example 6, simple exponential smoothing did not produce successful forecasts of Acme
Tool Company saw sales. Because Figure 8 suggests that there might be a trend in these data,
Holt’s linear exponential smoothing is used to develop forecasts. To begin the computations
shown in Table 8, two estimated initial values are needed, namely, the initial level and the ini-
tial trend value. The estimate of the level is set equal to the first observation. The trend is esti-
mated to equal zero. The technique is demonstrated in Table 8 for a = .3 and b = .1.
The value for α used here is close to the optimal α (a = .266) for simple exponential
smoothing in Example 6. α is used to smooth the data to eliminate randomness and estimate
level. The smoothing constant b is like α, except that it is used to smooth the trend in the
data. Both smoothing constants are used to average past values and thus to remove ran-
domness. The computations leading to the forecast for period 3 are shown next.
1. Update the exponentially smoothed series or level:

Lt = aYt + 11 - a21Lt-1 + Tt-12

L2 = .3Y2 + 11 - .321L2-1 + T2-12
L2 = .313502 + .71500 + 02 = 455

2. Update the trend estimate:

Tt = $1Lt - Lt-12 + 11 - $2Tt-1

T2 = .11L2 - L2-12 + 11 - .12T2-1
T2 = .11455 - 5002 + .9102 = -4.5

3. Forecast one period into the future:

YN t+p = Lt + pTt

YN2+1 = L2 + 1T2 = 455 + 11-4.52 = 450.5

4. Determine the forecast error:

e3 = Y3 - YN3 = 250 -450.5 = -200.5

The forecast for period 25 is computed as follows:

1. Update the exponentially smoothed series or level:

L24 = .3Y24 + 11 - .321L24-1 + T24-12

L24 = .316502 + .71517.6 + 9.82 = 564.2
 Moving Averages and Smoothing Methods

TABLE 8 Exponentially Smoothed Values for Acme Tool

Company Sales, Holt’s Method, for Example 9

Year t Yt Lt Tt YN t+p et

2000 1 500 500.0 0.0 500.0 0.0

2 350 455.0 -4.5 500.0 -150.0
3 250 390.4 -10.5 450.5 -200.5
4 400 385.9 -9.9 379.8 20.2
2001 5 450 398.2 -7.7 376.0 74.0
6 350 378.3 -8.9 390.5 -40.5
7 200 318.6 -14.0 369.4 -169.4
8 300 303.2 -14.1 304.6 -4.6
2002 9 350 307.4 -12.3 289.1 60.9
10 200 266.6 -15.2 295.1 -95.1
11 150 221.0 -18.2 251.4 -101.4
12 400 262.0 -12.3 202.8 197.2
2003 13 550 339.8 -3.3 249.7 300.3
14 350 340.6 -2.9 336.5 13.5
15 250 311.4 -5.5 337.7 -87.7
16 550 379.1 1.8 305.9 244.1
2004 17 550 431.7 6.9 381.0 169.0
18 400 427.0 5.7 438.6 -38.6
19 350 407.9 3.3 432.7 -82.7
20 600 467.8 8.9 411.2 188.8
2005 21 750 558.7 17.1 476.8 273.2
22 500 553.1 14.8 575.9 -75.9
23 400 517.6 9.8 567.9 -167.9
24 650 564.2 13.5 527.4 122.6
2006 25 850 — — 577.7 272.3

MSE = 20,515.5

2. Update the trend estimate:

T24 = .11L24 - L24-12 + 11 - .12T24-1

T24 = .11564.2 - 517.62 + .919.82 = 13.5

3. Forecast one period into the future:

YN24+1 = L24 + 1T24

YN25 = 564.2 + 1113.52 = 577.7

On the basis of minimizing the MSE over the period 2000 to 2006, Holt’s linear
smoothing (with a = .3 and b = .1) does not reproduce the data any better than sim-
ple exponential smoothing that used a smoothing constant of .266. A comparison of the
MAPEs shows them to be about the same. When the forecasts for the actual sales for
 Moving Averages and Smoothing Methods

FIGURE 10 Holt’s Linear Exponential Smoothing for Acme Tool

Company Data for Example 9

the first quarter of 2006 are compared, again Holt smoothing and simple exponential
smoothing are comparable. To summarize:
a = .266 MSE = 19,447 MAPE = 32.2%
a = .3, b = .1 MSE = 20,516 MAPE = 35.4%
Figure 10 shows the results when Holt’s method using a = .3 and b = .1 is run on
Minitab.2 The autocorrelation function for the residuals from Holt’s linear exponential
smoothing is given in Figure 11. The autocorrelation coefficients at time lags 2 and 4
appear to be significant. Also, when the Ljung-Box Q statistic is computed for six time
lags, the large value of LBQ (36.33) shows that the residuals contain extensive autocor-
relation; they are not random. The large residual autocorrelations at lags 2 and 4
suggest a seasonal component may be present in Acme Tool Company data.
The results in Examples 6 and 9 (see Figures 8 and 10) are not much different
because the smoothing constant α is about the same in both cases and the smoothing
constant b in Example 9 is small. (For b = 0, Holt’s linear smoothing reduces to simple
exponential smoothing.)

Exponential Smoothing Adjusted for Trend

and Seasonal Variation: Winters’ Method
Examination of the data for Acme Tool Company in Table 8 indicates that sales are
consistently higher during the first and fourth quarters and lower during the third
quarter. A seasonal pattern appears to exist. Winters’ three-parameter linear and sea-
sonal exponential smoothing method, an extension of Holt’s method, might represent
the data better and reduce forecast error. In Winters’ method, one additional equation
is used to estimate seasonality. In the multiplicative version of Winters’ method, the
seasonality estimate is given as a seasonal index, and it is calculated with Equation 20.
Equation 20 shows that to compute the current seasonal component, St, the product of g

2In the Minitab program, the trend parameter gamma (g) is identical to our beta (b).
 Moving Averages and Smoothing Methods

FIGURE 11 Autocorrelation Function for the Residuals from Holt’s Linear

Exponential Smoothing for Acme Tool Company Data for
Example 9

and an estimate of the seasonal index given by Yt >Lt is added to 11 - g2 times the pre-
vious seasonal component, St-s. This procedure is equivalent to smoothing current and
previous values of Yt >Lt. Yt is divided by the current level estimate, Lt, to create an
index (ratio) that can be used in a multiplicative fashion to adjust a forecast to account
for seasonal peaks and valleys.
The four equations used in Winters’ (multiplicative) smoothing are
1. The exponentially smoothed series, or level estimate:
Yt
Lt = a + 11 - a21Lt-1 + Tt-12 (18)
St-s
2. The trend estimate:
Tt = b1Lt - Lt-12 + 11 - b2Tt-1 (19)
3. The seasonality estimate:
Yt
St = % + 11 - %2St-s (20)
Lt
4. The forecast for p periods into the future:
YNt+p = 1Lt + pTt2St-s+p (21)

where
Lt = the new smoothed value or current level estimate
a = the smoothing constant for the level
Yt = the new observation or actual value in period t
b = the smoothing constant for the trend estimate
Tt = the trend estimate
g = the smoothing constant for the seasonality estimate
St = the seasonal estimate
 Moving Averages and Smoothing Methods

p = the periods to be forecast into the future

s = the length of seasonality
YNt+p = the forecast for p periods into the future
Equation 18 updates the smoothed series. A slight difference in this equation distin-
guishes it from the corresponding one in Holt’s procedure, Equation 15. In Equation
18, Yt is divided by St-s, which adjusts Yt for seasonality, thus removing the seasonal
effects that might exist in the original data, Yt.
After the trend estimate and seasonal estimate have been smoothed in Equations
19 and 20, a forecast is obtained with Equation 21. It is almost the same as the corre-
sponding formula, Equation 17, used to obtain a forecast with Holt’s smoothing. The
difference is that this estimate for future periods, t + p, is multiplied by St-s+p. This sea-
sonal index is the last one available and is therefore used to adjust the forecast for sea-
sonality.
As with Holt’s linear exponential smoothing, the weights α, b, and g can be
selected subjectively or generated by minimizing a measure of forecast error, such as
the MSE. The most common approach for determining these values is to use an opti-
mization algorithm to find the optimal smoothing constants.
To begin the algorithm for Equation 18, the initial values for the smoothed series,
Lt; the trend, Tt; and the seasonal indices, St, must be set. One approach is to set the first
estimate of the smoothed series (level) equal to the first observation. The trend is then
estimated to equal zero, and each seasonal index is set to 1.0. Other approaches for ini-
tializing the level, trend, and seasonal estimates are available. Minitab, for example,
develops a regression equation using the variable of interest as Y and time as the inde-
pendent variable X. The constant from this equation is the initial estimate of the
smoothed series or level component, and the slope or regression coefficient is the ini-
tial estimate of the trend component. Initial values for the seasonal components are
obtained from a dummy variable regression using detrended data.
Example 10
Winters’ technique is demonstrated in Table 9 for a = .4, b = .1, and g = .3 for the Acme
Tool Company data. The value for α is similar to the one used for simple exponential
smoothing in Example 6, and it is used to smooth the data to create a level estimate. The
smoothing constant b is used to create a smoothed estimate of trend. The smoothing con-
stant g is used to create a smoothed estimate of the seasonal component in the data.
Minitab can be used to solve this example (see the Minitab Applications section at the
end of the chapter for the instructions).3 The results are shown in Table 9 and Figure 12. The
forecast for the first quarter of 2006 is 778.2. The computations leading to the forecast value
for the first quarter of 2006, or period 25, are shown next.
1. The exponentially smoothed series, or level estimate:

Yt
Lt = a + 11 - a21Lt - 1 + Tt - 12
St - s
Y24
L24 = .4 + 11 - .421L24 - 1 + T24 - 12
S24 - 4
650
L24 = .4 + 11 - .421501.286 + 9.1482
1.39628
L24 = .41465.522 + .61510.4342 = 492.469

3In the Minitab program, the trend parameter gamma (g) is identical to our beta (b) and the seasonal param-
eter delta (δ) is identical to our gamma (g) in Equations 19 and 20, respectively.
 Moving Averages and Smoothing Methods

TABLE 9 Exponentially Smoothed Values for Acme Tool

Company Sales, Winters’ Method, for Example 10

Year t Yt Lt Tt St YN t+p et

2000 1 500 415.459 -41.9541 1.26744 563.257 -63.257

2 350 383.109 -40.9937 0.89040 328.859 21.141
3 250 358.984 -39.3068 0.66431 222.565 27.435
4 400 328.077 -38.4668 1.18766 375.344 24.656
2001 5 450 315.785 -35.8494 1.31471 367.063 82.937
6 350 325.194 -31.3235 0.94617 249.255 100.745
7 200 296.748 -31.0358 0.66721 195.221 4.779
8 300 260.466 -31.5604 1.17690 315.576 -15.576
2002 9 350 243.831 -30.0679 1.35093 300.945 49.055
10 200 212.809 -30.1632 0.94426 202.255 -2.255
11 150 199.515 -28.4764 0.69259 121.863 28.137
12 400 238.574 -21.7228 1.32682 201.294 198.706
2003 13 550 292.962 -14.1117 1.50886 292.949 257.051
14 350 315.575 -10.4393 0.99371 263.306 86.694
15 250 327.466 -8.2062 0.71385 211.335 38.665
16 550 357.366 -4.3956 1.39048 423.599 126.401
2004 17 550 357.588 -3.9339 1.51763 532.584 17.416
18 400 373.206 -1.9787 1.01713 351.428 48.572
19 350 418.856 2.7843 0.75038 264.999 85.001
20 600 425.586 3.1788 1.39628 586.284 13.716
2005 21 750 454.936 5.7959 1.55691 650.706 99.294
22 500 473.070 7.0297 1.02907 468.626 31.374
23 400 501.286 9.1484 0.76465 360.255 39.745
24 650 492.469 7.3518 1.37336 712.712 -62.712
2006 25 850 — — — 778.179 —
26 600 — — — 521.917 —
27 450 — — — 393.430 —
28 700 — — — 716.726 —

MSE " 7,636.86

2. The trend estimate:

Tt = b1Lt - Lt-12 + 11 - b2Tt-1
T24 = .11L24 - L24 - 12 + 11 - .12T24 - 1
T24 = .11492.469 - 501.2862 + .919.1482
T24 = .11-8.8172 + .919.1482 = 7.352
3. The seasonality estimate:
Yt
St = % + 11 - %2St-s
Lt
Y24
S24 = .3 + 11 - .32S24 - 4
L24
650
S24 = .3 + .711.396282
492.469
S24 = .311.31992 + .9774 = 1.3734
 Moving Averages and Smoothing Methods

FIGURE 12 Winters’ Exponential Smoothing for Acme Tool Company Data

for Example 10

4. The forecast for p = 1 period into the future:

YN24 + 1 = (L24 + 1T24)S24 - 4 + 1

YN 25 = 1492.469 + 117.352221.5569 = 778.17

For the parameter values considered, Winters’ technique is better than both of the
previous smoothing procedures in terms of minimizing the MSE. When the forecasts for
the actual sales for the first quarter of 2006 are compared, Winters’ technique also
appears to do a better job. Figure 13 shows the autocorrelation function for the Winters’
exponential smoothing residuals. None of the residual autocorrelation coefficients
appears to be significantly larger than zero. When the Ljung-Box Q statistic is calculated
for six time lags, the small value of LBQ (5.01) shows that the residual series is random.
Winters’ exponential smoothing method seems to provide adequate forecasts for the
Acme Tool Company data.

Winters’ method provides an easy way to account for seasonality when data have a
seasonal pattern. An alternative method consists of first deseasonalizing or seasonally
adjusting the data. Deseasonalizing is a process that removes the effects of seasonality
from the raw data. The forecasting model is applied to the deseasonalized data, and if
required, the seasonal component is reinserted to provide accurate forecasts.
Exponential smoothing is a popular technique for short-run forecasting. Its major
advantages are its low cost and simplicity. When forecasts are needed for inventory sys-
tems containing thousands of items, smoothing methods are often the only acceptable
approach.
Simple moving averages and exponential smoothing base forecasts on weighted
averages of past measurements. The rationale is that past values contain information
about what will occur in the future. Since past values include random fluctuations as
well as information concerning the underlying pattern of a variable, an attempt is made
 Moving Averages and Smoothing Methods

FIGURE 13 Autocorrelation Function for the Residuals from Winters’

Multiplicative Exponential Smoothing Method for Acme Tool
Company Data for Example 10

to smooth these values. Smoothing assumes that extreme fluctuations represent ran-
domness in a series of historical observations.
Moving averages are the means of a certain number, k, of values of a variable. The
most recent average is then the forecast for the next period. This approach assigns an
equal weight to each past value involved in the average. However, a convincing argu-
ment can be made for using all the data but emphasizing the most recent values.
Exponential smoothing methods are attractive because they generate forecasts by
using all the observations and assigning weights that decline exponentially as the
observations get older.

APPLICATION TO MANAGEMENT

Forecasts are one of the most important inputs managers have to aid them in the
decision-making process. Virtually every important operating decision depends to
some extent on a forecast. The production department has to schedule employment
needs and raw material orders for the next month or two; the finance department must
determine the best investment opportunities; marketing must forecast the demand for
a new product. The list of forecasting applications is quite lengthy.
Executives are keenly aware of the importance of forecasting. Indeed, a great deal
of time is spent studying trends in economic and political affairs and how events might
affect demand for products and/or services. One issue of interest is the importance
executives place on quantitative forecasting methods compared to their own opinions.
This issue is especially sensitive when events that have a significant impact on demand
are involved. One problem with quantitative forecasting methods is that they depend
on historical data. For this reason, they are probably least effective in determining the
dramatic change that often results in sharply higher or lower demand.
The averaging and smoothing forecasting methods discussed in this chapter are
useful because of their relative simplicity. These simple methods tend to be less costly,
easier to implement, and easier to understand than complex methods. Frequently, the
cost and potential difficulties associated with constructing more sophisticated models
outweigh any gains in their accuracy. For these reasons, small businesses find simple
 Moving Averages and Smoothing Methods

methods practical. Businesses without personnel capable of handling statistical models

also turn to simple methods. Business managers frequently face the need to prepare
short-term forecasts for a number of different items. A typical example is the manager
who must schedule production on the basis of some forecast of demand for several
hundred different products in a product line. Also, new businesses without lengthy his-
torical databases find these simple approaches helpful.
With a judicious choice of order k, the moving average method can do a good job
of adjusting to shifts in levels. It is economical to update, and it does not require much
data storage. The moving average method is most frequently used when repeated fore-
casts are necessary.
Exponential smoothing is a popular technique whose strength lies in good short-
term accuracy combined with quick, low-cost updating. The technique is widely used
when regular monthly or weekly forecasts are needed for a large number, perhaps
thousands, of items. Inventory control is one example where exponential smoothing
methods are routinely used.

Glossary
Exponential smoothing. Exponential smoothing is Simple average. A simple average uses the mean
a procedure for continually revising a forecast in of all relevant historical observations as the fore-
the light of more-recent experience. cast for the next period.
Moving average. A moving average of order k is Tracking signal. A tracking signal involves com-
the mean value of k consecutive observations. The puting a measure of forecast errors over time and
most recent moving average value provides a fore- setting limits so that, when the cumulative error
cast for the next period. goes outside those limits, the forecaster is alerted.

Key Formulas

Naive model

YNt + 1 = Yt (1)
Naive trend model

YNt + 1 = Yt + 1Yt - Yt - 12 (2)

Naive rate of change model

Yt
YNt + 1 = Yt (3)
Yt - 1
Naive seasonal model for quarterly data

YNt + 1 = Yt - 3 (4)
Naive trend and seasonal model for quarterly data

Yt - Yt - 4
YNt + 1 = Yt - 3 + (5)
4
Simple average model

YNt + 1 = a Yi
1 t
(6)
t i=1
 Moving Averages and Smoothing Methods

Updated simple average, new period

tYNt + 1 + Yt + 1
YNt + 2 = (7)
t + 1
Moving average for k time periods
Yt + Yt - 1 + Á + Yt - k + 1
YNt + 1 = (8)
k
Double moving average
Mt + Mt-1 + Mt-2 + Á + Mt-k + 1
M ¿t = (9)
k
at = 2Mt - M t¿ (10)
2
bt = 1M - M ¿t2 (11)
k - 1 t
YNt + p = at + bt p (12)

Simple exponential smoothing

YNt + 1 = aYt + 11 - a)YNt (13)

Equivalent alternative expression:

YNt + 1 = aYt + a11 - a2Yt - 1 + a11 - a22Yt - 2 + a11 - a23Yt - 3 + Á (14)

Holt’s linear smoothing

The exponentially smoothed series, or current level estimate:
Lt = aYt + 11 - a21Lt-1 + Tt-12 (15)

The trend estimate:

Tt = b1Lt - Lt-12 + 11 - b2Tt-1 (16)
The forecast for p periods into the future:
YNt + p = Lt + pTt (17)

Winters’ multiplicative smoothing

The exponentially smoothed series, or level estimate:
Yt
Lt = a + 11 - a21Lt-1 + Tt-12 (18)
St-s
The trend estimate:
Tt = b1Lt - Lt-12 + 11 - b2Tt-1 (19)
The seasonality estimate:
Yt
St = % + 11 - %2St-s (20)
Lt

The forecast for p periods into the future:

YNt + p = 1Lt + pTt2St - s + p (21)

 Moving Averages and Smoothing Methods

Problems
1. Which forecasting technique continually revises an estimate in the light of more-
recent experiences?
2. Which forecasting technique uses the value for the current period as the forecast
for the next period?
3. Which forecasting technique assigns equal weight to each observation?
4. Which forecasting technique(s) should be tried if the data are trending?
5. Which forecasting technique(s) should be tried if the data are seasonal?
6. Apex Mutual Fund invests primarily in technology stocks. The price of the fund at
the end of each month for the 12 months of 2006 is shown in Table P-6.
a. Find the forecast value of the mutual fund for each month by using a naive
model (see Equation 1). The value for December 2005 was 19.00.
b. Evaluate this forecasting method using the MAD.
c. Evaluate this forecasting method using the MSE.
d. Evaluate this forecasting method using the MAPE.
e. Evaluate this forecasting method using the MPE.
f. Using a naive model, forecast the mutual fund price for January 2007.
g. Write a memo summarizing your findings.
7. Refer to Problem 6. Use a three-month moving average to forecast the mutual
fund price for January 2007. Is this forecast better than the forecast made using the
naive model? Explain.
8. Given the series Yt in Table P-8:
a. What is the forecast for period 9, using a five-period moving average?
b. If simple exponential smoothing with a smoothing constant of .4 is used, what is
the forecast for time period 4?
c. In part b, what is the forecast error for time period 3?
9. The yield on a general obligation bond for the city of Davenport fluctuates with
the market. The monthly quotations for 2006 are given in Table P-9.

TABLE P-6

Month Mutual Fund Price

January 19.39
February 18.96
March 18.20
April 17.89
May 18.43
June 19.98
July 19.51
August 20.63
September 19.78
October 21.25
November 21.18
December 22.14
 Moving Averages and Smoothing Methods

TABLE P-8

Time Period Yt YNt et

1 200 200 —
2 210 — —
3 215 — —
4 216 — —
5 219 — —
6 220 — —
7 225 — —
8 226 — —

TABLE P-9

Month Yield

January 9.29
February 9.99
March 10.16
April 10.25
May 10.61
June 11.07
July 11.52
August 11.09
September 10.80
October 10.50
November 10.86
December 9.97

a. Find the forecast value of the yield for the obligation bonds for each month,
starting with April, using a three-month moving average.
b. Find the forecast value of the yield for the obligation bonds for each month,
starting with June, using a five-month moving average.
c. Evaluate these forecasting methods using the MAD.
d. Evaluate these forecasting methods using the MSE.
e. Evaluate these forecasting methods using the MAPE.
f. Evaluate these forecasting methods using the MPE.
g. Forecast the yield for January 2007 using the better technique.
h. Write a memo summarizing your findings.
10. This question refers to Problem 9. Use exponential smoothing with a smoothing
constant of .2 and an initial value of 9.29 to forecast the yield for January 2007. Is
this forecast better than the forecast made using the better moving average
model? Explain.
11. The Hughes Supply Company uses an inventory management method to deter-
mine the monthly demands for various products. The demand values for the last 12
months of each product have been recorded and are available for future forecast-
ing. The demand values for the 12 months of 2006 for one electrical fixture are pre-
sented in Table P-11.
 Moving Averages and Smoothing Methods

TABLE P-11

Month Demand

January 205
February 251
March 304
April 284
May 352
June 300
July 241
August 284
September 312
October 289
November 385
December 256

Source: Based on Hughes Supply Company records.

Use exponential smoothing with a smoothing constant of .5 and an initial value of

205 to forecast the demand for January 2007.
12. General American Investors Company, a closed-end regulated investment man-
agement company, invests primarily in medium- and high-quality stocks. Jim
Campbell is studying the asset value per share for this company and would like to
forecast this variable for the remaining quarters of 1996. The data are presented in
Table P-12.
Evaluate the ability to forecast the asset value per share variable of the follow-
ing forecasting methods: naive, moving average, and exponential smoothing. When
you compare techniques, take into consideration that the actual asset value per
share for the second quarter of 1996 was 26.47. Write a report for Jim indicating
which method he should use and why.

TABLE P-12 General American Investors Company

Assets per Share, 1985–1996

Quarter

Year 1 2 3 4

1985 16.98 18.47 17.63 20.65

1986 21.95 23.85 20.44 19.29
1987 22.75 23.94 24.84 16.70
1988 18.04 19.19 18.97 17.03
1989 18.23 19.80 22.89 21.41
1990 21.50 25.05 20.33 20.60
1991 25.33 26.06 28.89 30.60
1992 27.44 26.69 28.71 28.56
1993 25.87 24.96 27.61 24.75
1994 23.32 22.61 24.08 22.31
1995 22.67 23.52 25.41 23.94
1996 25.68 — — —

Source: The Value Line Investment Survey (New York: Value Line,
1990, 1993, 1996).
 Moving Averages and Smoothing Methods

TABLE P-13 Southdown Revenues, 1986–1999

Quarter

Year 1 2 3 4

1986 77.4 88.8 92.1 79.8

1987 77.5 89.1 92.4 80.1
1988 74.7 185.2 162.4 178.1
1989 129.1 158.4 160.6 138.7
1990 127.2 149.8 151.7 132.9
1991 103.0 136.8 141.3 123.5
1992 107.3 136.1 138.6 123.7
1993 106.1 144.4 156.1 138.2
1994 111.8 149.8 158.5 141.8
1995 119.1 158.0 170.4 151.8
1996 127.4 178.2 189.3 169.5
1997 151.4 187.2 199.2 181.4
1998 224.9 317.7 341.4 300.7
1999 244.9 333.4 370.0 326.7

Source: The Value Line Investment Survey (New York: Value Line,
1990, 1993, 1996, 1999).

13. Southdown, Inc., the nation’s third largest cement producer, is pushing ahead
with a waste fuel burning program. The cost for Southdown will total about
$37 million. For this reason, it is extremely important for the company to have an
accurate forecast of revenues for the first quarter of 2000. The data are presented
in Table P-13.
a. Use exponential smoothing with a smoothing constant of .4 and an initial value
of 77.4 to forecast the quarterly revenues for the first quarter of 2000.
b. Now use a smoothing constant of .6 and an initial value of 77.4 to forecast the
quarterly revenues for the first quarter of 2000.
c. Which smoothing constant provides the better forecast?
d. Refer to part c. Examine the residual autocorrelations. Are you happy with sim-
ple exponential smoothing for this example? Explain.
14. The Triton Energy Corporation explores for and produces oil and gas. Company
president Gail Freeman wants to have her company’s analyst forecast the com-
pany’s sales per share for 2000. This will be an important forecast, since Triton’s
restructuring plans have hit a snag. The data are presented in Table P-14.
Determine the best forecasting method and forecast sales per share for 2000.
15. The Consolidated Edison Company sells electricity (82% of revenues), gas (13%),
and steam (5%) in New York City and Westchester County. Bart Thomas, company
forecaster, is assigned the task of forecasting the company’s quarterly revenues for
the rest of 2002 and all of 2003. He collects the data shown in Table P-15.
Determine the best forecasting technique and forecast quarterly revenue for
the rest of 2002 and all of 2003.
16. A job-shop manufacturer that specializes in replacement parts has no forecasting
system in place and manufactures products based on last month’s sales. Twenty-
four months of sales data are available and are given in Table P-16.
 Moving Averages and Smoothing Methods

TABLE P-14 Triton Sales per Share, 1974–1999

Year Sales per Share Year Sales per Share

1974 .93 1987 5.33

1975 1.35 1988 8.12
1976 1.48 1989 10.65
1977 2.36 1990 12.06
1978 2.45 1991 11.63
1979 2.52 1992 6.58
1980 2.81 1993 2.96
1981 3.82 1994 1.58
1982 5.54 1995 2.99
1983 7.16 1996 3.69
1984 1.93 1997 3.98
1985 5.17 1998 4.39
1986 7.72 1999 6.85

Source: The Value Line Investment Survey (New York: Value Line,
1990, 1993, 1996, 1999)

TABLE P-15 Quarterly Revenues for Consolidated Edison

($ millions), 1985–June 2002

Year Mar. 31 Jun. 30 Sept. 30 Dec. 31

1985 1,441 1,209 1,526 1,321

1986 1,414 1,187 1,411 1,185
1987 1,284 1,125 1,493 1,192
1988 1,327 1,102 1,469 1,213
1989 1,387 1,218 1,575 1,371
1990 1,494 1,263 1,613 1,369
1991 1,479 1,330 1,720 1,344
1992 1,456 1,280 1,717 1,480
1993 1,586 1,396 1,800 1,483
1994 1,697 1,392 1,822 1,461
1995 1,669 1,460 1,880 1,528
1996 1,867 1,540 1,920 1,632
1997 1,886 1,504 2,011 1,720
1998 1,853 1,561 2,062 1,617
1999 1,777 1,479 2,346 1,889
2000 2,318 2,042 2,821 2,250
2001 2,886 2,112 2,693 1,943
2002 2,099 1,900 — —

Source: The Value Line Investment Survey (New York: Value Line, 1990, 1993,
1996, 1999, 2001).

a. Plot the sales data as a time series. Are the data seasonal?
Hint: For monthly data, the seasonal period is s = 12. Is there a pattern (e.g.,
summer sales relatively low, fall sales relatively high) that tends to repeat
itself every 12 months?
 Moving Averages and Smoothing Methods

TABLE P-16

Month Sales Month Sales

January 2005 430 January 2006 442

February 420 February 449
March 436 March 458
April 452 April 472
May 477 May 463
June 420 June 431
July 398 July 400
August 501 August 487
September 514 September 503
October 532 October 503
November 512 November 548
December 410 December 432

b. Use a naive model to generate monthly sales forecasts (e.g., the February
2005 forecast is given by the January 2005 value, and so forth). Compute the
MAPE.
c. Use simple exponential smoothing with a smoothing constant of .5 and an initial
smoothed value of 430 to generate sales forecasts for each month. Compute the
MAPE.
d. Do you think either of the models in parts b and c is likely to generate accurate
forecasts for future monthly sales? Explain.
e. Use Minitab and Winters’ multiplicative smoothing method with smoothing con-
stants a = b = g = .5 to generate a forecast for January 2007. Save the residuals.
f. Refer to part e. Compare the MAPE for Winters’ method from the computer
printout with the MAPEs in parts b and c. Which of the three forecasting proce-
dures do you prefer?
g. Refer to part e. Compute the autocorrelations (for six lags) for the residuals
from Winters’ multiplicative procedure. Do the residual autocorrelations sug-
gest that Winters’ procedure works well for these data? Explain.
17. Consider the gasoline purchases for the Spokane Transit Authority given in Table
2. In Example 3, a five-week moving average is used to smooth the data and gener-
ate forecasts.
a. Use Minitab to smooth the Spokane Transit Authority data using a four-week
moving average. Which moving average length, four weeks or five weeks,
appears to represent the data better? Explain.
b. Use Minitab to smooth the Spokane Transit Authority data using simple expo-
nential smoothing. Compare your results with those in part a. Which procedure,
four-week moving average or simple exponential smoothing, do you prefer for
these data? Explain.
18. Table P-18 contains the number of severe earthquakes (those with a Richter scale
magnitude of 7 and above) per year for the years 1900–1999.
a. Use Minitab to smooth the earthquake data with moving averages of orders
k = 5, 10, and 15. Describe the nature of the smoothing as the order of the mov-
ing average increases. Do you think there might be a cycle in these data? If so,
provide an estimate of the length (in years) of the cycle.
 Moving Averages and Smoothing Methods

TABLE P-18 Number of Severe Earthquakes, 1900–1999

Year Number Year Number Year Number Year Number

1900 13 1927 20 1954 17 1981 14

1901 14 1928 22 1955 19 1982 10
1902 8 1929 19 1956 15 1983 15
1903 10 1930 13 1957 34 1984 8
1904 16 1931 26 1958 10 1985 15
1905 26 1932 13 1959 15 1986 6
1906 32 1933 14 1960 22 1987 11
1907 27 1934 22 1961 18 1988 8
1908 18 1935 24 1962 15 1989 7
1909 32 1936 21 1963 20 1990 12
1910 36 1937 22 1964 15 1991 11
1911 24 1938 26 1965 22 1992 23
1912 22 1939 21 1966 19 1993 16
1913 23 1940 23 1967 16 1994 15
1914 22 1941 24 1968 30 1995 25
1915 18 1942 27 1969 27 1996 22
1916 25 1943 41 1970 29 1997 20
1917 21 1944 31 1971 23 1998 16
1918 21 1945 27 1972 20 1999 23
1919 14 1946 35 1973 16
1920 8 1947 26 1974 21
1921 11 1948 28 1975 21
1922 14 1949 36 1976 25
1923 23 1950 39 1977 16
1924 18 1951 21 1978 18
1925 17 1952 17 1979 15
1926 19 1953 22 1980 18

Source: U.S. Geological Survey Earthquake Hazard Program.

b. Use Minitab to smooth the earthquake data using simple exponential smooth-
ing. Store the residuals and generate a forecast for the number of severe earth-
quakes in the year 2000. Compute the residual autocorrelations. Does simple
exponential smoothing provide a reasonable fit to these data? Explain.
c. Is there a seasonal component in the earthquake data? Why or why not?
19. This problem was intentionally excluded from this text.
20. Table P-20 contains quarterly sales ($MM) of The Gap for fiscal years 1980–2004.
Plot The Gap sales data as a time series and examine its properties. The objec-
tive is to generate forecasts of sales for the four quarters of 2005. Select an appro-
priate smoothing method for forecasting and justify your choice.
 Moving Averages and Smoothing Methods

TABLE P-20 Quarterly Sales for The Gap, Fiscal Years 1980–2004

Year Q1 Q2 Q3 Q4

1980 65.3 72.1 107.1 125.3

1981 76.0 76.9 125.4 139.1
1982 84.4 86.0 125.4 139.1
1983 87.3 90.9 133.3 169.0
1984 98.0 105.3 141.4 189.4
1985 105.7 120.1 181.7 239.8
1986 160.0 164.8 224.8 298.4
1987 211.1 217.7 273.6 359.6
1988 241.3 264.3 322.8 423.7
1989 309.9 325.9 405.6 545.2
1990 402.4 405.0 501.7 624.7
1991 490.3 523.1 702.0 803.5
1992 588.9 614.1 827.2 930.2
1993 643.6 693.2 898.7 1,060.2
1994 751.7 773.1 988.3 1,209.8
1995 848.7 868.5 1,155.9 1,522.1
1996 1,113.2 1,120.3 1,383.0 1,667.9
1997 1,231.2 1,345.2 1,765.9 2,165.5
1998 1,719.7 1,905.0 2,399.9 3,029.8
1999 2,277.7 2,453.3 3,045.4 3,858.9
2000 2,732.0 2,947.7 3,414.7 4,579.1
2001 3,179.7 3,245.2 3,333.4 4,089.6
2002 2,890.8 3,268.3 3,645.0 4,650.6
2003 3,353.0 3,685.0 3,929.0 4,887.0
2004 3,668.0 3,721.0 3,980.0 4,898.0

Source: Based on The Value Line Investment Survey (New York: Value Line, various years),
and 10K filings with the Securities and Exchange Commission.

CASES

CASE 1 THE SOLAR ALTERNATIVE

COMPANY4
The Solar Alternative Company is about to enter founded the company. The Johnsons started the
its third year of operation. Bob and Mary Johnson, Solar Alternative Company to supplement their
who both teach science in the local high school, teaching income. Based on their research into solar

4This case was contributed by William P. Darrow of Towson State University, Towson, Maryland.
 Moving Averages and Smoothing Methods

energy systems, they were able to put together a than the first. Many of the second-year customers
solar system for heating domestic hot water. The sys- are neighbors of people who had purchased the sys-
tem consists of a 100-gallon fiberglass storage tank, tem in the first year. Apparently, after seeing the
two 36-foot solar panels, electronic controls, PVC system operate successfully for a year, others were
pipe, and miscellaneous fittings. willing to try the solar concept. Sales occur through-
The payback period on the system is 10 years. out the year. Demand for the system is greatest in
Although this situation does not present an attrac- late summer and early fall, when homeowners typi-
tive investment opportunity from a financial point cally make plans to winterize their homes for the
of view, there is sufficient interest in the novelty of upcoming heating season.
the concept to provide a moderate level of sales. With the anticipated growth in the business,
The Johnsons clear about $75 on the $2,000 price of the Johnsons felt that they needed a sales forecast
an installed system, after costs and expenses. to manage effectively in the coming year. It usually
Material and equipment costs account for 75% of takes 60 to 90 days to receive storage tanks after
the installed system cost. An advantage that helps placing the order. The solar panels are available
to offset the low profit margin is the fact that the off the shelf most of the year. However, in the late
product is not profitable enough to generate any summer and throughout the fall, the lead time can
significant competition from heating contractors. be as much as 90 to 100 days. Although there is
The Johnsons operate the business out of their limited competition, lost sales are nevertheless a
home. They have an office in the basement, and real possibility if the potential customer is asked to
their one-car garage is used exclusively to store the wait several months for installation. Perhaps more
system components and materials. As a result, over- important is the need to make accurate sales pro-
head is at a minimum. The Johnsons enjoy a modest jections to take advantage of quantity discount
supplemental income from the company’s opera- buying. These factors, when combined with the
tion. The business also provides a number of tax high cost of system components and the limited
advantages. storage space available in the garage, make it nec-
Bob and Mary are pleased with the growth of essary to develop a reliable forecast. The sales his-
the business. Although sales vary from month to tory for the company’s first two years is given in
month, overall the second year was much better Table 10.

TABLE 10

Month 2005 2006 Month 2005 2006

January 5 17 July 23 44
February 6 14 August 26 41
March 10 20 September 21 33
April 13 23 October 15 23
May 18 30 November 12 26
June 15 38 December 14 17

ASSIGNMENT

1. Identify the model Bob and Mary should use as 2. Forecast sales for 2007.
the basis for their business planning in 2007, and
discuss why you selected this model.
 Moving Averages and Smoothing Methods

CASE 2 MR. TUX

John Mosby, owner of several Mr. Tux rental stores, the program finds the optimum α value to be
is beginning to forecast his most important business .867. Again he records the appropriate error
variable, monthly dollar sales. One of his employees, measurements:
Virginia Perot, gathered the sales data. John now
MAD = 46,562
wants to create a forecast based on these sales data
using moving average and exponential smoothing MAPE = 44.0%
techniques. John asks the program to use Holt’s linear exponential
John used Minitab to determine that these data smoothing on his data. This program uses the expo-
are both trending and seasonal. He has been told nential smoothing method but can account for a trend
that simple moving averages and exponential in the data as well. John has the program use a
smoothing techniques will not work with these data smoothing constant of .4 for both α and b. The two
but decides to find out for himself. summary error measurements for Holt’s method are
He begins by trying a three-month moving
MAD = 63,579
average. The program calculates several summary
forecast error measurements. These values summa- MAPE = 59.0%
rize the errors found in predicting actual historical John is surprised to find larger measurement
data values using a three-month moving average. errors for this technique. He decides that the seasonal
John decides to record two of these error measure- aspect of the data is the problem. Winters’ multiplica-
ments: tive exponential smoothing is the next method John
tries. This method can account for seasonal factors as
MAD = 54,373
well as trend. John uses smoothing constants of
MAPE = 47.0% a = .2, b = .2, and g = .2. Error measurements are
The MAD (mean absolute deviation) is the average MAD = 25,825
absolute error made in forecasting past values. Each
MAPE = 22.0%
forecast using the three-month moving average
method is off by an average of 54,373. The MAPE When John sits down and begins studying the results
(mean absolute percentage error) shows the error as of his analysis, he is disappointed. The Winters’
a percentage of the actual value to be forecast. The method is a big improvement; however, the MAPE
average error using the three-month moving aver- is still 22%. He had hoped that one of the methods
age technique is 47%, or almost half as large as the he used would result in accurate forecasts of past
value to be forecast. periods; he could then use this method to forecast
Next, John tries simple exponential smoothing. the sales levels for coming months over the next
The program asks him to input the smoothing year. But the average absolute errors (MADs) and
constant (α) to be used or to ask that the optimum percentage errors (MAPEs) for these methods lead
α value be calculated. John does the latter, and him to look for another way of forecasting.

QUESTIONS
1. Summarize the forecast error level for the best methods. What should John do, for example, to
method John has found using Minitab. determine the adequacy of the Winters’ fore-
2. John used the Minitab default values for α, b, casting technique?
and g. John thinks there are other choices for 4. Although not calculated directly in Minitab, the
these parameters that would lead to smaller MPE (mean percentage error) measures fore-
error measurements. Do you agree? cast bias. What is the ideal value for the MPE?
3. Although disappointed with his initial results, What is the implication of a negative sign on the
this may be the best he can do with smoothing MPE?
 Moving Averages and Smoothing Methods

CASE 3 CONSUMER CREDIT

COUNSELING

The executive director, Marv Harnishfeger, con- seen by CCC for the period from January 1985
cluded that the most important variable that through March 1993. Dorothy then used autocorre-
Consumer Credit Counseling (CCC) needed to lation analysis to explore the data pattern. Use the
forecast was the number of new clients that would results of this investigation to complete the follow-
be seen in the rest of 1993. Marv provided Dorothy ing tasks.
Mercer monthly data for the number of new clients

ASSIGNMENT
1. Develop a naive model to forecast the number 4. Evaluate these forecasting methods using the
of new clients seen by CCC for the rest of 1993. forecast error summary measures.
2. Develop a moving average model to forecast 5. Choose the best model and forecast new clients
the number of new clients seen by CCC for the for the rest of 1993.
rest of 1993. 6. Determine the adequacy of the forecasting
3. Develop an exponential smoothing procedure model you have chosen.
to forecast the number of new clients seen by
CCC for the rest of 1993.

CASE 4 MURPHY BROTHERS FURNITURE

Julie Murphy knows that most important operat- investment opportunities and must forecast the
ing decisions depend, to some extent, on a fore- demand for a new furniture line.
cast. For Murphy Brothers Furniture, sales fore- Julie Murphy used monthly sales for all retail
casts impact adding new furniture lines or stores from 1983 through 1995 to develop a pattern
dropping old ones; planning purchases; setting for Murphy Brothers Furniture sales. Glen Murphy
sales quotas; and making personnel, advertising, discovered actual sales data for the past four years,
and financial decisions. Specifically, Julie is aware 1992 through 1995. Julie was not excited about her
of several current forecasting needs. She knows father’s discovery because she was not sure which
that the production department has to schedule set of data to use to develop a forecast for 1996. She
employees and determine raw material orders for determined that sales for all retail stores had some-
the next month or two. She also knows that her what the same pattern as actual Murphy Brothers’
dad, Glen Murphy, needs to determine the best sales data.

QUESTIONS
1. Do any of the forecasting models studied in this 3. Which data set and forecasting model should
chapter work with the national sales data? Julie use to forecast sales for 1996?
2. Do any of the forecasting models studied in this
chapter work with the actual Murphy Brothers’
sales data?
 Moving Averages and Smoothing Methods

CASE 5 FIVE-YEAR REVENUE PROJECTION FOR

DOWNTOWN RADIOLOGY

Some years ago Downtown Radiology developed a METHODOLOGY

medical imaging center that was more complete and Medical Procedures
technologically advanced than any located in an area The following steps were implemented in order to
of eastern Washington and northern Idaho called the complete the five-year projection of revenue. An
Inland Empire.The equipment planned for the center analysis of the past number of procedures was per-
equaled or surpassed the imaging facilities of all med- formed. The appropriate forecasting model was
ical centers in the region. The center initially con- developed and used to determine a starting point for
tained a 9800 series CT scanner and nuclear magnetic the projection of each procedure.
resonance imaging (MRI) equipment.The center also
included ultrasound, nuclear medicine, digital sub- 1. The market area was determined for each type
traction angiography (DSA), mammography, and of procedure, and population forecasts were
conventional radiology and fluoroscopy equipment. obtained for 1986 and 1990.
Ownership interest was made available in a type of 2. Doctor referral patterns were studied to deter-
public offering, and Downtown Radiology used an mine the percentage of doctors who refer to
independent evaluation of the market. Professional Downtown Radiology and the average number
Marketing Associates, Inc., evaluated the market and of referrals per doctor.
completed a five-year projection of revenue. 3. National rates were acquired from the National
Center for Health Statistics. These rates were
STATEMENT OF THE PROBLEM compared with actual numbers obtained from
The purpose of this study is to forecast revenue for the Hospital Commission.
the next five years for the proposed medical imaging 4. Downtown Radiology’s market share was calcu-
center, assuming you are employed by Professional lated based on actual CT scans in the market
Marketing Associates, Inc., in the year 1984. area. (Market share for other procedures was
determined based on Downtown Radiology’s
OBJECTIVES share compared to rates provided by the
The objectives of this study are to National Center for Health Statistics.)
• Identify market areas for each type of medical Assumptions
procedure to be offered by the new facility. The following assumptions, which were necessary to
• Gather and analyze existing data on market develop a quantitative forecast, were made:
area revenue for each type of procedure to be
• The new imaging center will be operational,
offered by the new facility.
with all equipment functional except the MRI,
• Identify trends in the health care industry that will on January 1, 1985.
positively or negatively affect revenue of proce- • The nuclear magnetic resonance imaging equip-
dures to be provided by the proposed facility. ment will be functional in April 1985.
• Identify factors in the business, marketing, or • The offering of the limited partnership will be
facility planning of the new venture that will pos- successfully marketed to at least 50 physicians
itively or negatively impact revenue projections. in the service area.
• Physicians who have a financial interest in the
• Analyze past procedures of Downtown
new imaging center will increase their referrals
Radiology when compiling a database for the
to the center.
forecasting model to be developed.
• There will be no other MRIs in the market area
• Utilize the appropriate quantitative forecasting before 1987.
model to arrive at five-year revenue projections • The new imaging center will offer services at
for the proposed center. lower prices than the competition.
 Moving Averages and Smoothing Methods

• An effective marketing effort will take place, ANALYSIS OF PAST DATA

especially concentrating on large employers, Office X-Rays
insurance groups, and unions. The number of X-ray procedures performed was
• The MRI will replace approximately 60% of the analyzed from July 1981 to May 1984. The data
head scans that are presently done with the CT included diagnostic X-rays, gastrointestinal X-rays,
scanner during the first six months of operation breast imaging, injections, and special procedures.
and 70% during the next 12 months. Examination of these data indicated that no trend or
• The general public will continue to pressure the seasonal or cyclical pattern is present. For this rea-
health care industry to hold down costs. son, simple exponential smoothing was chosen as the
• Costs of outlays in the health care industry rose appropriate forecasting method. Various smoothing
13.2% annually from 1971 to 1981. The Health constants were examined, and a smoothing constant
Care Financing Administration estimates that of .3 was found to provide the best model.The results
the average annual rate of increase will be are presented in Figure 14. The forecast for period
reduced to approximately 11% to 12% between 36, June 1984, is 855 X-ray procedures.
1981 and 1990 (Industry Surveys, April 1984).
• Insurance firms will reimburse patients for (at Office Ultrasound
worst) 0% up to (at best) 100% of the cost of The number of ultrasound procedures performed
magnetic resonance imaging (Imaging News, was analyzed from July 1981 to May 1984. Figure 15
February 1984). shows the data pattern. Again, no trend or seasonal
or cyclical pattern was present. Exponential smooth-
ing with a smoothing constant of a = .5 was deter-
Models mined to provide the best model. The forecast for
A forecast was developed for each procedure, June 1984 plotted in Figure 15 is 127 ultrasound pro-
based on past experience, industry rates, and rea- cedures.
sonable assumptions. The models were developed The number of ultrasound procedures performed
based on the preceding assumptions; however, if the by the two mobile units owned by Downtown
assumptions are not valid, the models will not be Radiology was analyzed from July 1981 to May 1984.
accurate. Figure 16 shows the data pattern. An increasing trend

FIGURE 14 Simple Exponential Smoothing: Downtown

Radiology X-Rays
 Moving Averages and Smoothing Methods

FIGURE 15 Simple Exponential Smoothing: Downtown Radiology

Ultrasound

FIGURE 16 Holt’s Linear Exponential Smoothing:

Downtown Radiology Nonoffice Ultrasound

is apparent and can be modeled using Holt’s two- Downtown Radiology was analyzed from August
parameter linear exponential smoothing. Smooth-ing 1982 to May 1984. Figure 17 shows the data pattern.
constants of a = .5 and b = .1 are used, and the The data were not seasonal and had no trend or
forecast for period 36, June 1984, is 227. cyclical pattern. For this reason, simple exponential
smoothing was chosen as the appropriate forecast-
Nuclear Medicine Procedures ing method. A smoothing factor of a = .5 was found
The number of nuclear medicine procedures to provide the best model. The forecast for period
performed by the two mobile units owned by 23, June 1984, is 48 nuclear medicine procedures.
 Moving Averages and Smoothing Methods

FIGURE 17 Simple Exponential Smoothing: Downtown

Radiology Nonoffice Nuclear Medicine

Office CT Scans was examined and compared to an exponential

The number of CT scans performed was also analyzed smoothing model with a smoothing constant of
from July 1981 to May 1984. Seasonality was not a = .461. The larger smoothing constant gives the
found, and the number of CT scans did not seem to most recent observation more weight in the forecast.
have a trend. However, a cyclical pattern seemed to be The exponential smoothing model was determined to
present. Knowing how many scans were performed be better than the autoregressive model,
last month would be important in forecasting what is and Figure 18 shows the projection of the number of
going to happen this month. An autoregressive model CT scans for period 36, June 1984, to be 221.

FIGURE 18 Simple Exponential Smoothing: Downtown Radiology

CT Scans
 Moving Averages and Smoothing Methods

MARKET AREA ANALYSIS referrals per procedure is extremely large. A few

Market areas were determined for procedures cur- doctors referred an extremely large percentage of
rently done by Downtown Radiology by examining the procedures done by Downtown Radiology. If a
patient records and doctor referral patterns. Market few new many-referral doctors are recruited, they
areas were determined for procedures not currently can have a major effect on the total number of pro-
done by Downtown Radiology by investigating the cedures done by Downtown Radiology.
competition and analyzing the geographical areas Finally, the effect that a new imaging center will
they served. have on Downtown Radiology’s market share must
be estimated. The new imaging center will have the
CT Scanner Market Area best equipment and will be prepared to do the total
The market area for CT scanning for the proposed spectrum of procedures at a lower cost. The number
medical imaging center includes Spokane, Whitman, of new doctors referring should increase on the basis
Adams, Lincoln, Stevens, and Pend Oreille Counties of word of mouth from the new investing doctors.
in Washington and Bonner, Boundary, Kootenai, If insurance companies, large employers, and/or
Benewah, and Shoshone Counties in Idaho. Based unions enter into agreements with the new imaging
on the appropriate percentage projections, the CT center, Downtown Radiology should be able to
scanning market area will have a population of increase its share of the market by at least 4% in
630,655 in 1985 and 696,018 in 1990. 1985, 2% in 1986, and 1% in 1987 and retain this
market share in 1988 and 1989. This market share
Quantitative Estimates increase will be referred to as the total imaging effect
To project revenue, it is necessary to determine in the rest of this report.
certain quantitative estimates. The most important
estimate involves the number of doctors who will par- Revenue Projections
ticipate in the limited partnership. The estimate used Revenue projections were completed for every pro-
in future computations is that at least 8% of the doc- cedure. Only the projections for the CT scanner are
tor population of Spokane County will participate. shown in this case.
The next uncertainty that must be quantified
involves the determination of how the referral pat- CT Scan Projections
tern will be affected by the participation of 50 doc- Based on the exponential smoothing model and
tors in the limited partnership. It is assumed that 30 what has already taken place in the first five months
of the doctors who presently refer to Downtown of 1984, the forecast of CT scans for 1984 (January
Radiology will join the limited partnership. Of the 1984 to January 1985) is 2,600.
30 who join, it is assumed that 10 will not increase The National Center for Health Statistics reports
their referrals and 20 will double their referrals. It is a rate of 261 CT scans per 100,000 population per
also assumed that 20 doctors who had never month. Using the population of 630,655 projected
referred to Downtown Radiology will join the lim- for the CT scan market area, the market should be
ited partnership and will begin to refer at least half 19,752 procedures for all of 1985. The actual number
of their work to Downtown Radiology. of CT scans performed in the market area during
The quantification of additional doctor referrals 1983 was estimated to be 21,600. This estimate was
should be clarified with some qualitative observa- based on actual known procedures for Downtown
tions. The estimate of 50 doctors joining the pro- Radiology (2,260), Sacred Heart (4,970), Deaconess
posed limited partnership is conservative. There is a (3,850), Valley (2,300), and Kootenai (1,820) and on
strong possibility that doctors from areas outside of estimates for Radiation Therapy (2,400) and
Spokane County may join. Traditionally, the doctor Northwest Imaging (4,000). If the estimates are
referral pattern changes very slowly. However, the accurate, Downtown Radiology had a market share
sudden competitive nature of the marketplace will of approximately 10.5% in 1983. The actual values
probably have an impact on doctor referrals. If the were also analyzed for 1982, and Downtown
limited partnership is marketed to doctors in spe- Radiology was projected to have approximately
cialties with high radiology referral potential, the 15.5% of the CT scan market during that year.
number of referrals should increase more than Therefore, Downtown Radiology is forecast to aver-
projected. The variability in the number of doctor age about 13% of the market.
 Moving Averages and Smoothing Methods

Based on the increased referrals from doctors

TABLE 11 Five-Year Projected Revenue for
belonging to the limited partnership and an analysis CT Scans
of the average number of referrals of CT scans, an
increase of 320 CT scans is projected for 1985 from Year Procedures Revenue ($)
this source. If actual values for 1983 are used, the
1985 3,138 1,129,680
rate for the Inland Empire CT scan market area is
1986 2,531 1,012,400
3,568 (21,600/6.054) per 100,000 population. If this 1987 2,716 1,205,904
pattern continues, the number of CT scans in the 1988 2,482 1,223,626
market area will increase to 22,514 (3,568 * 6.31) in 1989 2,529 1,383,363
1985. Therefore, Downtown Radiology’s market
share is projected to be 13% (2,920/22,514). When
the 4% increase in market share based on total
imaging is added, Downtown Radiology’s market for the next five years.The cost of these procedures is
share increases to 17.0%, and its projected number estimated to increase approximately 11% per year.
of CT scans is 3,827 (22,514 * .17). Without the effect of the MRI, the projection
However, research seems to indicate that the MRI for CT scans in 1986 is estimated to be 4,363
will eventually replace a large number of CT head (6.31 * 1.02 * 3,568 * .19). However, if 60% are
scans (Applied Radiology, May/June 1983, and CT head scans and the MRI replaces 70% of the
Diagnostic Imaging, February 1984). The National head scans, the projected number of CT scans
Center for Health Statistics indicated that 60% of all should drop to 2,531 [4,363 - 14,363 * .60 * .702].
CT scans were of the head. Downtown Radiology The projection of CT scans without the MRI
records showed that 59% of its CT scans in 1982 were effect for 1987 is 4,683 (6.31 * 1.04 * 3,568 * .20).
head scans and 54% in 1983. If 60% of Downtown The forecast with the MRI effect is 2,716
Radiology’s CT scans are of the head and the MRI [4,683 - 14,683 * .60 * .702].
approach replaces approximately 60% of them, new The projection of CT scans without the MRI
projections for CT scans in 1985 are necessary. Since effect for 1988 is 4,773 (6.31 * 1.06 * 3,568 * .20).
the MRI will operate for only half the year, a reduc- The forecast with the MRI effect is 2,482 [4,773 -
tion of 689 (3,827>2 * .60 * .60) CT scans is forecast. 14,773 * .60 * .802].
The projected number of CT scans for 1985 is The projection of CT scans without the MRI
3,138. The average cost of a CT scan is $360, and the effect for 1989 is 4,863 (6.31 * 1.08 * 3,568 * .20).
projected revenue from CT scans is $1,129,680. Table The forecast with the MRI effect is 2,529 [4,863 -
11 shows the projected revenue from CT scans 14,863 * .60 * .802].

QUESTION
1. Downtown Radiology’s accountant projected Downtown Radiology’s management must
that revenue would be considerably higher make a decision concerning the accuracy of
than that provided by Professional Marketing Professional Marketing Associates’ projections.
Associates. Since ownership interest will be You are asked to analyze the report. What rec-
made available in some type of public offering, ommendations would you make?

CASE 6 WEB RETAILER

Pat Niebuhr and his team are responsible for develop- of the total orders and contacts per order (CPO) sup-
ing a global staffing plan for the contact centers of a plied by the finance department and ultimately
large web retailer. Pat needs to take a monthly forecast forecast the number of customer contacts (phone,
 Moving Averages and Smoothing Methods

email, and so forth) arriving at the retailer’s contact Pat thinks it might be a good idea to use the
centers weekly. The contact centers are open 24 hours historical data to generate forecasts of orders and
7 days a week and must be appropriately staffed to contacts per order directly. He is interested in
maintain a high service level. The retailer recognizes determining whether these forecasts are more accu-
that excellent customer service will likely result in rate than the forecasts for these quantities that the
repeat visits and purchases. finance department derives from revenue projec-
The key equation for Pat and his team is tions. As a start, Pat and his team are interested in
the data patterns of the monthly historical orders
Contacts = Orders * CPO
and contacts per order and decide to plot these time
Historical data provide the percentage of contacts series and analyze the autocorrelations. The data
for each day of the week. For example, historically are given in Table 12 and plotted in Figures 19 and
9.10% of the weekly contacts occur on Sundays, 20. The autocorrelations are shown in Figures 21
17.25% of the weekly contacts occur on Mondays, and 22.
and so forth. Keeping in mind the number of Pat is intrigued with the time series plots and
Sundays, Mondays, and so on in a given month, the autocorrelation functions and feels a smoothing
monthly forecasts of contacts can be converted to procedure might be the right tool for fitting the time
weekly forecasts of contacts. It is the weekly fore- series for orders and contacts per order and for gen-
casts that are used for staff planning purposes. erating forecasts.

TABLE 12 Orders and Contacts per

Order (CPO) for Web Retailer,
June 2001–June 2003

Month Orders CPO

Jun-01 3,155,413 0.178

Jul-01 3,074,723 0.184
Aug-01 3,283,838 0.146
Sep-01 2,772,971 0.144
Oct-01 3,354,889 0.144
Nov-01 4,475,792 0.152
Dec-01 5,944,348 0.152
Jan-02 3,742,334 0.174
Feb-02 3,681,370 0.123
Mar-02 3,546,647 0.121
Apr-02 3,324,321 0.117
May-02 3,318,181 0.116
Jun-02 3,181,115 0.129
Jul-02 3,022,091 0.131
Aug-02 3,408,870 0.137
Sep-02 3,501,779 0.140
Oct-02 3,712,424 0.144
Nov-02 4,852,090 0.129
Dec-02 7,584,065 0.124
Jan-03 4,622,233 0.136
Feb-03 3,965,540 0.116
Mar-03 3,899,108 0.111
Apr-03 3,670,589 0.108
May-03 3,809,110 0.101
Jun-03 4,159,358 0.105
 Moving Averages and Smoothing Methods

FIGURE 19 Time Series Plot of Orders, June 2001–June 2003

FIGURE 20 Time Series Plot of Contacts per Order (CPO), June

2001–June 2003

QUESTIONS
1. What did Pat and his team learn about the data 2. Fit an appropriate smoothing procedure to the
patterns for orders and contacts per order from the orders time series and generate forecasts for
time series plots and autocorrelation functions? the next four months. Justify your choice.
 Moving Averages and Smoothing Methods

FIGURE 21 Autocorrelation Function for Orders

FIGURE 22 Autocorrelation Function for Contacts per Order (CPO)

3. Fit an appropriate smoothing procedure to the contacts directly instead of multiplying forecasts
contacts per order time series and generate fore- of orders and contacts per order to get a fore-
casts for the next four months. Justify your choice. cast. Does this seem reasonable? Why?
4. Use the results for Questions 2 and 3 to generate 6. Many orders consist of more than one item
forecasts of contacts for the next four months. (unit). Would it be better to focus on number of
5. Pat has access to a spreadsheet with historical units and contacts per unit to get a forecast of
actual contacts. He is considering forecasting contacts? Discuss.
 Moving Averages and Smoothing Methods

CASE 7 SOUTHWEST MEDICAL CENTER

Mary Beasley is responsible for keeping track of the If so, how many new doctors should be hired and/or
number of billable visits to the Medical Oncology be reassigned from other areas?
group at Southwest Medical Center. Her anecdotal To provide some insight into the nature of the
evidence suggests that the number of visits has been demand for service, Mary opens her Excel spreadsheet
increasing and some parts of the year seem to be and examines the total number of billable visits on a
busier than others. Some doctors are beginning to monthly basis for the last several fiscal years. The data
complain about the work load and suggest they are listed in Table 13.
don’t always have enough time to interact with indi- A time series plot of Mary’s data is shown in
vidual patients. Will additional medical staff be Figure 23. As expected, the time series shows
required to handle the apparently increasing demand? an upward trend, but Mary is not sure if there is a

TABLE 13 Total Billable Visits to Medical Oncology, FY1995–FY2004

Year Sept. Oct. Nov. Dec. Jan. Feb. Mar. Apr. May Jun. Jul. Aug.

FY1994–95 725 789 893 823 917 811 1,048 970 1,082 1,028 1,098 1,062
FY1995–96 899 1,022 895 828 1,011 868 991 970 934 784 1,028 956
FY1996–97 916 988 921 865 998 963 992 1,118 1,041 1,057 1,200 1,062
FY1997–98 1,061 1,049 829 1,029 1,120 1,084 1,307 1,458 1,295 1,412 1,553 1,480
FY1998–99 1,554 1,472 1,326 1,231 1,251 1,092 1,429 1,399 1,341 1,409 1,367 1,483
FY1999–00 1,492 1,650 1,454 1,373 1,466 1,477 1,466 1,182 1,208 1,132 1,094 1,061
FY2000–01 1,018 1,233 1,112 1,107 1,305 1,181 1,391 1,324 1,259 1,236 1,227 1,294
FY2001–02 1,083 1,404 1,329 1,107 1,313 1,156 1,184 1,404 1,310 1,200 1,396 1,373
FY2002–03 1,259 1,295 1,100 1,097 1,357 1,256 1,350 1,318 1,271 1,439 1,441 1,352
FY2003–04 1,339 1,351 1,197 1,333 1,339 1,307 — — — — — —

FIGURE 23 Time Series Plot of Total Visits to Medical

Oncology, FY1995–FY2004
 Moving Averages and Smoothing Methods

seasonal component in the total visits series. She and so forth. Mary knows from a course in her
decides to investigate this issue by constructing the Executive MBA program that Winters’ smoothing
autocorrelation function. If a seasonal component procedure might be a good way to generate fore-
exists with monthly data, Mary expects to see fairly casts of future visits if trend and seasonal compo-
large autocorrelations at the seasonal lags: 12, 24, nents are present.

QUESTIONS
1. What did Mary’s autocorrelation analysis 3. Given the results in Question 2, do you think it
show? is likely another forecasting method would gen-
2. Fit an appropriate smoothing procedure to erate “better” forecasts? Discuss.
Mary’s data, examine the residual autocor- 4. Do you think additional medical staff might be
relations, and generate forecasts for the remain- needed to handle future demand? Write a brief
der of FY2003–04. Do these forecasts seem report summarizing Mary’s data analysis and
reasonable? the implications for additional staff.

CASE 8 SURTIDO COOKIES

Jame Luna investigated the data pattern of monthly steps in selecting a forecasting method are plotting
Surtido cookie sales. In that case, Karin, one of the the sales time series and conducting an autocorrela-
members of Jame’s team, suggested forecasts of tion analysis. He knows you can often learn a lot by
future sales for a given month might be generated simply examining a plot of your time series.
by simply using the historical average sales for that Moreover, the autocorrelations tend to reinforce the
month. After learning something about smoothing pattern observed from the plot. Jame is ready to
methods however, Jame thinks a smoothing proce- begin with the goal of generating forecasts of
dure might be a better way to construct forecasts of monthly cookie sales for the remaining months
future sales. Jame recognizes that important first of 2003.

QUESTIONS
1. What pattern(s) did Jame observe from a time and produce forecasts for the remaining months
series plot of Surtido cookie sales? of 2003.
2. Are the autocorrelations consistent with the pat- 4. Use Karin’s historical monthly average sugges-
tern(s) Jame observed in the time series plot? tion to construct forecasts for the remaining
3. Select and justify an appropriate smoothing months of 2003. Which forecasts, yours or
procedure for forecasting future cookie sales Karin’s, do you prefer? Why?

Minitab Applications

The problem. In Example 3, the Spokane Transit Authority data need to be forecast
using a five-week moving average.
Minitab Solution
1. Enter the Spokane Transit Authority data shown in Table 2 into column C1. Click
on the following menus:
Stat>Time Series>Moving Average
 Moving Averages and Smoothing Methods

2. The Moving Average dialog box appears.

a. Double-click on the variable Gallons and it will appear to the right of Variable.
b. Since we want a five-month moving average, indicate 5 for MA length.
c. Do not click on the Center moving average box.
d. Click on Generate forecasts and indicate 1 to the right of Number of forecasts.
e. Click on OK and Figure 4 will appear.
The problem. In Example 6, the Acme Tool Company data need to be forecast using
single exponential smoothing.
Minitab Solution
1. Enter the Acme Tool Company data shown in Table 1 for the years 2000 through
2006 into column C1. Click on the following menus:
Stat>Time Series>Single Exponential Smoothing
2. The Single Exponential Smoothing dialog box Appears.
a. Double-click on the variable Saws and it will appear to the right of Variable.
b. Under Weight to Use in Smoothing, choose Optimal ARIMA and then click on
OK. The result is shown in Figure 8.
The problem. In Example 10, the Acme Tool Company data need to be forecast using
exponential smoothing adjusted for trend and seasonality.
Minitab Solution
1. Enter the Acme Tool Company data shown in Table 1 for the years 2000 through
2006 in column C1. Click on the following menus:
Stat>Time Series>Winters’ Method

FIGURE 24 Minitab Winters’ Method Dialog Box

 Moving Averages and Smoothing Methods

2. The Winters’ Method dialog box appears, as shown in Figure 24.

a. The variable of interest is Saws.
b. Since the data are quarterly, indicate 4 for Seasonal length.
c. The Weights to Use in Smoothing are Level: 0.4; Trend: 0.1; and Seasonal: 0.3.
d. Click on Generate forecasts, and for Number of forecasts, indicate 4.
e. Click on Storage.
3. The Winters’ Method Storage dialog box appears.
a. Click on Level estimates, Trend estimates, Seasonal estimates, Fits (one-period-
ahead forecasts), and Residuals.
b. Click on OK on both the Winters’ Method Storage dialog box and the Winters’
Method dialog box. The results are shown in Table 9 and Figure 12. The forecast
for the first quarter of 2007 is 778.2.
4. To store the data for further use, click on the following menus:
File>Save Worksheet As
5. The Save Worksheet As dialog box appears.
a. Type a name such as Saws in the File Name space.
b. The Save as Type space allows you to choose how you want to save your file.
Most of the time you will select Minitab. However, you can save your file so sev-
eral software programs can use it. As an example, you could choose to save the
file as an Excel file. The file is saved as Saws.xls and will be used in the Excel
Applications section.

Excel Applications

The problem. In Example 5, the Acme Tool Company data were forecast using single
exponential smoothing with a smoothing constant equal to .6.
Excel Solution
1. Open the file containing the data presented in Table 1 by clicking on the following
menus:
File>Open

Look for the file called Saws.xls.

2. Click on the following menus:
Tools>Data Analysis
The Data Analysis dialog box appears. Under Analysis Tools, choose Exponential
Smoothing and click on OK. The Exponential Smoothing dialog box, shown in
Figure 25, appears.
a. Enter A2:A25 in the Input Range edit box.
b. Check the Labels box.
c. Enter .4 in the Damping factor edit box, since the damping factor (1 - a) is
defined as the complement of the smoothing constant.
d. Enter B3 in the Output Range edit box. (This will put the forecast YNt opposite
the corresponding value in column A.)
e. Check the Chart Output box.
f. Now click on OK.
4. The results (column B) and the graph are shown in Figure 26. Note that the
Exponential Smoothing analysis tool puts formulas in the worksheet. Cell B5 is high-
lighted and the formula = 0.6 * A4 + 0.4 * B4 is shown on the formula toolbar.
 Moving Averages and Smoothing Methods

FIGURE 25 Excel Exponential Smoothing Dialog Box

FIGURE 26 Excel Exponential Smoothing: Example 5 Results

5. Notice that, although Excel starts exponential smoothing differently from

the way the smoothing was started in Table 7 (see the first few values in the
column corresponding to a = .6 ), after six or seven iterations the numbers in
 Moving Averages and Smoothing Methods

column B in Figure 26 and the numbers in the column corresponding to a = .6

in Table 7 are exactly the same. Fluctuations due to different choices of starting
values die out fairly rapidly.

References
Aaker, D. A., and R. Jacobson. “The Sophistication Work Force. Englewood Cliffs, N.J.: Prentice-Hall,
of ‘Naive’ Modeling.” International Journal of 1960.
Forecasting 3 (314) (1987): 449–452. Koehler, A. B., R. D. Snyder, and D. K. Ord.
Bowerman, B. L., R. T. O’Connell, and A. B. Koehler. “Forecasting Models and Prediction Intervals for
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661–669. Journal of Forecasting 3 (1) (1984): 79–84.
Gardner, E. S., Jr. “Exponential Smoothing: The State Makridakis, S., S. C. Wheelwright, and R. Hyndman.
of the Art.” Journal of Forecasting 4 (1985): 1–28. Forecasting Methods and Applications. New York:
Gardner, E. S., Jr., and D. G. Dannenbring. Wiley, 1998.
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 TIME SERIES AND THEIR
COMPONENTS
Observations of a variable Y that become available over time are called time series data, or
simply a time series. These observations are often recorded at fixed time intervals. For
example, Y might represent sales, and the associated time series could be a sequence of
annual sales figures. Other examples of time series include quarterly earnings, monthly
inventory levels, and weekly exchange rates. In general, time series do not behave like ran-
dom samples and require special methods for their analysis. Observations of a time series
are typically related to one another (autocorrelated). This dependence produces patterns
of variability that can be used to forecast future values and assist in the management of
business operations. Consider these situations.
American Airlines (AA) compares current reservations with forecasts based on
projections of historical patterns. Whether current reservations are lagging behind or
exceeding the projections, AA adjusts the proportion of discounted seats accordingly.
The adjustments are made for each flight segment in the AA system.
A Canadian importer of cut flowers buys from growers in the United States,
Mexico, Central America, and South America. However, because these sources pur-
chase their growing stock and chemicals from the United States, all the selling prices
are quoted in U.S. dollars at the time of the sale. An invoice is not paid immediately,
and since the Canadian–U.S. exchange rate fluctuates, the cost to the importer in
Canadian dollars is not known at the time of purchase. If the exchange rate does not
change before the invoice is paid, there is no monetary risk to the importer. If the index
rises, the importer loses money for each U.S. dollar of purchase. If the index drops, the
importer gains. The importer uses forecasts of the weekly Canadian-dollar-to-U.S.-dollar
exchange rate to manage the inventory of cut flowers.
Although time series are often generated internally and are unique to the organi-
zation, many time series of interest in business can be obtained from external sources.
Publications such as Statistical Abstract of the United States, Survey of Current
Business, Monthly Labor Review, and Federal Reserve Bulletin contain time series of
all types. These and other publications provide time series data on prices, production,
sales, employment, unemployment, hours worked, fuel used, energy produced, earn-
ings, and so on, reported on a monthly, quarterly, or annual basis. Today, extensive col-
lections of time series are available on the World Wide Web at sites maintained by U.S.
government agencies, statistical organizations, universities, and individuals.
It is important that managers understand the past and use historical data and
sound judgment to make intelligent plans to meet the demands of the future. Properly
constructed time series forecasts help eliminate some of the uncertainty associated
with the future and can assist management in determining alternative strategies.

From Chapter 5 of Business Forecasting, Ninth Edition. John E. Hanke, Dean W. Wichern.
Copyright © 2009 by Pearson Education, Inc. All rights reserved.
 Time Series and Their Components

The alternative, of course, is not to plan ahead. In a dynamic business environment,

however, this lack of planning might be disastrous. A mainframe computer manufac-
turer that some years ago ignored the trend to personal computers and workstations
would have lost a large part of its market share rather quickly.
Although we will focus our attention on a model-based approach to time series
analysis that relies primarily on the data, a subjective review of the forecasting effort is
very important. The past is relevant in the search for clues about the future only to the
extent that causal conditions previously in effect continue to hold in the period ahead.
In economic and business activity, causal conditions seldom remain constant. The
multitude of causal factors at work tends to be constantly shifting, so the connections
among the past, the present, and the future must be continually reevaluated.
The techniques of time series provide a conceptual approach to forecasting that
has proved to be very useful. Forecasts are made with the aid of a set of specific formal
procedures, and judgments that follow are indicated explicitly.

DECOMPOSITION
One approach to the analysis of time series data involves an attempt to identify the
component factors that influence each of the values in a series. This identification pro-
cedure is called decomposition. Each component is identified separately. Projections of
each of the components can then be combined to produce forecasts of future values of
the time series. Decomposition methods are used for both short-run and long-run fore-
casting. They are also used to simply display the underlying growth or decline of a
series or to adjust the series by eliminating one or more of the components.
Analyzing a time series by decomposing it into its component parts has a long
history. Recently, however, decomposition methods of forecasting have lost some of
their luster. Projecting the individual components into the future and recombining
these projections to form a forecast of the underlying series often does not work very
well in practice. The difficulty lies in getting accurate forecasts of the components. The
development of more-flexible model-based forecasting procedures has made decom-
position primarily a tool for understanding a time series rather than a forecasting
method in its own right.
To understand decomposition, we start with the four components of a time series.
These are the trend component, the cyclical component, the seasonal component, and
the irregular or random component.

1. Trend. The trend is the component that represents the underlying growth (or
decline) in a time series. The trend may be produced, for example, by consistent
population change, inflation, technological change, and productivity increases. The
trend component is denoted by T.
2. Cyclical. The cyclical component is a series of wavelike fluctuations or cycles of
more than one year’s duration. Changing economic conditions generally produce
cycles. C denotes the cyclical component.
In practice, cycles are often difficult to identify and are frequently regarded as
part of the trend. In this case, the underlying general growth (or decline) compo-
nent is called the trend-cycle and denoted by T. We use the notation for the trend
because the cyclical component often cannot be separated from the trend.
3. Seasonal. Seasonal fluctuations are typically found in quarterly, monthly, or weekly
data. Seasonal variation refers to a more or less stable pattern of change that
appears annually and repeats itself year after year. Seasonal patterns occur
 Time Series and Their Components

because of the influence of the weather or because of calendar-related events such

as school vacations and national holidays. S denotes the seasonal component.
4. Irregular. The irregular component consists of unpredictable or random fluctua-
tions. These fluctuations are the result of a myriad of events that individually may
not be particularly important but whose combined effect could be large. I denotes
the irregular component.

To study the components of a time series, the analyst must consider how the
components relate to the original series. This task is accomplished by specifying a model
(mathematical relationship) that expresses the time series variable Y in terms of the
components T, C, S, and I. A model that treats the time series values as a sum of the
components is called an additive components model. A model that treats the time series
values as the product of the components is called a multiplicative components model.
Both models are sometimes referred to as unobserved components models, since, in
practice, although we observe the values of the time series, the values of the components
are not observed. The approach to time series analysis described in this chapter involves
an attempt, given the observed series, to estimate the values of the components. These
estimates can then be used to forecast or to display the series unencumbered by the sea-
sonal fluctuations. The latter process is called seasonal adjustment.
It is difficult to deal with the cyclical component of a time series. To the extent that
cycles can be determined from historical data, both their lengths (measured in years)
and their magnitudes (differences between highs and lows) are far from constant. This
lack of a consistent wavelike pattern makes distinguishing cycles from smoothly evolv-
ing trends difficult. Consequently, to keep things relatively simple, we will assume any
cycle in the data is part of the trend. Initially, then, we consider only three components,
T, S, and I. A brief discussion of one way to handle cyclical fluctuations in the decom-
position approach to time series analysis is available in the Cyclical and Irregular
Variations section of this chapter.
The two simplest models relating the observed value (Yt) of a time series to the
trend (Yt ), seasonal (St), and irregular (It) components are the additive components
model

Yt = Tt + St + It (1)

and the multiplicative components model

Yt = Tt * St * It (2)

The additive components model works best when the time series being analyzed
has roughly the same variability throughout the length of the series. That is, all the val-
ues of the series fall essentially within a band of constant width centered on the trend.
The multiplicative components model works best when the variability of the time
series increases with the level.1 That is, the values of the series spread out as the trend
increases, and the set of observations has the appearance of a megaphone or funnel. A
time series with constant variability and a time series with variability increasing with

1It is possible to convert a multiplicative decomposition to an additive decomposition by working

with the logarithms of the data. Using Equation 2 and the properties of logarithms, we have
log Y = log (T * S * I ) = logT + logS + logI. Decomposition of logged data is explored in Problem 15.
 Time Series and Their Components

1,000

900

Milk Production
800

700

600

50 100 150
Month

900

800

700

600
Monthly Sales

500

400

300

200

100

0
10 20 30 40 50 60 70
Month

FIGURE 1 Time Series with Constant Variability (Top) and a Time

Series with Variability Increasing with Level (Bottom)

level are shown in Figure 1. Both of these monthly series have an increasing trend and
a clearly defined seasonal pattern.2

Trend
Trends are long-term movements in a time series that can sometimes be described by a
straight line or a smooth curve. Examples of the basic forces producing or affecting the
trend of a series are population change, price change, technological change, productiv-
ity increases, and product life cycles.

2Variants of the decomposition models (see Equations 1 and 2) exist that contain both multiplicative and
additive terms. For example, some software packages do “multiplicative” decomposition using the model
Y = T * S + I.
 Time Series and Their Components

A population increase may cause retail sales of a community to rise each year for
several years. Moreover, the sales in current dollars may have been pushed upward
during the same period because of general increases in the prices of retail goods—even
though the physical volume of goods sold did not change.
Technological change may cause a time series to move upward or downward. The
development of high-speed computer chips, enhanced memory devices, and improved
display panels, accompanied by improvements in telecommunications technology, has
resulted in dramatic increases in the use of personal computers and cellular
telephones. Of course, the same technological developments have led to a downward
trend in the production of mechanical calculators and rotary telephones.
Productivity increases—which, in turn, may be due to technological change—give
an upward slope to many time series. Any measure of total output, such as manufactur-
ers’ sales, is affected by changes in productivity.
For business and economic time series, it is best to view the trend (or trend-cycle)
as smoothly changing over time. Rarely can we realistically assume that the trend can
be represented by some simple function such as a straight line over the whole period
for which the time series is observed. However, it is often convenient to fit a trend
curve to a time series for two reasons: (1) It provides some indication of the general
direction of the observed series, and (2) it can be removed from the original series to
get a clearer picture of the seasonality.
If the trend appears to be roughly linear—that is, if it increases or decreases like a
straight line—then it is represented by the equation
TNt = b0 + b1t (3)

Here, TNt is the predicted value for the trend at time t. The symbol t represents time, the
independent variable, and ordinarily assumes integer values 1, 2, 3, . . . corresponding
to consecutive time periods. The slope coefficient, b1, is the average increase or
decrease in T for each one-period increase in time.
Time trend equations, including the straight-line trend, can be fit to the data using
the method of least squares. Recall that the method of least squares selects the values
of the coefficients in the trend equation (b0 and b1 in the straight-line case) so that the
estimated trend values (TNt) are close to the actual values (Yt ) as measured by the sum
of squared errors criterion

SSE = ©1Yt - TNt22 (4)

Example 1
Data on annual registrations of new passenger cars in the United States from 1960 to 1992
are shown in Table 1 and plotted in Figure 2. The values from 1960 to 1992 are used to
develop the trend equation. Registrations is the dependent variable, and the independent
variable is time t, coded as 1960 = 1, 1961 = 2, and so on.
The fitted trend line has the equation
TNt = 7.988 + .0687t
The slope of the trend equation indicates that registrations are estimated to increase an
average of 68,700 each year. Figure 3 shows the straight-line trend fitted to the actual data.
Figure 3 also shows forecasts of new car registrations for the years 1993 and 1994 (t = 34
and t = 35), which were obtained by extrapolating the trend line. We will say more about
forecasting trend shortly.
The estimated trend values for passenger car registrations from 1960 to 1992 are
shown in Table 1 under TN . For example, the trend equation estimates registrations in 1992
(t = 33) to be

TN33 = 7.988 + .06871332 = 10.255

 Time Series and Their Components

TABLE 1 Registration of New Passenger

Cars in the United States,
1960–1992, for Example 1

Registrations Trend Estimates Error

(millions) (millions) (millions)
Year Y Time t TN Y - TN

1960 6.577 1 8.0568 -1.4798

1961 5.855 2 8.1255 -2.2705
1962 6.939 3 8.1942 -1.2552
1963 7.557 4 8.2629 -0.7059
1964 8.065 5 8.3316 -0.2666
1965 9.314 6 8.4003 0.9138
1966 9.009 7 8.4690 0.5401
1967 8.357 8 8.5376 -0.1807
1968 9.404 9 8.6063 0.7977
1969 9.447 10 8.6750 0.7720
1970 8.388 11 8.7437 -0.3557
1971 9.831 12 8.8124 1.0186
1972 10.409 13 8.8811 1.5279
1973 11.351 14 8.9498 2.4012
1974 8.701 15 9.0185 -0.3175
1975 8.168 16 9.0872 -0.9192
1976 9.752 17 9.1559 0.5961
1977 10.826 18 9.2246 1.6014
1978 10.946 19 9.2933 1.6527
1979 10.357 20 9.3620 0.9950
1980 8.761 21 9.4307 -0.6697
1981 8.444 22 9.4994 -1.0554
1982 7.754 23 9.5681 -1.8141
1983 8.924 24 9.6368 -0.7128
1984 10.118 25 9.7055 0.4125
1985 10.889 26 9.7742 1.1148
1986 11.140 27 9.8429 1.2971
1987 10.183 28 9.9116 0.2714
1988 10.398 29 9.9803 0.4177
1989 9.833 30 10.0490 -0.2160
1990 9.160 31 10.1177 -0.9577
1991 9.234 32 10.1863 -0.9524
1992 8.054 33 10.2550 -2.2010

Source: Data from U.S. Department of Commerce, Survey of Current

Business (various years).

or 10,255,000 registrations. However, registrations of new passenger cars were actually

8,054,000 in 1992. Thus, for 1992, the trend equation overestimates registrations by approxi-
mately 2.2 million. This error and the remaining estimation errors are listed in Table 1 under
Y - TN . These estimation errors were used to compute the measures of fit, the MAD, MSD,
and MAPE shown in Figure 3. (Minitab commands used to produce the results in Example 1
are given in the Minitab Applications section at the end of this chapter.)
 Time Series and Their Components

FIGURE 2 Car Registrations Time Series for Example 1

FIGURE 3 Trend Line for the Car Registrations Time Series for Example 1

Additional Trend Curves

The life cycle of a new product has three stages: introduction, growth, and maturity and
saturation. A curve representing sales (in dollars or units) over a new product’s life
cycle is shown in Figure 4. Time, shown on the horizontal axis, can vary from days to
years, depending on the nature of the market. A straight-line trend would not work for
these data. Linear models assume that a variable is increasing (or decreasing) by a con-
stant amount each time period. The increases per time period in the product’s life cycle
 Time Series and Their Components

Trend

Sales, Units

Introduction Growth Maturity and Saturation

Time

FIGURE 4 Life Cycle of a Typical New Product

curve are quite different depending on the stage of the cycle. A curve, other than a
straight line, is needed to model the trend over a new product’s life cycle.
A simple function that allows for curvature is the quadratic trend
TNt = b0 + b1t + b2t2 (5)

As an illustration, Figure 5 shows a quadratic trend curve fit to the passenger car regis-
trations data of Example 1 using the SSE criterion. The quadratic trend can be pro-
jected beyond the data for, say, two additional years, 1993 and 1994. We will consider
the implications of this projection in the next section, Forecasting Trend.

FIGURE 5 Quadratic Trend Curve for the Car Registrations

Time Series for Example 1
 Time Series and Their Components

Based on the MAPE, MAD, and MSD accuracy measures, a quadratic trend appears
to be a better representation of the general direction of the car registrations series than
the linear trend in Figure 3. Which trend model is appropriate? Before considering this
issue, we will introduce a few additional trend curves that have proved useful.
When a time series starts slowly and then appears to be increasing at an increasing
rate (see Figure 4) such that the percentage difference from observation to observation
is constant, an exponential trend can be fitted. The exponential trend is given by

TNt = b0bt1 (6)

The coefficient b1 is related to the growth rate. If the exponential trend is fit to annual
data, the annual growth rate is estimated to be 1001b1 - 12%.
Figure 6 indicates the number of mutual fund salespeople employed by a particu-
lar company for several consecutive years. The increase in the number of salespeople is
not constant. It appears as if increasingly larger numbers of people are being added in
the later years.
An exponential trend curve fit to the salespeople data has the equation

TNt = 10.01611.3132t

implying an annual growth rate of about 31%. Consequently, if the model estimates
51 salespeople for 2005, the increase for 2006 would be 16 151 * .312 for an estimated
total of 67. This can be compared to the actual value of 68 salespeople.
A linear trend fit to the salespeople data would indicate a constant average
increase of about nine salespeople per year. This trend overestimates the actual
increase in the earlier years and underestimates the increase in the last year. It does not
model the apparent trend in the data as well as the exponential curve does.
It is clear that extrapolating an exponential trend with a 31% growth rate will quickly
result in some very big numbers. This is a potential problem with an exponential trend
model. What happens when the economy cools off and stock prices begin to retreat? The

FIGURE 6 Graph of Mutual Fund Salespeople

 Time Series and Their Components

demand for mutual fund salespeople will decrease, and the number of salespeople could
even decline. The trend forecast by the exponential curve will be much too high.
Growth curves of the Gompertz or logistic type represent the tendency of many
industries and product lines to grow at a declining rate as they mature. If the plotted
data reflect a situation in which sales begin low, then increase as the product catches on,
and finally ease off as saturation is reached, the Gompertz curve or Pearl–Reed logistic
model might be appropriate. Figure 7 shows a comparison of the general shapes of
(a) the Gompertz curve and (b) the Pearl–Reed logistic model. Note that the logistic
curve is very similar to the Gompertz curve but has a slightly gentler slope. Figure 7
shows how the Y intercepts and maximum values for these curves are related to some of
the coefficients in their functional forms. The formulas for these trend curves are com-
plex and not within the scope of this text. Many statistical software packages, including
Minitab, allow one to fit several of the trend models discussed in this section.
Although there are some objective criteria for selecting an appropriate trend, in
general, the correct choice is a matter of judgment and therefore requires experience
and common sense on the part of the analyst. As we will discuss in the next section, the
line or curve that best fits a set of data points might not make sense when projected as
the trend of the future.

Forecasting Trend
Suppose we are presently at time t = n (end of series) and we want to use a trend model
to forecast the value of Y, p steps ahead. The time period at which we make the forecast,
n in this case, is called the forecast origin. The value p is called the lead time. For the lin-
ear trend model, we can produce a forecast by evaluating TNn + p = b0 + b11n + p2.
Using the trend line fitted to the car registration data in Example 1, a forecast of the
trend for 1993 (t = 34) made in 1992 (t = n = 33) would be the p = 1 step ahead forecast

TN33 + 1 = 7.988 + .0687133 + 12 = 7.988 + .06871342 = 10.324

Similarly, the p = 2 step ahead (1994) forecast is given by

TN33 + 2 = 7.988 + .0687133 + 22 = 7.988 + .06871352 = 10.393

These two forecasts are shown in Figure 3 as extrapolations of the fitted trend line.

^ ^
Tt Tt

b0 1
b0

1
b 0b 1 b0 + b1
t t
0 0
(a) Gompertz Trend Curve (b) Logistic (Pearl-Reed) Trend Curve

FIGURE 7 S-Shaped Growth Curves

 Time Series and Their Components

Figure 5 shows the fitted quadratic trend curve for the car registration data. Using
the equation shown in the figure, we can calculate forecasts of the trend for 1993 and
1994 by setting t = 33 + 1 = 34 and t = 33 + 2 = 35. The reader can verify that
TN33 + 1 = 8.688 and TN33 + 2 = 8.468. These numbers were plotted in Figure 5 as extrapola-
tions of the quadratic trend curve.
Recalling that car registrations are measured in millions, the two forecasts of trend
produced from the quadratic curve are quite different from the forecasts produced by
the linear trend equation. Moreover, they are headed in the opposite direction. If we
were to extrapolate the linear and quadratic trends for additional time periods, their
differences would be magnified.
The car registration example illustrates why great care must be exercised in using
fitted trend curves for the purpose of forecasting future trends. Two equations, both of
which may reasonably represent the observed time series, can give very different
results when projected over future time periods. These differences can be substantial
for large lead times (long-run forecasting).
Trend curve models are based on the following assumptions:
1. The correct trend curve has been selected.
2. The curve that fits the past is indicative of the future.
These assumptions suggest that judgment and expertise play a substantial role in the
selection and use of a trend curve. To use a trend curve for forecasting, we must be able
to argue that the correct trend has been selected and that, in all likelihood, the future
will be like the past.
There are objective criteria for selecting a trend curve. However, although these
and other criteria help to determine an appropriate model, they do not replace good
judgment.

Seasonality
A seasonal pattern is one that repeats itself year after year. For annual data, seasonal-
ity is not an issue because there is no chance to model a within-year pattern with data
recorded once per year. Time series consisting of weekly, monthly, or quarterly obser-
vations, however, often exhibit seasonality.
The analysis of the seasonal component of a time series has immediate short-term
implications and is of greatest importance to mid- and lower-level management.
Marketing plans, for example, have to take into consideration expected seasonal pat-
terns in consumer purchases.
Several methods for measuring seasonal variation have been developed. The basic
idea in all of these methods is to first estimate and remove the trend from the original
series and then smooth out the irregular component. Keeping in mind our decomposi-
tion models, this leaves data containing only seasonal variation. The seasonal values
are then collected and summarized to produce a number (generally an index number)
for each observed interval of the year (week, month, quarter, and so on).
Thus, the identification of the seasonal component in a time series differs from
trend analysis in at least two ways:
1. The trend is determined directly from the original data, but the seasonal compo-
nent is determined indirectly after eliminating the other components from the
data, so that only the seasonality remains.
2. The trend is represented by one best-fitting curve, or equation, but a separate sea-
sonal value has to be computed for each observed interval (week, month, quarter)
of the year and is often in the form of an index number.
 Time Series and Their Components

If an additive decomposition is employed, estimates of the trend, seasonal, and

irregular components are added together to produce the original series. If a multiplica-
tive decomposition is used, the individual components must be multiplied together to
reconstruct the original series, and in this formulation, the seasonal component is rep-
resented by a collection of index numbers. These numbers show which periods within
the year are relatively low and which periods are relatively high. The seasonal indexes
trace out the seasonal pattern.

Index numbers are percentages that show changes over time.

With monthly data, for example, a seasonal index of 1.0 for a particular month means
the expected value for that month is 1/12 the total for the year. An index of 1.25 for a dif-
ferent month implies the observation for that month is expected to be 25% more than
1/12 of the annual total.A monthly index of 0.80 indicates that the expected level of activ-
ity that month is 20% less than 1/12 of the total for the year, and so on.The index numbers
indicate the expected ups and downs in levels of activity over the course of a year after the
effects due to the trend (or trend-cycle) and irregular components have been removed.
To highlight seasonality, we must first estimate and remove the trend. The trend
can be estimated with one of the trend curves we discussed previously, or it can be esti-
mated using a moving average.
Assuming a multiplicative decomposition model, the ratio to moving average is a
popular method for measuring seasonal variation. In this method, the trend is esti-
mated using a centered moving average. We illustrate the ratio-to-moving-average
method using the monthly sales of the Cavanaugh Company, shown in Figure 1
(Bottom) in the next example.

Example 2
To illustrate the ratio-to-moving-average method, we use two years of the monthly sales of
the Cavanaugh Company.3 Table 2 gives the monthly sales from January 2004 to December
2005 to illustrate the beginning of the computations. The first step for monthly data is to
compute a 12-month moving average (for quarterly data, a four-month moving average
would be computed). Because all of the months of the year are included in the calculation of
this moving average, effects due to the seasonal component are removed, and the moving
average itself contains only the trend and the irregular components.
The steps (identified in Table 2) for computing seasonal indexes by the ratio-to-moving-
average method follow:
Step 1. Starting at the beginning of the series, compute the 12-month moving total, and
place the total for January 2004 through December 2004 between June and July
2004.
Step 2. Compute a two-year moving total so that the subsequent averages are centered on
July rather than between months.
Step 3. Since the two-year total contains the data for 24 months (January 2004 once,
February 2004 to December 2004 twice, and January 2005 once), this total is cen-
tered on July 2004.
Step 4. Divide the two-year moving total by 24 in order to obtain the 12-month centered
moving average.
Step 5. The seasonal index for July is calculated by dividing the actual value for July by the
12-month centered moving average.4

3The units have been omitted and the dates and name have been changed to protect the identity of the company.
4This is the ratio-to-moving-average operation that gives the procedure its name.
 Time Series and Their Components

TABLE 2 Sales of the Cavanaugh Company,

2004–2005, for Example 2

12-Month
12-Month Two-Year Centered
Moving Moving Moving Seasonal
Period Sales Total Total Average Index

2004
January

4
518
February 404
March 300
April 210
May 196
June 186 1 4,869 2

4
July 247 4,964 9,833} 3 409.7} 4 0.60} 5
August 343 4,952 9,916 413.2 0.83
September 464 4,925 9,877 411.5 1.13
October 680 5,037 9,962 415.1 1.64
November 711 5,030 10,067 419.5 1.69
December 610 10,131 422.1 1.45
2005
January 613 5,101 10,279 428.3 1.43
February 392 5,178 10,417 434.0 0.90
March 273 5,239 10,691 445.5 0.61
April 322 5,452 11,082 461.8 0.70
May 189 5,630 11,444 476.8 0.40
June 257 5,814 11,682 486.8 0.53
July 324 5,868
August 404
September 677
October 858
November 895
December 664

Repeat steps 1 to 5 beginning with the second month of the series, August 2004, and so on.
The process ends when a full 12-month moving total can no longer be calculated.
Because there are several estimates (corresponding to different years) of the seasonal
index for each month, they must be summarized to produce a single number. The median,
rather than the mean, is used as the summary measure. Using the median eliminates the
influence of data for a month in a particular year that are unusually large or small. A sum-
mary of the seasonal ratios, along with the median value for each month, is contained in
Table 3.
The monthly seasonal indexes for each year must sum to 12, so the median for each
month must be adjusted to get the final set of seasonal indexes.5 Since this multiplier should
be greater than 1 if the total of the median ratios before adjustment is less than 12 and
smaller than 1 if the total is greater than 12, the multiplier is defined as

12
Multiplier =
Actual total

5The monthly indexes must sum to 12 so that the expected annual total equals the actual annual total.
 Time Series and Their Components

TABLE 3 A Summary of the Monthly Seasonal Indexes for the Cavanaugh

Company for Example 2

Adjusted
Seasonal
Index (Median
Month 2000 2001 2002 2003 2004 2005 2006 Median ! 1.0044)
January — 1.208 1.202 1.272 1.411 1.431 — 1.272 1.278
February — 0.700 0.559 0.938 1.089 0.903 — 0.903 0.907
March — 0.524 0.564 0.785 0.800 0.613 — 0.613 0.616
April — 0.444 0.433 0.480 0.552 0.697 — 0.480 0.482
May — 0.424 0.365 0.488 0.503 0.396 — 0.424 0.426
June — 0.490 0.459 0.461 0.465 0.528 0.465 0.467
July 0.639 0.904 0.598 0.681 0.603 0.662 0.651 0.654
August 1.115 0.913 0.889 0.799 0.830 0.830 0.860 0.864
September 1.371 1.560 1.346 1.272 1.128 1.395 1.359 1.365
October 1.792 1.863 1.796 1.574 1.638 1.771 1.782 1.790
November 1.884 2.012 1.867 1.697 1.695 1.846 1.857 1.865
December 1.519 1.088 1.224 1.282 1.445 — 1.282 1.288
11.948 12.002

Using the information in Table 3,

12
Multiplier = = 1.0044
11.948
The final column in Table 3 contains the final seasonal index for each month, determined by
making the adjustment (multiplying by 1.0044) to each of the median ratios.6 The final sea-
sonal indexes, shown in Figure 8, represent the seasonal component in a multiplicative
decomposition of the sales of the Cavanaugh Company time series. The seasonality in sales

Seasonal Indices
1.9

1.4
Index

0.9

0.4

1 2 3 4 5 6 7 8 9 10 11 12
Month

FIGURE 8 Seasonal Indexes for the Cavanaugh Company

for Example 2

6The seasonal indexes are sometimes multiplied by 100 and expressed as percentages.
 Time Series and Their Components

is evident from Figure 8. Sales for this company are periodic, with relatively low sales in the
late spring and relatively high sales in the late fall.

Our analysis of the sales series in Example 2 assumed that the seasonal pattern
remained constant from year to year. If the seasonal pattern appears to change over
time, then estimating the seasonal component with the entire data set can produce mis-
leading results. It is better, in this case, either (1) to use only recent data (from the last
few years) to estimate the seasonal component or (2) to use a time series model that
allows for evolving seasonality.
The seasonal analysis illustrated in Example 2 is appropriate for a multiplicative
decomposition model. However, the general approach outlined in steps 1 to 5 works
for an additive decomposition if, in step 5, the seasonality is estimated by subtracting
the trend from the original series rather than dividing by the trend (moving average) to
get an index. In an additive decomposition, the seasonal component is expressed in the
same units as the original series.
In addition, it is apparent from our sales example that using a centered moving
average to determine trend results in some missing values at the ends of the series. This
is particularly problematic if forecasting is the objective. To forecast future values using
a decomposition approach, alternative methods for estimating the trend must be used.
The results of a seasonal analysis can be used to (1) eliminate the seasonality in
data; (2) forecast future values; (3) evaluate current positions in, for example, sales,
inventory, and shipments; and (4) schedule production.

Seasonally Adjusted Data

Once the seasonal component has been isolated, it can be used to calculate seasonally
adjusted data. For an additive decomposition, the seasonally adjusted data are com-
puted by subtracting the seasonal component:

Yt - St = Tt + It (7a)

For a multiplicative decomposition, the seasonally adjusted data are computed by

dividing the original observations by the seasonal component:

Yt
= Tt * It (7b)
St
Most economic series published by government agencies are seasonally adjusted
because seasonal variation is not of primary interest. Rather, it is the general pattern of
economic activity, independent of the normal seasonal fluctuations, that is of interest.
For example, new car registrations might increase by 10% from May to June, but is this
increase an indication that new car sales are completing a banner quarter? The answer
is “no” if the 10% increase is typical at this time of year largely due to seasonal factors.
In a survey concerned with the acquisition of seasonally adjusted data, Bell and
Hillmer (1984) found that a wide variety of users value seasonal adjustment. They
identified three motives for seasonal adjustment:

1. Seasonal adjustment allows reliable comparison of values at different points in

time.
2. It is easier to understand the relationships among economic or business variables
once the complicating factor of seasonality has been removed from the data.
3. Seasonal adjustment may be a useful element in the production of short-term fore-
casts of future values of a time series.
 Time Series and Their Components

Bell and Hillmer concluded that “seasonal adjustment is done to simplify data so that
they may be more easily interpreted by statistically unsophisticated users without a sig-
nificant loss of information”.

Cyclical and Irregular Variations

Cycles are long-run, wavelike fluctuations that occur most frequently in macro indica-
tors of economic activity. As we have discussed, to the extent that they can be mea-
sured, cycles do not have a consistent pattern. However, some insight into the cyclical
behavior of a time series can be obtained by eliminating the trend and seasonal compo-
nents to give, using a multiplicative decomposition,7

Yt Tt * Ct * St * It
= = Ct * It (8)
Tt * St Tt * St

A moving average can be used to smooth out the irregularities, It, leaving the cyclical
component, Ct. To eliminate the centering problem encountered when a moving aver-
age with an even number of time periods is used, the irregularities are smoothed using a
moving average with an odd number of time periods. For monthly data, a 5-, a 7-, a
9-, or even an 11-period moving average will work. For quarterly data, an estimate of C
can be computed using a three-period moving average of the values.8
Finally, the irregular component is estimated by

Ct * It
It = (9)
Ct

The irregular component represents the variability in the time series after the other
components have been removed. It is sometimes called the residual or error. With a
multiplicative decomposition, both the cyclical and the irregular components are
expressed as indexes.

Summary Example
One reason for decomposing a time series is to isolate and examine the components of
the series. After the analyst is able to look at the trend, seasonal, cyclical, and irregular
components of a series one at a time, insights into the patterns in the original data val-
ues may be gained. Also, once the components have been isolated, they can be recom-
bined or synthesized to produce forecasts of future values of the time series.
Example 3
In Example 3.5, Perkin Kendell, the analyst for the Coastal Marine Corporation, used auto-
correlation analysis to determine that sales were seasonal on a quarterly basis. Now he uses
decomposition to understand the quarterly sales variable. Perkin uses Minitab (see the
Minitab Applications section at the end of the chapter) to produce Table 4 and Figure 9. In
order to keep the seasonal pattern current, only the last seven years (2000 to 2006) of sales
data, Y, were analyzed.
The original data are shown in the chart in the upper left of Figure 10. The trend is com-
puted using the linear model: TNt = 261.24 + .759t. Since 1 represented the first quarter of
2000, Table 4 shows the trend value equal to 262.000 for this time period, and estimated sales
(the T column) increased by .759 each quarter.

7Notice that we have added the cyclical component, C, to the multiplicative decomposition shown in
Equation 2.
8For annual data, there is no seasonal component, and the cyclical * irregular component is obtained by
simply removing the trend from the original series.
 Time Series and Their Components

TABLE 4 The Multiplicative Decomposition for Coastal Marine

Sales for Example 3

t Year Quarter Sales T SCI S TCI CI C I

1 2000 1 232.7 262.000 0.888 0.780 298.458 1.139 — —

2 2 309.2 262.759 1.177 1.016 304.434 1.159 1.118 1.036
3 3 310.7 263.518 1.179 1.117 278.239 1.056 1.078 0.980
4 4 293.0 264.276 1.109 1.088 269.300 1.019 1.022 0.997
5 2001 1 205.1 265.035 0.774 0.780 263.059 0.993 0.960 1.034
6 2 234.4 265.794 0.882 1.016 230.787 0.868 0.940 0.924
7 3 285.4 266.553 1.071 1.117 255.582 0.959 0.906 1.059
8 4 258.7 267.312 0.968 1.088 237.775 0.890 0.924 0.962
9 2002 1 193.2 268.071 0.721 0.780 247.796 0.924 0.927 0.998
10 2 263.7 268.830 0.981 1.016 259.635 0.966 0.954 1.012
11 3 292.5 269.589 1.085 1.117 261.940 0.972 1.003 0.969
12 4 315.2 270.348 1.166 1.088 289.705 1.072 0.962 1.114
13 2003 1 178.3 271.107 0.658 0.780 228.686 0.844 0.970 0.870
14 2 274.5 271.866 1.010 1.016 270.269 0.994 0.936 1.062
15 3 295.4 272.625 1.084 1.117 264.537 0.970 0.976 0.994
16 4 286.4 273.383 1.048 1.088 263.234 0.963 0.942 1.022
17 2004 1 190.8 274.142 0.696 0.780 244.718 0.893 0.933 0.957
18 2 263.5 274.901 0.959 1.016 259.438 0.944 0.957 0.986
19 3 318.8 275.660 1.157 1.117 285.492 1.036 0.998 1.038
20 4 305.3 276.419 1.104 1.088 280.605 1.015 1.058 0.960
21 2005 1 242.6 277.178 0.875 0.780 311.156 1.123 1.089 1.031
22 2 318.8 277.937 1.147 1.016 313.886 1.129 1.104 1.023
23 3 329.6 278.696 1.183 1.117 295.164 1.059 1.100 0.963
24 4 338.2 279.455 1.210 1.088 310.844 1.112 1.078 1.032
25 2006 1 232.1 280.214 0.828 0.780 297.689 1.062 1.059 1.004
26 2 285.6 280.973 1.016 1.016 281.198 1.001 0.996 1.005
27 3 291.0 281.732 1.033 1.117 260.597 0.925 0.947 0.977
28 4 281.4 282.491 0.996 1.088 258.639 0.916 — —

The chart in the upper right of Figure 10 shows the detrended data. These data are also
shown in the SCI column of Table 4. The detrended value for the first quarter of 2000 was9

Y 232.7
SCI = = = .888
T 262.000

The seasonally adjusted data are shown in the TCI column in Table 4 and in Figure 10.
The seasonally adjusted value for the first quarter of 2000 was

232.7
TCI = = 298.458
.77967

Sales in the first quarter of 2005 were 242.6. However, examination of the seasonally
adjusted column shows that the sales for this quarter were actually high when the data were
adjusted for the fact that the first quarter is typically a very weak quarter.

9To simplify the notation in this example, we omit the subscript t on the original data, Y, and each of its com-
ponents, T, S, C, and I. We also omit the multiplication sign, !, between components, since it is clear we are
considering a multiplicative decomposition.
 FIGURE 9 Minitab Output for Decomposition of Coastal Marine
Quarterly Sales for Example 3

FIGURE 10 Component Analysis for Coastal Marine Sales for Example 3

 Time Series and Their Components

The seasonal indexes in Figure 9 were

First quarter = .77967 : 78.0%

Second quarter = 1.01566 : 101.6%
Third quarter = 1.11667 : 111.7%
Fourth quarter = 1.08800 : 108.8%

The chart on the left of Figure 11 shows the seasonal components relative to 1.0. We see that
first-quarter sales are 22% below average, second-quarter sales are about as expected,
third-quarter sales are almost 12% above average, and fourth-quarter sales are almost 9%
above normal.
The cyclical-irregular value for first quarter of 2000 was10

Y 232.7
CI = = = 1.139
TS 1262.00021.779672

In order to calculate the cyclical column, a three-period moving average was computed. The
value for the second quarter of 2000 was

1.139
1.159
1.056
3.354 3.354/3 = 1.118

Notice how smooth the C column is compared to the CI column. The reason is that using the
moving average has smoothed out the irregularities.
Finally, the I column was computed. For example, for the second quarter of 2000,

CI 1.159
I = = = 1.036
C 1.118

Examination of the I column shows that there were some large changes in the irregular
component. The irregular index dropped from 111.4% in the fourth quarter of 2002 to 87%

FIGURE 11 Seasonal Analysis for Coastal Marine Sales for Example 3

10Minitab calculates the cyclical * irregular component (or simply the irregular component if no cyclical
component is contemplated) by subtracting the trend * seasonal component from the original data. In sym-
bols, Minitab sets CI = Y - TS. The Minitab CI component is shown in the lower right-hand chart of Figure
10. Moreover, Minitab fits the trend line to the seasonally adjusted data. That is, the seasonal adjustment is
done before the trend is determined.
 Time Series and Their Components

in the first quarter of 2003 and then increased to 106.2% in the second quarter of 2003. This
behavior results from the unusually low sales in the first quarter of 2003.

Business Indicators
The cyclical indexes can be used to answer the following questions:
1. Does the series cycle?
2. If so, how extreme is the cycle?
3. Does the series follow the general state of the economy (business cycle)?
One way to investigate cyclical patterns is through the study of business indicators.
A business indicator is a business-related time series that is used to help assess the gen-
eral state of the economy, particularly with reference to the business cycle. Many busi-
nesspeople and economists systematically follow the movements of such statistical
series to obtain economic and business information in the form of an unfolding picture
that is up to date, comprehensive, relatively objective, and capable of being read and
understood with a minimum expenditure of time.

Business indicators are business-related time series that are used to help assess
the general state of the economy.

The most important list of statistical indicators originated during the sharp busi-
ness setback from 1937 to 1938. Secretary of the Treasury Henry Morgenthau
requested the National Bureau of Economic Research (NBER) to devise a system that
would signal when the setback was nearing an end. Under the leadership of Wesley
Mitchell and Arthur F. Burns, NBER economists selected 21 series that from past per-
formance promised to be fairly reliable indicators of business revival. Since then, the
business indicator list has been revised several times. The current list consists of 21
indicators—10 classified as leading, 4 as coincident, and 7 as lagging.
1. Leading indicators. In practice, components of the leading series are studied to help
anticipate turning points in the economy. The Survey of Current Business publishes
this list each month, along with the actual values of each series for the past several
months and the most recent year. Also, a composite index of leading indicators is
computed for each month and year; the most recent monthly value is frequently
reported in the popular press to indicate the general direction of the future economy.
Examples of leading indicators are building permits and an index of stock prices.
2. Coincident indicators. The four coincident indicators provide a measure of how the
U.S. economy is currently performing. An index of these four series is computed
each month. Examples of coincident indicators are industrial production and man-
ufacturing and trade sales.
3. Lagging indicators. The lagging indicators tend to lag behind the general state of
the economy, both on the upswing and on the downswing. A composite index is
also computed for this list. Examples of lagging indicators are the prime interest
rate and the unemployment rate.
Cycles imply turning points. That is, turning points come into existence only as a
consequence of a subsequent decline or gain in the business cycle. Leading indicators
change direction ahead of turns in general business activity, coincident indicators turn at
about the same time as the general economy, and turns in the lagging indicators follow
 Time Series and Their Components

those of the general economy. However, it is difficult to identify cyclical turning points
at the time they occur, since all areas of the economy do not expand at the same time
during periods of expansion or contract at the same time during periods of contraction.
Hence, several months may go by before a genuine cyclical upturn or downturn is finally
identified with any assurance.
Leading indicators are the most useful predictive tool, since they attempt to signal
economic changes in advance. Coincident and lagging indicators are of minimal inter-
est from a forecasting perspective, but they are used to assess the effectiveness of cur-
rent and past economic policy and so to help formulate future policy.
In their article entitled “Early Warning Signals for the Economy,” Geoffrey H.
Moore and Julius Shiskin (1976) have the following to say on the usefulness of business
cycle indicators:

It seems clear from the record that business cycle indicators are helpful in
judging the tone of current business and short-term prospects. But because of
their limitations, the indicators must be used together with other data and with
full awareness of the background of business and consumer confidence and
expectations, governmental policies, and international events. We also must
anticipate that the indicators will often be difficult to interpret, that interpreta-
tions will sometimes vary among analysts, and that the signals they give will
not be correctly interpreted. Indicators provide a sensitive and revealing pic-
ture of the ebb and flow of economic tides that a skillful analyst of the eco-
nomic, political, and international scene can use to improve his chances of
making a valid forecast of short-run economic trends. If the analyst is aware of
their limitations and alert to the world around him, he will find the indicators
useful guideposts for taking stock of the economy and its needs.

Cyclical components of individual time series generally conform only loosely—

and sometimes not at all—to the business cycle as identified by the NBER indicators.
However, if a cyclical component for a given time series is estimated, it should always
be plotted over time to get some indication of the magnitudes and lengths of any cycles
that appear to exist. In addition, the plot can be examined for any relation to the ups
and downs of general economic activity.
The discussion so far shows how the factors that create variation in a time series
can be separated and studied individually. Analysis is the process for taking the time
series apart; synthesis is the process for putting it back together. Next, we shall put the
components of the time series back together to do forecasting.

FORECASTING A SEASONAL TIME SERIES

In forecasting a seasonal time series, the decomposition process is reversed. Instead of

separating the series into individual components for examination, we recombine the com-
ponents to develop the forecasts for future periods. We will use the multiplicative model
and the results of Example 3 to develop forecasts for Coastal Marine Corporation sales.
Example 4
Forecasts of Coastal Marine Corporation sales for the four quarters of 2007 can be devel-
oped using Table 4.

1. Trend. The quarterly trend equation is TNt = 261.24 + .759t. The forecast origin is the
fourth quarter of 2006, or time period t = n = 28. Sales for the first quarter of 2007
occurred in time period t = 28 + 1 = 29. This notation shows we are forecasting p = 1
 Time Series and Their Components

period ahead from the end of the time series. Setting t = 29, the trend projection is
then

TN29 = 261.24 + .7591292 = 283.251

2. Seasonal. The seasonal index for the first quarter, .77967, is given in Figure 9.
3. Cyclical. The cyclical projection must be determined from the estimated cyclical pat-
tern (if any) and from any other information generated by indicators of the general
economy for 2007. Projecting the cyclical pattern for future time periods is fraught with
uncertainty, and as we indicated earlier, it is generally assumed, for forecasting pur-
poses, to be included in the trend. To demonstrate the completion of this example, we
set the cyclical index to 1.0.
4. Irregular. Irregular fluctuations represent random variation that can’t be explained by
the other components. For forecasting, the irregular component is set to the average
value 1.0.11
The forecast for the first quarter of 2007 is

YN29 = T29 * S29 * C29 * I29 = 1283.25121.77967211.0211.02 = 220.842

The forecasts for the rest of 2007 are

Second quarter = 288.455

Third quarter = 317.990
Fourth quarter = 310.654

The multiplicative decomposition fit for Coastal Marine Corporation sales, along with
the forecasts for 2007, is shown in Figure 12. We can see from the figure that the fit, con-
structed from the trend and seasonal components, represents the actual data reasonably
well. However, the fit is not good for the last two quarters of 2006, time periods 27 and 28.
The forecasts for 2007 mimic the pattern of the fit.

FIGURE 12 Decomposition Fit and Forecasts for Coastal

Marine Sales for Example 4

11For forecasts generated from an additive model, the irregular index is set to the average value 0.
 Time Series and Their Components

Forecasts produced by an additive or a multiplicative decomposition model reflect

the importance of the individual components. If a variable is highly seasonal, then the
forecasts will have a strong seasonal pattern. If, in addition, there is a trend, the fore-
casts will follow the seasonal pattern superimposed on the extrapolated trend. If one
component dominates the analysis, it alone might provide a practical, accurate short-
term forecast.

THE CENSUS II DECOMPOSITION METHOD

Time series decomposition methods have a long history. In the 1920s and early 1930s,
the Federal Reserve Board and the National Bureau of Economic Research were
heavily involved in the seasonal adjustment and smoothing of economic time series.
However, before the development of computers, the decomposition calculations were
laborious, and practical application of the methods was limited. In the early 1950s,
Julius Shiskin, chief economic statistician at the U.S. Bureau of the Census, developed
a large-scale computer program to decompose time series. The first computer program
essentially approximated the hand methods that were used up to that time and was
replaced a year later by an improved program known as Method II. Over the years,
improved variants of Method II followed. The current variant of the Census Bureau
time series decomposition program is known as X-12-ARIMA. This program is avail-
able from the Census Bureau at no charge and is widely used by government agencies
and private companies.12
Census II decomposition is usually multiplicative, since most economic time series
have seasonal variation that increases with the level of the series. Also, the decomposi-
tion assumes three components: trend-cycle, seasonal, and irregular.
The Census II method iterates through a series of steps until the components are
successfully isolated. Many of the steps involve the application of weighted moving
averages to the data. This results in inevitable loss of data at the beginning and end of
the series because of the averaging. The ARIMA part of X-12-ARIMA provides the
facility to extend the original series in both directions with forecasts so that more of
the observations are adjusted using the full weighted moving averages. These forecasts
are generated from an ARIMA time series model.
The steps for each iteration of the Census II method as implemented in X-12-
ARIMA are outlined next. It may seem that the method is complicated because of the
many steps involved. However, the basic idea is quite simple—to isolate the trend-
cycle, seasonal, and irregular components one by one. The various iterations are
designed to improve the estimate of each component. Good references for additional
study are Forecasting: Methods and Applications (Makridakis, Wheelwright, and
Hyndman 1998), Forecasting: Practice and Process for Demand Management
(Levenbach and Cleary 2006), and “New Capabilities and Methods of the X-12-
ARIMA Seasonal-Adjustment Program” (Findley et al. 1998).
Step 1. An s-period moving average is applied to the original data to get a rough
estimate of the trend-cycle. (For monthly data, s = 12; for quarterly data,
s = 4; and so forth.)
Step 2. The ratios of the original data to these moving average values are calculated
as in classical multiplicative decomposition, illustrated in Example 2.

12The PC version of the X-12-ARIMA program can be downloaded from the U.S. Census Bureau website.
At the time this text was written, the web address for the download page was www.census.gov/srd/www/
x12a/x12down_pc.html.
 Time Series and Their Components

Step 3. The ratios from step 2 contain both the seasonal and the irregular compo-
nents. They also include extreme values resulting from unusual events
such as strikes or wars. The ratios are divided by a rough estimate of the
seasonal component to give an estimate of the irregular component.
A large value for an irregular term indicates an extreme value in the orig-
inal data. These extreme values are identified and the ratios in step 2
adjusted accordingly. This effectively eliminates values that do not fit the
pattern of the remaining data. Missing values at the beginning and end of
the series are also replaced by estimates at this stage.
Step 4. The ratios created from the modified data (with extreme values replaced
and estimates for missing values) are smoothed using a moving average to
eliminate irregular variation. This creates a preliminary estimate of the
seasonal component.
Step 5. The original data are then divided by the preliminary seasonal component
from step 4 to get the preliminary seasonally adjusted series. This season-
ally adjusted series contains the trend-cycle and irregular components. In
symbols,

Yt Tt * St * It
= = Tt * It
St St

Step 6. The trend-cycle is estimated by applying a weighted moving average to

the preliminary seasonally adjusted series. This moving average eliminates
irregular variation and gives a smooth curve that indicates the preliminary
trend-cycle in the data.
Step 7. Repeat step 2 with this new estimate of the trend-cycle. That is, new ratios,
containing only the seasonal and irregular components, are obtained by
dividing the original observations by the trend-cycle from step 6. These
are the final seasonal-irregular ratios. Mathematically,
Yt Tt * St * It
= = St * It
Tt Tt

Step 8. Repeat step 3 using the new ratios computed in step 7.

Step 9. Repeat step 4 to get a new estimate of the seasonal component.
Step 10. Repeat step 5 with the seasonal component from step 9.
Step 11. Divide the seasonally adjusted data from step 10 by the trend-cycle
obtained in step 6 to get the estimated irregular component.
Step 12. Extreme values of the irregular component are replaced as in step 3.
A series of modified data is obtained by multiplying the trend-cycle, sea-
sonal component, and adjusted irregular component together. These data
reproduce the original data except for the extreme values.
The preceding 12 steps are repeated, beginning with the modified data from step
12 rather than the original data. Some of the lengths of the moving averages used in the
various steps are changed, depending on the variability in the data.
The final seasonally adjusted series is determined by dividing the final seasonal
component into the original data. The result contains only the product of the trend-
cycle and irregular components.
The value of each of the final components is printed out and plotted. A series of
diagnostic tests is available to determine if the decomposition was successful.
 Time Series and Their Components

The X-12-ARIMA program contains many additional features that we have not
described. For example, adjustments can be made for different numbers of trading days
and for holiday effects, missing values within the series can be estimated and replaced,
the effects of outliers can be removed before decomposition, and other changes in
trend such as shifts in level or temporary ramp effects can be modeled.

APPLICATION TO MANAGEMENT

Time series analysis is a widely used statistical tool for forecasting future events that
are intertwined with the economy in some fashion. Manufacturers are extremely inter-
ested in the boom–bust cycles of our economy as well as of foreign economies so that
they can better predict demand for their products, which, in turn, impacts their inven-
tory levels, employment needs, cash flows, and almost all other business activities
within the firm.
The complexity of these problems is enormous. Take, for example, the problem of
predicting demand for oil and its by-products. In the late 1960s, the price of oil per bar-
rel was very low, and there seemed to be an insatiable worldwide demand for gas and
oil. Then came the oil price shocks of the early and mid-1970s. What would the future
demand for oil be? What about prices? Firms such as Exxon and General Motors were
obviously very interested in the answers to these questions. If oil prices continued to
escalate, would the demand for large cars diminish? What would be the demand for
electricity? By and large, analysts predicted that the demand for energy, and therefore
oil, would be very inelastic; thus, prices would continue to outstrip inflation. However,
these predictions did not take into account a major downswing in the business cycle in
the early 1980s and the greater elasticity of consumer demand for energy than pre-
dicted. By 1980, the world began to see a glut of oil on the market and radically falling
prices. At the time, it seemed hard to believe that consumers were actually benefiting
once again from gasoline price wars. At the time this edition text was written, substan-
tial unrest in the Middle East created a shortage of oil once again. The price of a barrel
of oil and the cost of a gallon of gas in the United States were at record highs.
Oil demand is affected not only by long-term cyclical events but also by seasonal and
random events, as are most other forecasts of demand for any type of product or service.
For instance, consider the service and retail industries. We have witnessed a continued
movement of employment away from manufacturing to the retail and service fields.
However, retailing (whether in-store, catalog, or web-based) is an extremely seasonal
and cyclical business and demand and inventory projections are critical to retailers, so
time series analysis will be used more widely by increasingly sophisticated retailers.
Manufacturers will have a continued need for statistical projections of future
events. Witness the explosive growth in the technology and telecommunications fields
during the 1990s and the substantial contraction of these industries in the early 2000s.
This growth and contraction resulted, to a large extent, from projections of demand that
never completely materialized. Questions that all manufacturers must address include
these: What will the future inflation rate be? How will it affect the cost-of-living adjust-
ments that may be built into a company’s labor contract? How will these adjustments
affect prices and demand? What is the projected pool of managerial skills for 2025?
What will be the effect of the government’s spending and taxing strategies?
What will the future population of young people look like? What will the ethnic mix
be? These issues affect almost all segments of our economy. Demographers are closely
watching the current fertility rate and using almost every available time series forecast-
ing technique to try to project population variables. Very minor miscalculations will
 Time Series and Their Components

have major impacts on everything from the production of babies’ toys to the financial
soundness of the Social Security system. Interestingly, demographers are looking at very
long-term business cycles (20 years or more per cycle) in trying to predict what this gen-
eration’s population of women of childbearing age will do with regard to having chil-
dren. Will they have one or two children, as families in the 1960s and 1970s did, or will
they return to having two or three, as preceding generations did? These decisions will
determine the age composition of our population for the next 50 to 75 years.
Political scientists are interested in using time series analysis to study the changing
patterns of government spending on defense and social welfare programs. Obviously,
these trends have great impact on the future of whole industries.
Finally, one interesting microcosm of applications of time series analysis has shown
up in the legal field. Lawyers are making increasing use of expert witnesses to testify
about the present value of a person’s or a firm’s future income, the cost incurred from
the loss of a job due to discrimination, and the effect on a market of an illegal strike.
These questions can often be best answered through the judicious use of time series
analysis.
Satellite technology and the World Wide Web have made the accumulation and
transmission of information almost instantaneous. The proliferation of personal comput-
ers, the availability of easy-to-use statistical software programs, and increased access to
databases have brought information processing to the desktop. Business survival during
periods of major competitive change requires quick, data-driven decision making. Time
series analysis and forecasting play a major role in these decision-making processes.

APPENDIX: PRICE INDEX

Several of the series on production, sales, and other economic situations contain data
available only in dollar values. These data are affected by both the physical quantity of
goods sold and their prices. Inflation and widely varying prices over time can cause
analysis problems. For instance, an increased dollar volume may hide decreased sales
in units when prices are inflated. Thus, it is frequently necessary to know how much of
the change in dollar value represents a real change in physical quantity and how much
is due to change in price because of inflation. It is desirable in these instances to
express dollar values in terms of constant dollars.
The concept of purchasing power is important. The current purchasing power of $1
is defined as follows:

100
Current purchasing power of $1 = (10)
Consumer Price Index
Thus, if in November 2006 the consumer price index (with 2002 as 100) reaches 150, the
current purchasing power of the November 2006 consumer dollar is

100
Current purchasing power of $1 = = .67
150
The 2006 dollar purchased only two-thirds of the goods and services that could have
been purchased with a base period (2002) dollar.
To express dollar values in terms of constant dollars, Equation 11 is used.

Deflated dollar value = 1Dollar value2 * 1Purchasing power of $12 (11)

 Time Series and Their Components

Suppose that car sales rose from $300,000 in 2005 to $350,000 in 2006, while the
new-car price index (with 2002 as the base) rose from 135 to 155. Deflated sales for
2005 and 2006 would be

100
Deflated 2005 sales = 1$300,0002 ¢ ≤ = $222,222
135
100
Deflated 2006 sales = 1$350,0002 ¢ ≤ = $225,806
155

Note that actual dollar sales had a sizable increase of $350,000 - $300,000 = $50,000.
However, deflated sales increased by only $225,806 - $222,222 = $3,584.
The purpose of deflating dollar values is to remove the effect of price changes.
This adjustment is called price deflation or is referred to as expressing a series in con-
stant dollars.

Price deflation is the process of expressing values in a series in constant dollars.

The deflating process is relatively simple. To adjust prices to constant dollars, an

index number computed from the prices of commodities whose values are to be
deflated is used. For example, shoe store sales should be deflated by an index of shoe
prices, not by a general price index. For deflated dollar values that represent more than
one type of commodity, the analyst should develop a price index by combining the
appropriate price indexes together in the proper mix.
Example 5
Mr. Burnham wishes to study the long-term growth of the Burnham Furniture Store. The
long-term trend of his business should be evaluated using the physical volume of sales. If
this evaluation cannot be done, price changes reflected in dollar sales will follow no consis-
tent pattern and will merely obscure the real growth pattern. If sales dollars are to be used,
actual dollar sales need to be divided by an appropriate price index to obtain sales that are
measured in constant dollars.
The consumer price index (CPI) is not suitable for Burnham because it contains ele-
ments such as rent, food, and personal services not sold by the store, but some components
of this index may be appropriate. Burnham is aware that 70% of sales are from furniture
and 30% from appliances. He can therefore multiply the CPI retail furniture component by
.70, multiply the appliance component by .30, and then add the results to obtain a combined
price index. Table 5 illustrates this approach, in which the computations for 1999 are

90.11.702 + 94.61.302 = 91.45

The sales are deflated for 1999 in terms of 2002 purchasing power, so that

100
Deflated 1999 sales = 142.12 ¢ ≤ = 46.0
91.45

Table 5 shows that, although actual sales gained steadily from 1999 to 2006, physical volume
remained rather stable from 2004 to 2006. Evidently, the sales increases were due to price
markups that were generated, in turn, by the inflationary tendency of the economy.
 Time Series and Their Components

TABLE 5 Burnham Furniture Sales Data, 1999–2006,

for Example 5

Retail
Burnham Retail Furniture Appliance Price Price
Sales Price Index Index Indexa Deflated Salesb
Year ($1,000s) (2002=100) (2002=100) (2002=100) ($1,000s of 2002)

1999 42.1 90.1 94.6 91.45 46.0

2000 47.2 95.4 97.2 95.94 49.2
2001 48.4 97.2 98.4 97.56 49.6
2002 50.6 100.0 100.0 100.00 50.6
2003 55.2 104.5 101.1 103.48 53.3
2004 57.9 108.6 103.2 106.98 54.1
2005 59.8 112.4 104.3 109.97 54.4
2006 60.7 114.0 105.6 111.48 54.4

aConstructed for furniture (weight 70%) and appliances (weight 30%).

bSales divided by price index times 100.

Glossary
Business indicators. Business indicators are business- Price deflation. Price deflation is the process of
related time series that are used to help assess the expressing values in a series in constant dollars.
general state of the economy.
Index numbers. Index numbers are percentages that
show changes over time.

Key Formulas

Time series additive decomposition

Yt = Tt + St + It (1)

Time series multiplicative decomposition

Yt = Tt * St * It (2)

Linear trend
TNt = b0 + b1t (3)

Sum of squared errors criterion (with trend TN )

SSE = a 1Yt - TNt22 (4)

Quadratic trend
TNt = b0 + b1t + b2t2 (5)

Exponential trend
TNt = b0bt1 (6)
 Time Series and Their Components

Seasonally adjusted data (additive decomposition)

Yt - St = Tt + It (7a)

Seasonally adjusted data (multiplicative decomposition)

Yt
= Tt * It (7b)
St

Cyclical-irregular component (multiplicative decomposition)

Yt
Ct * It = (8)
Tt * St

Irregular component (multiplicative decomposition)

Ct * It
It = (9)
Ct

Current purchasing power of $1

100
(10)
Consumer Price Index

Deflated dollar value

1Dollar value2 * 1Purchasing power of $12 (11)

Problems

1. Explain the concept of decomposing a time series.

2. Explain when a multiplicative decomposition may be more appropriate than an
additive decomposition.
3. What are some basic forces that affect the trend-cycle of most variables?
4. What kind of trend model should be used in each of the following cases?
a. The variable is increasing by a constant rate.
b. The variable is increasing by a constant rate until it reaches saturation and
levels out.
c. The variable is increasing by a constant amount.
5. What are some basic forces that affect the seasonal component of most variables?
6. Value Line estimates of sales and earnings growth for individual companies are
derived by correlating sales, earnings, and dividends to appropriate components of
the National Income Accounts such as capital spending. Jason Black, an analyst for
Value Line, is examining the trend of the capital spending variable from 1977 to
1993. The data are given in Table P-6.
a. Plot the data and determine the appropriate trend model for the years 1977 to
1993.
b. If the appropriate model is linear, compute the linear trend model for the years
1977 to 1993.
 Time Series and Their Components

TABLE P-6 Capital Spending ($ billions), 1977–1993

Year $Billions Year $Billions Year $Billions

1977 214 1983 357 1989 571
1978 259 1984 416 1990 578
1979 303 1985 443 1991 556
1980 323 1986 437 1992 566
1981 369 1987 443 1993 623
1982 367 1988 545 1994 680a
a
Value Line estimate.
Source: The Value Line Investment Survey (New York: Value Line, 1988, 1990,
1994).
c. What has the average increase in capital spending per year been since 1977?
d. Estimate the trend value for capital spending in 1994.
e. Compare your trend estimate with Value Line’s.
f. What factor(s) influence the trend of capital spending?
7. A large company is considering cutting back on its TV advertising in favor of busi-
ness videos to be given to its customers. This action is being considered after the
company president read a recent article in the popular press touting business
videos as today’s “hot sales weapon.” One thing the president would like to inves-
tigate prior to taking this action is the history of TV advertising in this country,
especially the trend-cycle.
Table P-7 contains the total dollars spent on U.S. TV advertising (in millions of dollars).
a. Plot the time series of U.S. TV advertising expenditures.
b. Fit a linear trend to the advertising data and plot the fitted line on the time
series graph.
c. Forecast TV advertising dollars for 1998.
d. Given the results in part b, do you think there may be a cyclical component in
TV advertising dollars? Explain.
8. Assume the following specific percentage seasonal indexes for March based on the
ratio-to-moving-average method:
102.2 105.9 114.3 122.4 109.8 98.9

What is the seasonal index for March using the median?

TABLE P-7

Year Y Year Y
26,891
29,073
28,189
30,450
31,698
35,435
37,828
42,484
44,580
 Time Series and Their Components

9. The expected trend value for October is $850. Assuming an October seasonal
index of 1.12 (112%) and the multiplicative model given by Equation 2, what
would be the forecast for October?
10. The following specific percentage seasonal indexes are given for the month of
December:
75.4 86.8 96.9 72.6 80.0 85.4

Assume a multiplicative decomposition model. If the expected trend for

December is $900 and the median seasonal adjustment is used, what is the forecast
for December?
11. A large resort near Portland, Maine, has been tracking its monthly sales for several
years but has never analyzed these data. The resort computes the seasonal indexes
for its monthly sales. Which of the following statements about the index are correct?
a. The sum of the 12 monthly index numbers, expressed as percentages, should be
1,200.
b. An index of 85 for May indicates that sales are 15% lower than the average
monthly sales.
c. An index of 130 for January indicates that sales are 30% above the average
monthly sales.
d. The index for any month must be between zero and 200.
e. The average percent index for each of the 12 months should be 100.
12. In preparing a report for June Bancock, manager of the Kula Department Store,
you include the statistics from last year’s sales (in thousands of dollars) shown in
Table P-12. Upon seeing them, Ms. Bancock says, “This report confirms what I’ve
been telling you: Business is getting better and better.” Is this statement accurate?
Why or why not?
13. The quarterly sales levels (measured in millions of dollars) for Goodyear Tire are
shown in Table P-13. Does there appear to be a significant seasonal effect in these
sales levels? Analyze this time series to get the four seasonal indexes and deter-
mine the extent of the seasonal component in Goodyear’s sales.

TABLE P-12
Adjusted
Seasonal
Month Sales ($1,000s) Index (%)

January 125 51
February 113 50
March 189 87
April 201 93
May 206 95
June 241 99
July 230 96
August 245 89
September 271 103
October 291 120
November 320 131
December 419 189

Source: Based on Kula Department Store records.

 Time Series and Their Components

TABLE P-13
Quarter

Year 1 2 3 4

1985 2,292 2,450 2,363 2,477

1986 2,063 2,358 2,316 2,366
1987 2,268 2,533 2,479 2,625
1988 2,616 2,793 2,656 2,746
1989 2,643 2,811 2,679 2,736
1990 2,692 2,871 2,900 2,811
1991 2,497 2,792 2,838 2,780
1992 2,778 3,066 3,213 2,928
1993 2,874 3,000 2,913 2,916
1994 2,910 3,052 3,116 3,210
1995 3,243 3,351 3,305 3,267
1996 3,246 3,330 3,340a 3,300a
aValue Line estimates.
Source: The Value Line Investment Survey (New York: Value Line,
1988, 1989, 1993, 1994, 1996).

a. Would you use the trend component, the seasonal component, or both to forecast?
b. Forecast for third and fourth quarters of 1996.
c. Compare your forecasts to Value Line’s.
14. The monthly sales of the Cavanaugh Company, pictured in Figure 1 (bottom), are
given in Table P-14.
a. Perform a multiplicative decomposition of the Cavanaugh Company sales time
series, assuming trend, seasonal, and irregular components.
b. Would you use the trend component, the seasonal component, or both to forecast?
c. Provide forecasts for the rest of 2006.
15. Construct a table similar to Table P-14 with the natural logarithms of monthly
sales. For example, the value for January 2000 is ln11542 = 5.037.
a. Perform an additive decomposition of ln(sales), assuming the model
Y = T + S + I.

TABLE P-14
Month 2000 2001 2002 2003 2004 2005 2006

January 154 200 223 346 518 613 628

February 96 118 104 261 404 392 308
March 73 90 107 224 300 273 324
April 49 79 85 141 210 322 248
May 36 78 75 148 196 189 272
June 59 91 99 145 186 257
July 95 167 135 223 247 324
August 169 169 211 272 343 404
September 210 289 335 445 464 677
October 278 347 460 560 680 858
November 298 375 488 612 711 895
December 245 203 326 467 610 664
 Time Series and Their Components

b. Would you use the trend component, the seasonal component, or both to forecast?
c. Provide forecasts of ln(sales) for the remaining months of 2006.
d. Take the antilogs of the forecasts calculated in part c to get forecasts of the
actual sales for the remainder of 2006.
e. Compare the forecasts in part d with those in Problem 14, part c. Which set of
forecasts do you prefer? Why?
16. Table P-16 contains the quarterly sales (in millions of dollars) for the Disney
Company from the first quarter of 1980 to the third quarter of 1995.
a. Perform a multiplicative decomposition of the time series consisting of Disney’s
quarterly sales.
b. Does there appear to be a significant trend? Discuss the nature of the seasonal
component.
c. Would you use both trend and seasonal components to forecast?
d. Forecast sales for the fourth quarter of 1995 and the four quarters of 1996.
17. The monthly gasoline demand (in thousands of barrels/day) for Yukong Oil
Company of South Korea for the period from January 1986 to September 1996 is
contained in Table P-17.
a. Plot the gasoline demand time series. Do you think an additive or a multiplica-
tive decomposition would be appropriate for this time series? Explain.
b. Perform a decomposition analysis of gasoline demand.
c. Interpret the seasonal indexes.
d. Forecast gasoline demand for the last three months of 1996.
18. Table P-18 contains data values that represent the monthly sales (in billions of dol-
lars) of all retail stores in the United States. Using the data through 1994, perform
a decomposition analysis of this series. Comment on all three components of the
series. Forecast retail sales for 1995 and compare your results with the actual val-
ues provided in the table.

TABLE P-16

Quarter

Year 1 2 3 4

1980 218.1 245.4 265.5 203.5

1981 235.1 258.0 308.4 211.8
1982 247.7 275.8 295.0 270.1
1983 315.7 358.5 363.0 302.2
1984 407.3 483.3 463.2 426.5
1985 451.5 546.9 590.4 504.2
1986 592.4 647.9 726.4 755.5
1987 766.4 819.4 630.1 734.6
1988 774.5 915.7 1,013.4 1,043.6
1989 1,037.9 1,167.6 1,345.1 1,288.2
1990 1,303.8 1,539.5 1,712.2 1,492.4
1991 1,439.0 1,511.6 1,739.4 1,936.6
1992 1,655.1 1,853.5 2,079.1 2,391.4
1993 2,026.5 1,936.8 2,174.5 2,727.3
1994 2,275.8 2,353.6 2,698.4 3,301.7
1995 2,922.8 2,764.0 3,123.6
 Time Series and Their Components

TABLE P-17

Month 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

January 15.5 20.4 26.9 36.0 52.1 64.4 82.3 102.7 122.2 145.8 170.0
February 17.8 20.8 29.4 39.0 53.1 68.1 83.6 102.2 121.4 144.4 176.3
March 18.1 22.2 29.9 42.2 56.5 68.5 85.5 104.7 125.6 145.2 174.2
April 20.5 24.1 32.4 44.3 58.4 72.3 91.0 108.9 129.7 148.6 176.1
May 21.3 25.5 33.3 46.6 61.7 74.1 92.1 112.2 133.6 153.7 185.3
June 19.8 25.9 34.5 46.1 61.0 77.6 95.8 109.7 137.5 157.9 182.7
July 20.5 26.1 34.8 48.5 65.5 79.9 98.3 113.5 143.0 169.7 197.0
August 22.3 27.5 39.1 52.6 71.0 86.7 102.2 120.4 149.0 184.2 216.1
September 22.9 25.8 39.0 52.2 68.1 84.4 101.5 124.6 149.9 163.2 192.2
October 21.1 29.8 36.5 50.8 67.5 81.4 98.5 116.7 139.5 155.4
November 22.0 27.4 37.5 51.9 68.8 85.1 101.1 120.6 147.7 168.9
December 22.8 29.7 39.7 55.1 68.1 81.7 102.5 124.9 154.7 178.3

TABLE P-18

Month 1988 1989 1990 1991 1992 1993 1994 1995

January 113.6 122.5 132.6 130.9 142.1 148.4 154.6 167.0

February 115.0 118.9 127.3 128.6 143.1 145.0 155.8 164.0
March 131.6 141.3 148.3 149.3 154.7 164.6 184.2 192.1
April 130.9 139.8 145.0 148.5 159.1 170.3 181.8 187.5
May 136.0 150.3 154.1 159.8 165.8 176.1 187.2 201.4
June 137.5 149.0 153.5 153.9 164.6 175.7 190.1 202.6
July 134.1 144.6 148.9 154.6 166.0 177.7 185.8 194.9
August 138.7 153.0 157.4 159.9 166.3 177.1 193.8 204.2
September 131.9 144.1 145.6 146.7 160.6 171.1 185.9 192.8
October 133.8 142.3 151.5 152.1 168.7 176.4 189.7 194.0
November 140.2 148.8 156.1 155.6 167.2 180.9 194.7 202.4
December 171.0 176.5 179.7 181.0 204.1 218.3 233.3 238.0

Source: Based on Survey of Current Business, 1989, 1993, 1996.

TABLE P-19

Adjusted Adjusted
Month Seasonal Index Month Seasonal Index

January 120 July 153

February 137 August 151
March 100 September 95
April 33 October 60
May 47 November 82
June 125 December 97

Source: Based on Mt. Spokane Resort Hotel records.

19. The adjusted seasonal indexes presented in Table P-19 reflect the changing volume
of business of the Mt. Spokane Resort Hotel, which caters to family tourists in the
summer and skiing enthusiasts during the winter months. No sharp cyclical varia-
tions are expected during 2007.
 Time Series and Their Components

TABLE P-24

Commodity
Sales Price Index
Volume ($) (2001 = 100)

2005 January 358,235 118.0

February 297,485 118.4
March 360,321 118.7
April 378,904 119.2
May 394,472 119.7
June 312,589 119.6
July 401,345 119.3

a. If 600 tourists were at the resort in January 2007, what is a reasonable estimate
for February?
b. The monthly trend equation is TN = 140 + 5t where t = 0 represents January
15, 2001. What is the forecast for each month of 2007?
c. What is the average number of new tourists per month?
20. Discuss the performance of the composite index of leading indicators as a barom-
eter of business activity in recent years.
21. What is the present position of the business cycle? Is it expanding or contracting?
When will the next turning point occur?
22. What is the purpose of deflating a time series that is measured in dollars?
23. In the base period of June, the price of a selected quantity of goods was $1,289.73.
In the most recent month, the price index for these goods was 284.7. How much
would the selected goods cost if purchased in the most recent month?
24. Deflate the dollar sales volumes in Table P-24 using the commodity price index.
These indexes are for all commodities, with 2001 = 100.
25. Table P-25 contains the number (in thousands) of men 16 years of age and
older who were employed in the United States for the months from January

TABLE P-25
Year Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.
1993 63,344 63,621 64,023 64,482 65,350 66,412 67,001 66,861 65,808 65,961 65,779 65,545
1994 64,434 64,564 64,936 65,492 66,340 67,230 67,649 67,717 66,997 67,424 67,313 67,292
1995 65,966 66,333 66,758 67,018 67,227 68,384 68,750 68,326 67,646 67,850 67,219 67,049
1996 66,006 66,481 66,961 67,415 68,258 69,298 69,819 69,533 68,614 69,099 68,565 68,434
1997 67,640 67,981 68,573 69,105 69,968 70,619 71,157 70,890 69,890 70,215 70,328 69,849
1998 68,932 69,197 69,506 70,348 70,856 71,618 72,049 71,537 70,866 71,219 71,256 70,930
1999 69,992 70,084 70,544 70,877 71,470 72,312 72,803 72,348 71,603 71,825 71,797 71,699
2000 71,862 72,177 72,501 73,006 73,236 74,267 74,420 74,352 73,391 73,616 73,497 73,338
2001 72,408 72,505 72,725 73,155 73,313 74,007 74,579 73,714 73,483 73,228 72,690 72,547
2002 71,285 71,792 71,956 72,483 73,230 73,747 74,210 73,870 73,596 73,513 72,718 72,437
2003 71,716 72,237 72,304 72,905 73,131 73,894 74,269 74,032 73,715 73,979

Source: Based on Labor force statistics from the Current Population Survey.
 Time Series and Their Components

1993 to October 2003. Use Minitab to do a multiplicative decomposition of

these data and generate forecasts for the next 12 months. Does a multiplicative
decomposition appear to be appropriate in this case? Explain. Is there a strong
seasonal component in these data? Are you surprised? Do the forecasts seem
reasonable?
26. Refer to Problem 25. The default multiplicative decomposition in Minitab
assumes a linear trend. Plot the employed men data in Table P-25 and examine
the years 1993–2000 and 2001–2003. Is a linear trend appropriate? If not, can
you suggest a trend curve that might be appropriate? Fit your suggested trend
curve and store the residuals. Compute the autocorrelation function of the
residuals. Do the residual autocorrelations suggest a seasonal component?
Explain.
27. Table P-27 gives quarterly sales (in millions of dollars) for Wal-Mart Stores from
1990–2004. Use Minitab to do a multiplicative decomposition of the Wal-Mart
sales time series for the years 1990–2003 and generate forecasts for the four quar-
ter of 2004. Does a multiplicative decomposition appear to be appropriate for the
Wal-Mart data? Explain. Is there a strong seasonal component? Are you sur-
prised? Compare the quarterly forecasts for 2004 with the actual sales. Do the
results reinforce the choice of a multiplicative decomposition?
28. Refer to Problem 27. The default multiplicative decomposition in Minitab assumes
a linear trend. Fit and plot a linear trend line to the Wal-Mart sales. Is a linear trend
appropriate for these data? If not, can you suggest a trend curve that might be
appropriate? Fit your suggested trend curve and store the residuals. Compute the
residual autocorrelations. Do the residual autocorrelations suggest a seasonal
component? Explain.

TABLE P-27

Quarter

Year 1 2 3 4
1990 6,768 7,544 7,931 10,359
1991 9,281 10,340 10,628 13,639
1992 11,649 13,028 13,684 17,122
1993 13,920 16,237 16,827 20,361
1994 17,686 19,942 20,418 24,448
1995 20,440 22,723 22,914 27,550
1996 22,772 25,587 25,644 30,856
1997 25,409 28,386 28,777 35,386
1998 29,819 33,521 33,509 40,785
1999 35,129 28,913 40,899 51,868
2000 43,447 46,588 46,181 57,079
2001 48,565 53,187 53,185 64,735
2002 52,126 56,781 55,765 66,905
2003 57,224 63,231 63,036 75,190
2004 65,443 70,466 69,261 82,819
Source: Based on S&P Compustat North American Industrial Quarterly database.
 Time Series and Their Components

CASES

CASE 1 THE SMALL ENGINE DOCTOR13

The Small Engine Doctor is the name of a business the dealer had to back-order one or more parts for
developed by Thomas Brown, who is a mail carrier any given repair job. Parts ordered from the manu-
for the U.S. Postal Service. He had been a tinkerer facturer had lead times of anywhere from 30 to 120
since childhood, always taking discarded household days. As a result, Tom changed his policy and began
gadgets apart in order to understand “what made to order parts directly from the factory. He found
them tick.” As Tom grew up and became a typical that shipping and handling charges ate into his prof-
suburbanite, he acquired numerous items of lawn its, even though the part price was only 60% of retail.
and garden equipment. When Tom found out about a However, the two most important problems created
course in small engine repair offered at a local com- by the replacement parts were lost sales and storage
munity college, he jumped at the opportunity. Tom space. Tom attracted customers because of his qual-
started small engine repair by dismantling his own ity service and reasonable repair charges, which were
equipment, overhauling it, and then reassembling it. possible because of his low overhead. Unfortunately,
Soon after completing the course in engine repair, he many potential customers would go to equipment
began to repair lawn mowers, rototillers, snowblow- dealers rather than wait several months for repair.
ers, and other lawn and garden equipment for friends The most pressing problem was storage space. While
and neighbors. In the process, he acquired various a piece of equipment was waiting for spare parts, it
equipment manuals and special tools. had to be stored on the premises. It did not take long
It was not long before Tom decided to turn his for both his workshop and his one-car garage to
hobby into a part-time business. He placed an adver- overflow with equipment while he was waiting for
tisement in a suburban shopping circular under the spare parts. In the second year of operation, Tom
name of the Small Engine Doctor. Over the last two actually had to suspend advertising as a tactic to limit
years, the business has grown enough to provide a customers due to lack of storage space.
nice supplement to his regular salary. Although the Tom has considered stocking inventory for his
growth was welcomed, as the business is about to third year of operation. This practice will reduce pur-
enter its third year of operation there are a number of chasing costs by making it possible to obtain quantity
concerns.The business is operated out of Tom’s home. discounts and more favorable shipping terms. He also
The basement is partitioned into a family room, a hopes that it will provide much better turnaround
workshop, and an office. Originally, the office area time for the customers, improving both cash flow and
was used to handle the advertising, order processing, sales.The risks in this strategy are uncontrolled inven-
and bookkeeping. All engine repair was done in the tory carrying costs and part obsolescence.
workshop. Tom’s policy has been to stock only a lim- Before committing himself to stocking spare
ited number of parts, ordering replacement parts as parts, Tom wants to have a reliable forecast for busi-
they are needed. This seemed to be the only practical ness activity in the forthcoming year. He is confident
way of dealing with the large variety of parts involved enough in his knowledge of product mix to use an
in repairing engines made by the dozen or so manu- aggregate forecast of customer repair orders as a
facturers of lawn and garden equipment. basis for selectively ordering spare parts. The fore-
Spare parts have proved to be the most aggra- cast is complicated by seasonal demand patterns and
vating problem in running the business. Tom started a trend toward increasing sales.
his business by buying parts from equipment dealers. Tom plans to develop a sales forecast for the
This practice had several disadvantages. First, he had third year of operation. A sales history for the first
to pay retail for the parts. Second, most of the time two years is given in Table 6.

13This case was contributed by William P. Darrow of the Towson State University, Towson, Maryland.
 Time Series and Their Components

TABLE 6 Small Engine Doctor Sales History

2005 2006 2005 2006

Month (units) (units) Month (units) (units)

January 5 21 July 28 46
February 8 20 August 20 32
March 10 29 September 14 27
April 18 32 October 8 13
May 26 44 November 6 11
June 35 58 December 26 52

ASSIGNMENT
1. Plot the data on a two-year time horizon from constants: 1" = .1, # = .12, 1" = .25, # = .252,
2005 through 2006. Connect the data points to and 1" = .5, # = .52. Plot the three sets of
make a time series plot. smoothed values on the time series graph.
2. Develop a trend-line equation using linear Generate forecasts through the end of the third
regression and plot the results. year for each of the trend-adjusted exponential
3. Estimate the seasonal adjustment factors for smoothing possibilities considered.
each month by dividing the average demand 5. Calculate the MAD values for the two models
for corresponding months by the average of that visually appear to give the best fits (the
the corresponding trend-line forecasts. Plot the most accurate one-step-ahead forecasts).
fitted values and forecasts for 2007 given by 6. If you had to limit your choice to one of the models
Trend * Seasonal. in Questions 2 and 4, identify the model you would
4. Smooth the time series using Holt’s linear expo- use for your business planning in 2007, and dis-
nential smoothing with three sets of smoothing cuss why you selected that model over the others.

CASE 2 MR. TUX

John Mosby has been looking forward to the decom- solid forecasts on which to base their investment
position of his time series, monthly sales dollars. He decisions. John knows that his business is improving
knows that the series has a strong seasonal effect and that future prospects look bright, but investors
and would like it measured for two reasons. First, his want documentation.
banker is reluctant to allow him to make variable The monthly sales volumes for Mr. Tux for the
monthly payments on his loan. John has explained years 1999 through 2005 are entered into Minitab.
that because of the seasonality of his sales and Since 1998 was the first year of business, the sales
monthly cash flow, he would like to make extra pay- volumes were extremely low compared to the rest of
ments in some months and reduced payments, and the years. For this reason, John decides to eliminate
even no payments, in others. His banker wants to see these values from the analysis. The seasonal indexes
some verification of John’s assertion that his sales are shown in Table 7. The rest of the computer print-
have a strong seasonal effect. out is shown in Table 8.
Second, John wants to be able to forecast his John is not surprised to see the seasonal indexes
monthly sales. He needs such forecasts for planning shown in Table 7, and he is pleased to have some
purposes, especially since his business is growing. hard numbers to show his banker. After reviewing
Both bankers and venture capitalists want some these figures, the banker agrees that John will make
 Time Series and Their Components

TABLE 7 Summary of the Monthly

Seasonal Indexes for
Mr. Tux
Time Series Decomposition
Trend-Line Equation
TNt = 12,133 + 3,033t

Seasonal Index

Period Index

1 0.3144
2 0.4724
3 0.8877
4 1.7787
5 1.9180
6 1.1858
7 1.0292
8 1.2870
9 0.9377
10 0.8147
11 0.6038
12 0.7706

Accuracy of Model

MAPE: 20
MAD: 21,548
MSD: 9.12E $ 08

TABLE 8 Calculations for the Short-Term Components for Mr. Tux

t Year Month Sales T SCI TCI CI C I

1 1999 January 16,850 15,166 1.1111 53,589 3.5336 — —

2 February 12,753 18,198 0.7708 26,997 1.4835 — —
3 March 26,901 21,231 1.2671 30,306 1.4274 2.1387 0.6674
4 April 61,494 24,264 2.5344 34,572 1.4249 1.7545 0.8121
5 May 147,862 27,297 5.4169 77,092 2.8242 1.7567 1.6077
6 June 57,990 30,329 1.9120 48,902 1.6124 1.7001 0.9484
7 July 51,318 33,362 1.5382 49,862 1.4946 1.5397 0.9707
8 August 53,599 36,395 1.4727 41,647 1.1443 1.2142 0.9424
9 September 23,038 39,428 0.5843 24,568 0.6231 1.0325 0.6035
10 October 41,396 42,460 0.9749 50,815 1.1968 0.8550 1.3997
11 November 19,330 45,493 0.4249 32,014 0.7037 0.8161 0.8623
12 December 22,707 48,526 0.4679 29,466 0.6072 0.9305 0.6526
13 2000 January 15,395 51,559 0.2986 48,961 0.9496 0.7912 1.2002
14 February 30,826 54,592 0.5647 65,257 1.1954 0.8418 1.4201
15 March 25,589 57,624 0.4441 28,828 0.5003 1.0439 0.4793
16 April 103,184 60,657 1.7011 58,011 0.9564 1.0273 0.9309
17 May 197,608 63,690 3.1027 103,029 1.6177 0.8994 1.7985
18 June 68,600 66,723 1.0281 57,850 0.8670 0.9945 0.8719
19 July 39,909 69,755 0.5721 38,777 0.5559 0.9685 0.5740
20 August 91,368 72,788 1.2553 70,994 0.9754 0.8308 1.1740
 Time Series and Their Components

TABLE 8 (Continued)

t Year Month Sales T SCI TCI CI C I

21 September 58,781 75,821 0.7753 62,684 0.8267 0.7927 1.0430

22 October 59,679 78,854 0.7568 73,257 0.9290 0.8457 1.0986
23 November 33,443 81,887 0.4084 55,387 0.6764 0.8515 0.7944
24 December 53,719 84,919 0.6326 69,709 0.8209 0.8567 0.9582
25 2001 January 27,773 87,952 0.3158 88,327 1.0043 0.7935 1.2657
26 February 36,653 90,985 0.4029 77,592 0.8528 0.9102 0.9370
27 March 51,157 94,018 0.5441 57,632 0.6130 0.9609 0.6380
28 April 217,509 97,050 2.2412 122,285 1.2600 0.9401 1.3403
29 May 206,229 100,083 2.0606 107,523 1.0743 0.9579 1.1216
30 June 110,081 103,116 1.0676 92,830 0.9003 1.0187 0.8837
31 July 102,893 106,149 0.9693 99,973 0.9418 0.9658 0.9751
32 August 128,857 109,182 1.1802 100,124 0.9170 0.9875 0.9287
33 September 104,776 112,214 0.9337 111,732 0.9957 0.9858 1.0100
34 October 111,036 115,247 0.9635 136,299 1.1827 0.9743 1.2139
35 November 63,701 118,280 0.5386 105,499 0.8920 0.9516 0.9373
36 December 82,657 121,313 0.6814 107,260 0.8842 0.9131 0.9683
37 2002 January 31,416 124,345 0.2527 99,913 0.8035 0.8246 0.9745
38 February 48,341 127,378 0.3795 102,335 0.8034 0.8507 0.9444
39 March 85,651 130,411 0.6568 96,492 0.7399 0.8951 0.8266
40 April 242,673 133,444 1.8185 136,432 1.0224 0.9331 1.0957
41 May 289,554 136,477 2.1216 150,967 1.1062 0.9914 1.1158
42 June 164,373 139,509 1.1782 138,614 0.9936 1.0314 0.9634
43 July 160,608 142,542 1.1267 156,051 1.0948 1.0312 1.0616
44 August 176,096 145,575 1.2097 136,829 0.9399 0.9960 0.9437
45 September 142,363 148,608 0.9580 151,815 1.0216 1.0405 0.9819
46 October 114,907 151,640 0.7578 141,051 0.9302 1.0306 0.9026
47 November 113,552 154,673 0.7341 188,061 1.2159 1.0468 1.1615
48 December 127,042 157,706 0.8056 164,856 1.0453 1.0502 0.9953
49 2003 January 51,604 160,739 0.3210 164,118 1.0210 1.1464 0.8906
50 February 80,366 163,771 0.4907 170,129 1.0388 1.0779 0.9637
51 March 208,938 166,804 1.2526 235,383 1.4111 1.0210 1.3821
52 April 263,830 169,837 1.5534 148,327 0.8734 1.0273 0.8501
53 May 252,216 172,870 1.4590 131,500 0.7607 0.9815 0.7751
54 June 219,566 175,903 1.2482 185,157 1.0526 0.8819 1.1936
55 July 149,082 178,935 0.8332 144,852 0.8095 0.9135 0.8862
56 August 213,888 181,968 1.1754 166,194 0.9133 0.9359 0.9759
57 September 178,947 185,001 0.9673 190,828 1.0315 0.9281 1.1114
58 October 133,650 188,034 0.7108 164,059 0.8725 0.9857 0.8852
59 November 116,946 191,066 0.6121 193,682 1.0137 0.9929 1.0210
60 December 164,154 194,099 0.8457 213,015 1.0975 0.9609 1.1422
61 2004 January 58,843 197,132 0.2985 187,140 0.9493 1.0356 0.9167
62 February 82,386 200,165 0.4116 174,405 0.8713 1.0261 0.8492
63 March 224,803 203,198 1.1063 253,256 1.2464 0.9701 1.2847
64 April 354,301 206,230 1.7180 199,190 0.9659 1.0295 0.9382
65 May 328,263 209,263 1.5687 171,149 0.8179 1.0488 0.7798
66 June 313,647 212,296 1.4774 264,495 1.2459 1.0395 1.1985
 Time Series and Their Components

TABLE 8 (Continued)

t Year Month Sales T SCI TCI CI C I

67 July 214,561 215,329 0.9964 208,473 0.9682 1.0231 0.9463

68 August 337,192 218,361 1.5442 262,003 1.1999 1.0177 1.1790
69 September 183,482 221,394 0.8288 195,664 0.8838 0.9721 0.9092
70 October 144,618 224,427 0.6644 177,522 0.7910 0.9862 0.8020
71 November 139,750 227,460 0.6144 231,449 1.0175 0.9398 1.0828
72 December 184,546 230,493 0.8007 239,476 1.0390 1.0367 1.0022
73 2005 January 71,043 233,525 0.3042 225,940 0.9675 1.1142 0.8684
74 February 152,930 236,558 0.6465 323,742 1.3686 1.1005 1.2436
75 March 250,559 239,591 1.0458 282,272 1.1781 1.0602 1.1112
76 April 409,567 242,624 1.6881 230,261 0.9490 1.0518 0.9023
77 May 394,747 245,656 1.6069 205,813 0.8378 0.9559 0.8765
78 June 272,874 248,689 1.0973 230,111 0.9253 0.9492 0.9748
79 July 230,303 251,722 0.9149 223,768 0.8890 0.9211 0.9651
80 August 375,402 254,755 1.4736 291,693 1.1450 0.9169 1.2488
81 September 195,409 257,787 0.7580 208,383 0.8084 0.9599 0.8421
82 October 173,518 260,820 0.6653 212,998 0.8166 1.0337 0.7900
83 November 181,702 263,853 0.6887 300,928 1.1405 — —
84 December 258,713 266,886 0.9694 335,719 1.2579 — —

double payments on his loan in April, May, June, and 2005 November 104
August and make no payments at all in January, December 105
February, November, and December. His banker 2006 January 105
asks for a copy of the seasonal indexes to show his February 106
boss and include in John’s loan file. March 107
Turning to a forecast for the first six months of April 109
2006, John begins by projecting trend values using May 110
the trend equation TNt = 12,133 + 3,033t. The trend June 111
estimate for January 2006 is
TN85 = 12,133 + 3,0331852 = 269,938
Turning to the irregular (I ) value for these
Next, John obtains the seasonal index from months, John does not foresee any unusual events
Table 7. The index for January is 31.44%. John has except for March 2006. In that month, he plans to hold
been reading The Wall Street Journal and watching an open house and reduce the rates in one of his stores
the business news talk shows on a regular basis, so that he is finishing remodeling. Because of this promo-
he already has an idea of the overall nature of the tion, to be accompanied with radio and TV advertis-
economy and its future course. He also belongs to a ing, he expects sales in that store to be 50% higher
business service club that features talks by local eco- than normal. For his overall monthly sales, he thinks
nomic experts on a regular basis. As he studies the C this effect will result in about 15% higher sales overall.
column of his computer output, showing the cyclical Using all the figures he has estimated, along
history of his series, he thinks about how he will with his computer output, John makes the forecasts
forecast this value for the first six months of 2006. for Mr. Tux sales for the first six months of 2006,
Since the forecasts of national and local experts call shown in Table 9.
for an improvement in business in 2006 and since After studying the 2006 forecasts, John is
the last C value for October 2005 has turned up disturbed to see the wide range of monthly sales
(103.4%), he decides to use the following C values projections—from $89,112 to $595,111. Although he
for his forecasts: knew his monthly volume had considerable variability,
 Time Series and Their Components

TABLE 9 Forecasts for Mr. Tux

Sales Forecast = T ! S ! C ! I

January 89,112 = 269,938 .3144 1.05 1.00

February 136,689 = 272,971 .4724 1.06 1.00
March 301,483 = 276,004 .8877 1.07 1.15
April 540,992 = 279,037 1.7787 1.09 1.00
May 595,111 = 282,070 1.9180 1.10 1.00
June 375,263 = 285,103 1.1858 1.11 1.00

he is concerned about such wide fluctuations. John His real concern, however, is focused on his
has been thinking about expanding from his current worst months, January and February. He has recently
Spokane location into the Seattle area. He has been considering buying a tuxedo-shirt-making
recently discovered that there are several “dress up” machine that he saw at a trade show, thinking that he
events in Seattle that make it different from his pres- might be able to concentrate on that activity during
ent Spokane market. Formal homecoming dances, in the winter months. If he receives a positive reaction
particular, are big in Seattle but not in Spokane. from potential buyers of shirts for this period of time,
Since these take place in the fall, when his Spokane he might be willing to give it a try. As it is, the
business is slower (see the seasonal indexes for seasonal indexes on his computer output have
October and November), he sees the advantage of focused his attention on the extreme swings in his
leveling his business by entering the Seattle market. monthly sales levels.

QUESTIONS
1. Suppose John’s banker asked for two sentences Determine the Seattle seasonal indexes that
to show his boss that would justify John’s would be ideal to balance out the monthly rev-
request to make extra loan payments in some enues for Mr. Tux.
months and no payments in others. Write these 3. Disregarding Seattle, how much volume would
two sentences. John have to realize from his shirt-making
2. Assume that John will do exactly twice as much machine to make both January and February
business in Seattle as Spokane next year. “average”?

CASE 3 CONSUMER CREDIT

COUNSELING

The executive director, Marv Harnishfeger, con- Dorothy gave you these data and asked you to
cluded that the most important variable that complete a time series decomposition analysis. She
Consumer Credit Counseling (CCC) needed to fore- emphasized that she wanted to understand com-
cast was the number of new clients that would be pletely the trend and seasonality components.
seen for the rest of 1993. Marv provided Dorothy Dorothy wanted to know the importance of each
Mercer monthly data for the number of new clients component. She also wanted to know if any unusual
seen by CCC for the period from January 1985 irregularities appeared in the data. Her final instruc-
through March 1993. tion required you to forecast for the rest of 1993.
 Time Series and Their Components

ASSIGNMENT
Write a report that provides Dorothy with the infor-
mation she has requested.

CASE 4 MURPHY BROTHERS FURNITURE

Julie Murphy developed a naive model that com- production requirements, Julie is very anxious to
bined seasonal and trend estimates. One of the prepare short-term forecasts for the company that
major reasons why she chose this naive model was are based on the best available information concern-
its simplicity. Julie knew that her father, Glen, would ing demand.
need to understand the forecasting model used by For forecasting purposes, Julie has decided to
the company. use only the data gathered since 1996, the first full
It is now October of 2002, and a lot has changed. year Murphy Brothers manufactured its own line of
Glen Murphy has retired. Julie has completed sev- furniture (Table 10). Julie can see (Figure 13) that
eral business courses, including business forecasting, her data have both trend and seasonality. For this
at the local university. Murphy Brothers Furniture reason, she decides to use a time series decomposi-
built a factory in Dallas and began to manufacture tion approach to analyze her sales variable.
its own line of furniture in October 1995. Since Figure 13 shows that the time series she is
Monthly sales data for Murphy Brothers Furni- analyzing has roughly the same variability through-
ture from 1996 to October 2002 are shown in Table out the length of the series, Julie decides to use an
10. As indicated by the pattern of these data demon- additive components model to forecast. She runs the
strated in Figure 13, sales have grown dramatically model Yt = Tt + St + It. A summary of the results is
since 1996. Unfortunately, Figure 13 also demon- shown in Table 11. Julie checks the autocorrelation
strates that one of the problems with demand is that pattern of the residuals (see Figure 14) for random-
it is somewhat seasonal. The company’s general pol- ness. The residuals are not random, and the model
icy is to employ two shifts during the summer and does not appear to be adequate.
early fall months and then work a single shift Julie is stuck. She has tried a naive model that
through the remainder of the year. Thus, substantial combined seasonal and trend estimates, Winters’
inventories are developed in the late summer and exponential smoothing, and classical decomposition.
fall months until demand begins to pick up in Julie finally decides to adjust seasonality out of the
November and December. Because of these data so that forecasting techniques that cannot

TABLE 10 Monthly Sales for Murphy Brothers Furniture, 1996–2002

Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.

1996 4,964 4,968 5,601 5,454 5,721 5,690 5,804 6,040 5,843 6,087 6,469 7,002
1997 5,416 5,393 5,907 5,768 6,107 6,016 6,131 6,499 6,249 6,472 6,946 7,615
1998 5,876 5,818 6,342 6,143 6,442 6,407 6,545 6,758 6,485 6,805 7,361 8,079
1999 6,061 6,187 6,792 6,587 6,918 6,920 7,030 7,491 7,305 7,571 8,013 8,727
2000 6,776 6,847 7,531 7,333 7,685 7,518 7,672 7,992 7,645 7,923 8,297 8,537
2001 7,005 6,855 7,420 7,183 7,554 7,475 7,687 7,922 7,426 7,736 8,483 9,329
2002 7,120 7,124 7,817 7,538 7,921 7,757 7,816 8,208 7,828

Source: Murphy Brothers sales records.

 Time Series and Their Components

FIGURE 13 Murphy Brothers Furniture Monthly Sales, 1996–2002

TABLE 11 Summary of the

Decomposition Model for
Murphy Brothers
Furniture

Time Series Decomposition

Trend-Line Equation
TNt = 5,672 + 31.4t

Seasonal Index

Period Index
1 -674.60
2 -702.56
3 -143.72
4 -366.64
5 -53.52
6 -173.27
7 -42.74
8 222.32
9 -57.95
10 145.76
11 612.30
12 1234.63
Accuracy Measures

MAPE: 1.9
MAD: 135.1
MSD: 30,965.3
 Time Series and Their Components

FIGURE 14 Autocorrelation Function for Residuals Using an

Additive Time Series Decomposition Model for
Murphy Brothers Furniture

TABLE 12 Seasonally Adjusted Monthly Sales for Murphy Brothers Furniture,

1996–2002

Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec.

1996 5,621 5,671 5,745 5,821 5,775 5,863 5,847 5,818 5,901 5,941 5,857 5,767
1997 6,091 6,096 6,051 6,135 6,161 6,189 6,174 6,277 6,307 6,326 6,334 6,380
1998 6,551 6,521 6,486 6,510 6,496 6,580 6,588 6,536 6,543 6,659 6,749 6,844
1999 6,736 6,890 6,936 6,954 6,972 7,093 7,073 7,269 7,363 7,425 7,401 7,492
2000 7,451 7,550 7,675 7,700 7,739 7,691 7,715 7,770 7,703 7,777 7,685 7,302
2001 7,680 7,558 7,564 7,550 7,608 7,648 7,730 7,700 7,484 7,590 7,871 8,094
2002 7,795 7,827 7,961 7,905 7,975 7,930 7,859 7,986 7,886

handle seasonal data can be applied. Julie deseason- adds 674.60 to the data for each January and sub-
alizes the data by adding or subtracting the seasonal tracts 1,234.63 from the data for each December.
index for the appropriate month. For example, she Table 12 shows the seasonally adjusted data.

ASSIGNMENT
1. Using the data through 2001 in Table 12, subtracting the appropriate seasonal index in
develop a model to forecast the seasonally Table 11. Are these forecasts accurate when
adjusted sales data and generate forecasts for compared with the actual values?
the first nine months of 2002. 3. Forecast sales for October 2002 using the same
2. Using the forecasts from part 1, forecast sales procedure as in part 2.
for the first nine months of 2002 by adding or
 Time Series and Their Components

CASE 5 AAA WASHINGTON14

In 1993, AAA Washington was one of the two agency; and an insurance agency. The club provided
regional automobile clubs affiliated with the Ameri- these services through a network of offices located
can Automobile Association (AAA or Triple A) in Bellevue, Bellingham, Bremerton, Everett,
operating in Washington State. At that time, 69% of Lynnwood, Olympia, Renton, Seattle, Tacoma, the
all people belonging to automobile clubs were mem- Tri-Cities (Pasco, Richland, and Kennewick),
bers of the American Automobile Association, mak- Vancouver, Wenatchee, and Yakima, Washington.
ing it the largest automobile club in North America. Club research had consistently shown that the
AAA was a national association that serviced its emergency road service benefit was the primary rea-
individual members through a federation of approx- son that people join AAA. The importance of emer-
imately 150 regional clubs that chose to be affiliated gency road service in securing members was
with the national association. The national associa- reflected in the three types of memberships offered
tion set a certain number of minimum standards by AAA Washington: Basic, AAA Plus, and AAA
with which the affiliated clubs had to comply in Plus RV. Basic membership provided members five
order to retain their affiliation with the association. miles of towing from the point at which their vehicle
Each regional club was administered locally by its was disabled. AAA Plus provided members with 100
own board of trustees and management staff. The miles of towing from the point at which their vehicle
local trustees and managers were responsible for was disabled. AAA Plus RV provided the 100-mile
recruiting and retaining members within their towing service to members who own recreational
assigned territories and for ensuring the financial vehicles in addition to passenger cars and light
health of the regional club. Beyond compliance with trucks. Providing emergency road service was also
the minimum standards set by the AAA, each the club’s single largest operating expense. It was
regional club was free to determine what additional projected that delivering emergency road service
products and services it would offer and how it would cost $9.5 million, 37% of the club’s annual
would price these products and services. operating budget, in the next fiscal year.
AAA Washington was founded in 1904. Its ser- Michael DeCoria, a CPA and MBA graduate of
vice territory consisted of the 26 Washington coun- Eastern Washington University, had recently joined
ties west of the Columbia River. The club offered its the club’s management team as vice president of
members a variety of automobile and automobile- operations. One of the responsibilities Michael
travel-related services. Member benefits provided in assumed was the management of emergency road
cooperation with the national association included service. Early in his assessment of the emergency
emergency road services; a rating service for lodging, road service operation, Mr. DeCoria discovered that
restaurants, and automotive repair shops; tour guides emergency road service costs had increased at a rate
to AAA-approved lodging, restaurants, camping, and faster than could be justified by the rate of inflation
points of interest; and advocacy for legislation and and the growth in club membership. Michael began
public spending in the best interests of the motor- by analyzing the way the club delivered emergency
ing public. In addition to these services, AAA road service to determine if costs could be con-
Washington offered its members expanded protec- trolled more tightly in this area.
tion plans for emergency road service; financial ser- Emergency road service was delivered in one of
vices, including affinity credit cards, personal lines of four ways: the AAA Washington service fleet, con-
credit, checking and savings accounts, time deposits, tracting companies, reciprocal reimbursement, and
and no-fee American Express Travelers Cheques; direct reimbursement. AAA Washington’s fleet of
access to a fleet of mobile diagnostic vans for deter- service vehicles responded to emergency road ser-
mining the “health” of a member’s vehicle; a travel vice calls from members who became disabled in the

14This case was provided by Steve Branton, former student and MBA graduate, Eastern Washington
University.
 Time Series and Their Components

downtown Seattle area. Within AAA Washington’s association. Finally, members could contact a towing
service area, but outside of downtown Seattle, com- company of their choice directly, paying for the
mercial towing companies that had contracted with towing service and then submitting a request for
AAA Washington to provide this service responded reimbursement to the club. AAA Washington
to emergency road service calls. Members arranged reimbursed the actual cost of the towing or $50,
for both of these types of emergency road service by whichever was less, directly to the member. After a
calling the club’s dispatch center. Should a member careful examination of the club’s four service deliv-
become disabled outside of AAA Washington’s ser- ery methods, Michael concluded that the club was
vice area, the member could call the local AAA- controlling the cost of service delivery as tightly as
affiliated club to receive emergency road service. was practical.
The affiliate club paid for this service and then billed Another possible source of the increasing costs
AAA Washington for reciprocal reimbursement was a rise in the use of emergency road service.
through a clearing service provided by the national Membership had been growing steadily for several

TABLE 13 Emergency Road Call Volume by

Month for AAA Washington

Year Month Calls Year Month Calls

1988 May 20,002 1991 January 23,441

June 21,591 February 19,205
July 22,696 March 20,386
August 21,509 April 19,988
September 22,123 May 19,077
October 21,449 June 19,141
November 23,475 July 20,883
December 23,529 August 20,709
1989 January 23,327 September 19,647
February 24,050 October 22,013
March 24,010 November 22,375
April 19,735 December 22,727
May 20,153 1992 January 22,367
June 19,512 February 21,155
July 19,892 March 21,209
August 20,326 April 19,286
September 19,378 May 19,725
October 21,263 June 20,276
November 21,443 July 20,795
December 23,366 August 21,126
1990 January 23,836 September 20,251
February 23,336 October 22,069
March 22,003 November 23,268
April 20,155 December 26,039
May 20,070 1993 January 26,127
June 19,588 February 20,067
July 20,804 March 19,673
August 19,644 April 19,142
September 17,424
October 20,833
November 22,490
December 24,861
 Time Series and Their Components

years, but the increased cost was more than what road service calls per member grew by 3.28%, from
could be attributed to simple membership growth. an average of 0.61 calls per member to 0.63 calls.
Michael then checked to see if there was a growth in Concerned that a continuation of this trend would
emergency road service use on a per-member basis. have a negative impact on the club financially,
He discovered that between fiscal year 1990 and fis- Mr. DeCoria gathered the data on emergency road
cal year 1991, the average number of emergency service call volume presented in Table 13.

ASSIGNMENT
1. Perform a time series decomposition on the road service call volume that you discovered
AAA emergency road service calls data. from your time series decomposition analysis.
2. Write a memo to Mr. DeCoria summarizing the
important insights into changes in emergency

CASE 6 ALOMEGA FOOD STORES

Julie Ruth, Alomega Food Stores president, had After reviewing the results of this regression
collected data on her company’s monthly analysis, including the low r2 value (36%), she
sales along with several other variables she decided to try time series decomposition on the sin-
thought might be related to sales Julie used her gle variable, monthly sales. Figure 15 shows the plot
Minitab program to calculate a simple regression of sales data that she obtained. It looked like
equation using the best predictor for monthly sales were too widely scattered around the
sales. trend line for accurate forecasts. This impression

FIGURE 15 Trend Analysis for Alomega Food Store Sales

 Time Series and Their Components

FIGURE 16 Decomposition Fit for Alomega Food Store Sales

was confirmed when she looked at the MAPE value She also noted that the MAPE had dropped to
of 28. She interpreted this to mean that the average 12%, a definite improvement over the value
percentage error between the actual values and the obtained using the trend equation alone.
trend line was 28%, a value she considered too high. Finally, Julie had the program provide fore-
She next tried a multiplicative decomposition of the casts for the next 12 months, using the trend equa-
data. The results are shown in Figure 16. tion projections modified by the seasonal indexes.
In addition to the trend equation shown on the She thought she might use these as forecasts for
printout, Julie was interested in the seasonal her planning purposes but wondered if another
(monthly) indexes that the program calculated. She forecasting method might produce better fore-
noted that the lowest sales month was December casts. She was also concerned about what her pro-
(month 12, index = 0.49) and the highest was duction manager, Jackson Tilson, might say about
January (month 1, index = 1.74). She was aware of her forecasts, especially since he had expressed
the wide swing between December and January but concern about using the computer to make
didn’t realize how extreme it was. predictions.

QUESTION
1. What might Jackson Tilson say about her fore-
casts?

CASE 7 SURTIDO COOKIES

Jame Luna examined the autocorrelations for a smoothing method to generate forecasts of future
cookie sales at Surtido Cookies to determine if there sales. A member of Jame’s team has had some expe-
might be a seasonal component. He also considered rience with decomposition analysis and suggests that
 Time Series and Their Components

they try a multiplicative decomposition of the throughout the year. Jame doesn’t have a lot of faith
cookie sales data. Not only will they get an indica- in a procedure that tries to estimate components
tion of the trend in sales, but also they will be able to that cannot be observed directly. However, since
look at the seasonal indexes. The latter can be Minitab is available, he agrees to give decomposi-
important pieces of information for determining tion a try and to use it to generate forecasts of sales
truck float and warehouse (inventory) requirements for the remaining months of 2003.

QUESTIONS
1. Perform a multiplicative decomposition of the 3. Compute the residual autocorrelations. Examin-
Surtido Cookie sales data, store the residuals, ing the residual autocorrelations and the fore-
and generate forecasts of sales for the remain- casts of sales for the remainder of 2003, should
ing months of 2003. Jame change his thinking about the value of
2. What did Jame learn about the trend in sales? decomposition analysis? Explain.
What did the seasonal indexes tell him?

CASE 8 SOUTHWEST MEDICAL CENTER

Mary Beasley’s goal was to predict the number of evidence that some periods of the year were busier
future total billable visits to Medical Oncology at than others. (Scheduling doctors is never an easy
Southwest Medical Center. Mary learned that there task.) A colleague of Mary’s suggested she consider
was a seasonal component in her data and consid- decomposition analysis, a technique with which
ered using Winters’ smoothing method to generate Mary was not familiar. However, since she had a sta-
forecasts of future visits. Mary was not completely tistical software package available that included
satisfied with this analysis, since there appeared to decomposition, Mary was willing to give it a try. She
be some significant residual autocorrelations. also realized she had to understand decomposition
Moreover, Mary was interested in isolating the sea- well enough to sell the results to central administra-
sonal indexes because she wanted to have hard tion if necessary.

QUESTIONS
1. Write a brief memo to Mary explaining decom- 3. Interpret the trend component for Mary. What
position of a time series. did she learn from the seasonal indexes?
2. Perform a multiplicative decomposition of total 4. Compute the residual autocorrelations. Given
billable visits, save the residuals, and generate the residual autocorrelations and the forecasts,
forecasts of visits for the next 12 months, using should Mary be pleased with the decomposition
February FY2003–04 as the forecast origin. analysis of total billable visits? Explain.

Minitab Applications

The problem. In Example 1, a trend equation was developed for annual registration of
new passenger cars in the United States from 1960 to 1992.
 Time Series and Their Components

Minitab Solution

1. After the new passenger car registration data are entered into column C1 of the
worksheet, click on the following menus to run the trend analysis:
Stat>Time Series>Trend Analysis

2. The Trend Analysis dialog box appears.

a. The Variable is Cars.
b. Click on Linear for Model Type.
c. Click on Generate forecasts, and place a 1 in the Number of forecasts box in
order to forecast 1993.
d. Click on Options. In the space provided for a TITLE, place Linear Trend for
Annual Car Registrations.
e. Click on OK for the Options dialog box. Click on OK again, and the graph that
was shown in Figure 3 appears.

The problem. Table 1 was constructed to show the trend estimates and errors com-
puted for the new passenger car registration data.

Minitab Solution
1. Column C1 is labeled Year, C2 is labeled Y, C3 is labeled t, C4 is labeled Estimates,
and C5 is labeled Error. Clicking on the following menus creates the years:
Calc>Make Patterned Data>Simple Set of Numbers

2. The Simple Set of Numbers dialog box appears.

a. The following responses are given:
Store patterned data in: C1
From first value: 1960
To last value: 1992
In steps of: 1
b. Click on OK, and the years appear in C1.
c. The new passenger car registration data are entered into C2.
3. The time-coded data t are entered into C3, using the Simple Set of Numbers dialog
box.
4. The trend estimates are entered into C4 by clicking on the same menus for the
trend analysis used to solve Example 1, with one additional step.
5. Click on the Storage menu, and obtain the Trend Analysis-Storage dialog box.
a. Under Storage, click on Fits (trend line) and Residuals (detrended data).
b. Click on OK for this dialog box and then the Trend Analysis dialog box. The
trend estimates will appear in C4, and the errors (residuals) will appear in C5.

The problem. In Examples 3 and 4, Perkin Kendell, the analyst for the Coastal Marine
Corporation, wanted to forecast quarterly sales for 2007.

Minitab Solution

1. Enter the appropriate years into column C1, quarters into C2, and the data into
C3. To run a decomposition model, click on the following menus:
Stat>Time Series>Decomposition
 Time Series and Their Components

FIGURE 17 Minitab Decomposition Dialog Box

2. The Decomposition dialog box shown in Figure 17 appears.

a. The Variable is C3 or Sales.
b. Since the data are quarterly, the Seasonal length is 4.
c. The Model type is Multiplicative, and the Model Components are Trend plus
seasonal.
d. Click on Options. The initial seasonal period is 1. Click on OK.
e. Click on Generate forecasts, and enter 4 for the Number of forecasts.
3. Click on the Storage menu, and obtain the Decomposition-Storage dialog box
shown in Figure 18.
a. Under Storage, click on Trend line, Detrended data, Seasonals, and Seasonally
adjusted data.
b. Click on OK for both this dialog box and the Decomposition dialog box. Table
4 shows the trend estimates in C4 (labeled T), the detrended data in C5 (labeled
SCI), the seasonals in C6 (labeled S), and the seasonally adjusted data in C7
(labeled TCI).
4. Figures 10, 11, and 12 appear on the screen and can be printed one at a time using
the following menus:

File>Print Graph

5. After the graphs have been printed, click on

File>Print Session Window

and the forecasts shown in Figure 9 will print.

The CI, C, and I columns can be computed using Minitab, as the next steps demon-
strate.
 Time Series and Their Components

FIGURE 18 Minitab Decomposition-Storage Dialog Box

6. Label column C8 CI. Using the Calc>Calculator menu in Minitab, generate col-
umn C8 by dividing column C7 by column C4, so CI = TCI>T.
7. Label column C9 C. Generate column C9 by taking a centered moving average of
order 3 of the values in column C8. Use the menu

Stat>Time Series>Moving Average

Be sure to check the Center the moving averages box.

8. Label column C10 I. Using the Calc>Calculator menu in Minitab, generate column
C10 by dividing column C8 by column C9, so I = CI>C. The columns required for
Table 4 are now complete.

Excel Applications

The problem. Figure 6 shows data and a graph for mutual fund salespeople. An expo-
nential trend model is needed to fit these data.
Excel Solution

1. Enter Y in A1 and the salespeople data in A2:A8.

2. Enter X in B1 and the X-coded variable (1, 2, 3, 4, 5, 6, 7) in B2:B8.
3. Enter Log Y in C1, and create the logarithms (to the base 10) of the Y variable by
entering the formula = LOG10(A2) in cell C2. Copy this formula to the rest of
the column.
4. Click on the following menus to compute the exponential trend:

Tools>Data Analysis

5. The Data Analysis dialog box appears. Under Analysis Tools, choose Regression
and click on OK. The Regression dialog box shown in Figure 19 appears.
 Time Series and Their Components

FIGURE 19 Excel Regression Dialog Box

FIGURE 20 Excel Regression Output for the Mutual Fund Salespeople

Example
 Time Series and Their Components

a. Enter C1:C8 as the Input Y Range.

b. Enter B1:B8 as the Input X Range.
c. Select the Labels check box.
d. Enter Figure 20 as the name of the New Worksheet Ply. Click on OK.
Figure 20 represents Excel output for an exponential model of mutual fund sales-
people. The equation is

log TN = 1.00069 + 0.11834t

The antilogs of the regression coefficients in this equation are

b0 = antilog 1.00069 = 10.016

b1 = antilog 0.11834 = 1.313

Thus, the fitted exponential trend equation is

YN = 110.016211.3132t

References
Bell, W. R., and S. C. Hillmer. “Issues Involved with Program,” Journal of Business and Economic
the Seasonal Adjustment of Economic Time Statistics 16 (1998): 127–152.
Series,” Journal of Business and Economic Levenbach, H., and J. P. Cleary. Forecasting: Practice
Statistics 2 (1984): 291–320. and Process for Demand Management. Belmont,
Bowerman, B. L., R. T. O’connell, and A. B. Koehler. Calif.: Thomson Brooks/Cole, 2006.
Forecasting, Time Series and Regression, 4th ed. Makridakis, S., S. C. Wheelwright, and R. J.
Belmont, Calif.: Thomson Brooks/Cole, 2005. Hyndman. Forecasting Methods and Applications,
Diebold, F. X. Elements of Forecasting, 3rd ed. 3rd ed. New York: Wiley, 1998.
Cincinnati, Ohio: South-Western, 2004. Moore, G. H., and J. Shiskin. “Early Warning Signals
Findley, D. F., B. C. Monsell, W. R. Bell, M. C. Otto, for the Economy.” In Statistics: A Guide to
and B. Chen. “New Capabilities and Methods of Business and Economics, J. M. Tanur et al., eds.
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