Forecasting with Time Series

Analysis
Chapter 18

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Learning Objectives
LO18-1 Identify and describe time series patterns.
LO18-2 Compute forecasting using simple moving averages.
LO18-3 Compute and interpret the Mean Absolute Deviation.
LO18-4 Compute forecasts using exponential smoothing.
LO18-5 Compute a forecasting model using regression
analysis.
LO18-6 Apply the Durban-Watson statistic to test for
autocorrelation.
LO18-7 Compute seasonal indexes and use the indexes to
make seasonally adjusted forecasts.

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Components of a Time Series
 A time series is a collection of data over a period of time
 The trend is the long-run direction of the time series
TREND PATTERN The change of a variable over time.

 The seasonal variation is a pattern that tends to repeat

itself from year to year for most businesses
SEASONALITY Patterns of highs and lows in a time series within a
calendar year.These patterns tend to repeat each year.

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Components of a Time Series Continued

 The cyclical component is the fluctuation above and

below the long-term trend line over a longer time period
CYCLES A pattern of highs and lows occurring over periods of many
years.

 The irregular variation is divided into episodic and

residual components
IRREGULAR COMPONENT The random variation in a time series.

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Secular Trend Examples
 A graph of the secular trend of the number of Home Depot
associates shows how the number has increased over time

 The average price of gasoline increased from 2005 to 2013 and

since then has declined

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Seasonality Example
 Almost all businesses tend to have recurring seasonal
patterns
 Men’s and women’s apparel have high sales right before
Christmas and low sales in January
 Sporting good stores will have seasonal fluctuations

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Cyclical Variation Example
 A typical business cycle consists of a period of prosperity
followed by periods of recession, depression, and then
recovery
 In periods of recession, employment, production, the
DJIA, and other business and economic series are below
the long-term trend lines
 In times of prosperity, they are above the long-term trend
lines

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Moving Averages
 A moving average is used to smooth the trend in a time
series
 It is the basic method used in measuring seasonal
fluctuation
 To apply a moving average, the data needs to follow a
fairly linear trend and have a rhythmic pattern of
fluctuations
 This is accomplished by “moving” the mean values
through the time series

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Moving Average Example
Shown is a time series of the monthly market price for a
barrel of oil over 18 months. Use a three-period and a six-
period simple moving average to forecast the oil price for
May 2019.

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3- and 6- Period Moving Average Example
 Using a three-period simple moving average, the forecast for
May 2019 would be the average of the prices from the most
recent 3 months: February, March, and April of 2019. The
forecast is computed as follows:

 Using a six-period simple moving average, the forecast for May

2019 would be the average of the prices from the most recent
6 months: November, December, January, February, March, and
April of 2019. The forecast is computed as follows:

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Forecasting Error
 Any estimate or forecast is likely to be imprecise.The
error, or lack of precision, is the difference between the
actual observation and the forecast.

 This difference is called a deviation of the forecast from

the actual value.
 The mean of the absolute errors is called the mean
absolute deviation (MAD).

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3-Period Moving Average Including Error
 We report that the forecast for May 2019 is $64.50 with a MAD of $5.49.
Using a three-period simple moving average, we can expect the forecasted
May 2019 oil price to be between $59.01 (found by $64.50 − $5.49) and
$69.99 (found by $64.50 + $5.49).

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6-Period Moving Average Including Error
 Using a 6-month moving average model, the MAD or the average variability
of forecast error is $7.01. Recalling that the 6-month moving average
forecast for May 2019 is $61.06, we can expect the forecasted May 2019 oil
price to be between $54.05 (found by $61.06 − $7.01) and $68.07 (found
by $61.06 + $7.01).

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Simple Moving Average Comparison
 An outcome of using more periods in a simple moving average
is its effect on the variation of the forecasts.
 The variation in the forecasts is related to the number of
observations in a simple moving average. More periods will
reduce the variation in the forecasts.

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Simple Exponential Smoothing

 t = time period
 t+1 = next time period
 Alpha (α) = smoothing constant
SMOOTHING CONSTANT A value applied in exponential smoothing
to determine the weights assigned to past observations.

 Smoothing constant is between 0 and 1

 Selecting a smoothing constant value near 1 means that recent
data will receive more weight than older data.

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Simple Exponential Smoothing Example
 Using simple exponential smoothing with a smoothing
constant of 0.1, the exponential smoothing equation would be:
 Forecastt+1 = Forecastt + 0.1(error)t
 The forecast for January 2018 is:
 ForecastJanuary = ForecastDecember + 0.1(error)December
ForecastJanuary = $59.93 + 0.1($1.26) = $60.0560
Forecast ErrorJanuary = $66.23 − $60.06 = $6.1740

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Simple Exponential Smoothing Example
Continued
 The smoothing formula is applied through the time series
data until the last possible forecast for May 2019 is made.
 MAD is then computed:

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Simple Exponential Smoothing Example
Concluded
 The forecast with the high alpha value, the green line graph, is
very responsive to the most recent oil price.
 The forecast with the low alpha value, the red line graph, is
much smoother and follows the average of oil prices over
time.

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Time Series with a Trend: Regression
Analysis
 If the trend is linear,
regression analysis is used
to fit a linear trend model
to the time series.
 This time series is two
years of monthly demand
data. Each observation is
labeled with the month.

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Regression Analysis Example

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Regression Analysis Example Continued
 The data must be presented in terms of a dependent variable and an
independent variable.
 The line is represented by the following equation:

 Applying the results to the regression equation, the trend forecasting

model is:
Demand = 32.63768 + 4.82565 (Time Period)
 Applying the trend equation, the forecasts for months 25 and 26 (January
and February of year 3) are:
Demand (Time Period 25) = 32.63768 + 4.82565 (25) = 153.2789
Demand (Time Period 26) = 32.63768 + 4.82565 (26) = 158.1046

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Regression Analysis Example Concluded
 We now need an estimate of the forecast error.

 The absolute value of error for the first time period is:
Absolute Value of Forecast error = |40 − 37.4633| = 2.5367

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The Durbin-Watson Statistic
 One of the assumptions traditionally used in regression is that
the residuals are independent, that is, they’re not correlated
 But in time series data, successive residuals are not
independent because an event in one time period often
influences the event in the next time period
 This condition is called autocorrelation
AUTOCORRELATION Successive residuals are correlated.
Example
 The owner of a furniture store decides to have a sale this
month and spends a lot of money advertising the event. We
expect a correlation between the two events this month. But
it is likely that some of the effects of advertising carries over
to the next month

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The Durbin-Watson Statistic Continued
 Autocorrelation, r, is the strength of
the correlation
 But instead of hypothesis
testing r, we use d
 The Durbin-Watson statistic is
used to test for autocorrelation

 The value of d can range from 0 to 4. A value of 2 means

there is no autocorrelation among the residuals. If it’s
close to 0, positive autocorrelation; close to 4, negative

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The Durbin-Watson Statistic Hypothesis
Test
 Step 1: The null and alternate hypotheses are
H0: No residual correlation (
H1: Positive residual correlation ( > 0)
 Step 2: Select the level of significance
 Step 3: Select the test statistic; we use d
 Find d in Appendix B.9, you’ll need , n, and k
 Step 4: The decision rule is altered from what we are used to
because this time, there is also a range of values where the
data is inconclusive
 Step 5: Calculate the test statistic
 Step 6: If the null hypothesis is rejected, we conclude that
autocorrelation is present

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Durbin-Watson Statistic Example
Shown are monthly total sales (in
millions of dollars) for the retail and
food service industry sourced from the
U.S. Census data.

Evaluate the regression results for

autocorrelation using the Durbin-
Watson statistic.

Trend forecast equation:

Monthly retail and Food service sales =

412,980.44 + 1399.16 (Time Period)

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Durbin-Watson Statistic Example (2 of 5)
 Residuals are then calculated

 The residuals do not show a

random pattern distributed
around the expected value of
zero.
 Autocorrelation is indicated
by a non-random, downward
trend followed by an upward
trend.
 This pattern shows a strong
case for autocorrelation.

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Durbin-Watson Statistic Example (3 of 5)
We’ll use an Excel spreadsheet to investigate autocorrelation.

We find , the fitted values, for each of

the 20 months.The results are in
column E.
Next find the residual, the difference
between the actual value and the
fitted values, column F.
In column G, we lag the residuals one
period.
In H, we find the difference between
the current residual and the residual
in the previous and square the
difference.
In I, we square the values in F.

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Durbin-Watson Statistic Example (4 of 5)
We’ll use these results in the hypothesis test on the next slide.

To calculate d, we need the

sums of columns H and I.
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Durbin-Watson Statistic Example (5 of 5)
Step 1: State the null and alternate hypothesis
H0: No residual correlation
H1: Positive residual correlation
Step 2: Select the level of significance; we’ll use .05
Step 3: Select the test statistic, d
Step 4: Formulate the decision rule,
reject H0 if d < 1.20 and do not reject H 0 if d > 1.41,
no conclusion is reached if d is between 1.20 and 1.41
Step 5: Make decision; reject H0, d = 0.78
Step 6: Interpret: reject H0, autocorrelation is present

Now find the

critical values of d

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Seasonal Factor
 The seasonal factor is estimated using the ratio-to-moving-
average method
 Seasonal factors are computed on a monthly or a quarterly
basis
Example
 Line graph shows a sample of
monthly bookings (room nights)
from hotels, motels, and guest
houses in Victoria, Australia
 Shows an increasing, positive
trend in bookings over the 36
months
 Shows seasonality

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Seasonal Factor Continued
 To quantify a seasonal pattern in a time series, we apply
the concept of an index.
 An index is a quantitative way to compare values.
 For each time period in the time series, we will compare
the observed value to the value or base predicted by the
regression equation.
 For the periods with the highest recurring values, the
seasonal index will be greater than 1.0.
 For periods with the lowest recurring values, the seasonal
index will be less than 1.0.

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Seasonal Index Example
The line graph shows a sample of monthly bookings (room nights) from hotels,
motels, and guest houses in Victoria, Australia.The data spans 3 years, or 36 months.
Forecast monthly accommodation bookings for the next 12 months.

The graph shows a

pattern of seasonality
and a positive
increasing trend.

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Seasonal Index Example (2 of 5)
Step 1: Determine the regression line
Step 2: Calculate the base value for each
time period using the regression line.
Step 3: Calculate the index for each time
period by taking the y-value divided by the
base value.
Step 4: Average the indexes by month to
get a monthly index.

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 Seasonal Index Example (3 of 5)
Step 5: Calculate an estimate of the forecasting error by computing the MAD

Period 1 (June) Bookings = [391.098 + 2.628 (Time Period)] (Month Index for June)
Total Monthly Bookings (Period 1) = 391.098 + 2.628 (1) (0.88) = 347.920
Period 5 (October) Bookings = [391.098 = 2.628 (Time Period)] (Month Index for October
Totally Monthly Bookings (Period 5) = 391.098 + 2.628 (5) (1.12) = 451.816

This calculation is applied to all 36 month.The MAD is:

Σ|𝐸𝑟𝑟𝑜𝑟| 374.548
𝑀𝐴𝐷 = 𝑛
= 36
= 10.404

Step 6: Make forecasts of total monthly bookings for the next 12 months.

Total Bookings (Period 37) = 391.098 + 2.628 (Time Period)

= 391.098 + 2.628 (37) = 488.341

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Seasonal Index Example (4 of 5)
Step 7: Seasonally adjust the predictions by multiplying by the appropriate
monthly index.

Seasonally adjusted forecast (Period 37) = (488.341)(0.88) = 429.740

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Seasonal Index Example (5 of 5)

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 Chapter 18 Practice Problems

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Question 7 LO18-2,3
Using simple moving averages and the following time series data,
respond to each of the items.

a. Graph the time series data. What do you observe?

b. Compute all possible forecasts using a four-period simple moving
average model.
c. Compute all possible forecasts using a six-period simple moving
average model.
d. Compute the MADs for each moving average forecast.
e. Which forecast has less error?

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Question 11 LO18-4

Using simple exponential smoothing and the following time

series data, respond to each of the items. (Note the data is
the same as exercise 7.)
a. Graph the time series data.What do you
observe?
b. Compute all possible forecasts using a
smoothing coefficient (α) of 0.35.
c. Compute all possible forecasts using a
smoothing coefficient (α) of 0.85.
d. Compute the MADs for each moving
average forecast.
e. Which forecast model would you choose?
Why?

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Question 13 LO18-5

Using the time series data in the table, respond to the

following items.
a. Graph the data.
b. Based on the graph, describe the
time series pattern.
c. For this time series, why is
forecasting with a trend model
appropriate?
d. Evaluate a trend forecasting model
using simple linear regression.What
is the forecasting error?
e. What is the predicted annual
change of industry sales?
f. Predict sales for the next three
periods.
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Question 17 LO18-6

Using the same time series data and trend forecast model
as in exercise 13, respond to the following items.

a. Plot the residuals associated with

the trend model for this data.
b. Test for autocorrelation using the
.05 significance level.
c. Report and interpret your result.

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Question 19 LO18-7

Using the following time series data, respond to the

following items.

a. Graph the time series.

b. Based on the graph, describe the time series pattern.
c. For this time series, why is forecasting with a seasonally adjusted
trend model appropriate?
d. Evaluate a seasonally adjusted trend forecasting model.What is
the forecasting error?
e. What are the quarterly indexes?
f. Forecast sales for future periods 17 through 20.
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