Cengage EBA 2e Chapter08

Time Series Analysis and
Forecasting
Chapter 8
2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Introduction
Forecasting methods can be classified as qualitative or quantitative
Qualitative methods generally involve the use of expert judgment to
develop forecasts
Quantitative forecasting methods can be used when:
Past information about the variable being forecast is available
The information can be quantified
It is reasonable to assume that past is prologue
2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2
Introduction
The objective of time series analysis is to uncover a pattern in the
time series and then extrapolate the pattern into the future
The forecast is based solely on past values of the variable and/or on
past forecast errors
Modern data-collection technologies have enabled individuals,
businesses, and government agencies to collect vast amounts of data
that may be used for causal forecasting
Time Series Patterns
Horizontal Pattern Trend and Seasonal Pattern
Trend Pattern Cyclical Pattern
Seasonal Pattern Identifying Time Series Patterns
Time series: a sequence of observations on a variable measured at
successive points in time or over successive periods of time
The measurements may be taken every hour, day, week, month, year,
or any other regular interval. The pattern of the data is an important
to understand the series past behavior
If the behavior of the times series data of the past is expected to
continue in the future, we can use it to guide us in selecting an
appropriate forecasting method
Horizontal Pattern
Exists when the data fluctuate randomly around a constant mean
over time
Stationary time series: denotes a time series whose statistical
properties are independent of time
The process generating the data has a constant mean
The variability of the time series is constant over time
A time series plot for a stationary time series will always exhibit a
horizontal pattern with random fluctuations
Table 8.1: Gasoline Sales Time Series
Figure 8.1: Gasoline Sales Time Series Plot
Table 8.2: Gasoline Sales Time Series after Obtaining the
Contract with the Vermont State Police
Figure 8.2: Gasoline Sales Time Series Plot after
Obtaining the Contract with the Vermont State Police
Trend Pattern
A trend pattern is gradual shifts or movements to relatively higher or
lower values over a longer period of time
A trend is usually the result of long-term factors such as:
Population increases or decreases
Shifting demographic characteristics of the population
Improving technology
Changes in the competitive landscape
Changes in consumer preferences
Table 8.3: Bicycle Sales Time Series
Figure 8.3: Bicycle Sales Time Series Plot
Table 8.4: Cholesterol Drug Revenue Time Series
Figure 8.4: Cholesterol Drug Revenue Times Series
Plot ($ millions)
Seasonal Pattern
Seasonal patterns are recurring patterns over successive periods of
time
Example: A manufacturer of swimming pools expects low sales activity in the
fall and winter months, with peak sales in the spring and summer months to
occur every year
Time series plot not only exhibits a seasonal pattern over a one-year
period but also for less than one year in duration
Example: daily traffic volume shows within-the-day seasonal behavior
Figure 8.5:
Table 8.5: Umbrella Sales Time Series Umbrella Sales Time Series Plot
Trend and Seasonal Pattern
Some time series include both a trend and a seasonal pattern
Table 8.6: Quarterly Smartphone Sales Figure 8.6: Quarterly Smartphone Sales
Time Series Time Series Plot
Cyclical Pattern
A cyclical pattern exists if the time series plot shows an alternating
sequence of points below and above the trendline that lasts for more
than one year
Example: Periods of moderate inflation followed by periods of rapid inflation
can lead to a time series that alternates below and above a generally
increasing trendline
Cyclical effects are often combined with long-term trend effects and
referred to as trend-cycle effects
Identifying Time Series Patterns
The underlying pattern in the time series is an important factor in
selecting a forecasting method
A time series plot should be one of the first analytic tools
We need to use a forecasting method that is capable of handling the
pattern exhibited by the time series effectively
Forecast Accuracy
Table 8.7: Computing Forecasts and Measures of
Forecast Accuracy Using the Most Recent Value as
the Forecast for the Next Period
Forecast Accuracy
Nave forecasting method: Using the most recent data to predict
future data
The key concept associated with measuring forecast accuracy is
forecast error
Measures to determine how well a particular forecasting method is
able to reproduce the time series data that are already available
Forecast error
Mean forecast error
Mean absolute error (MAE)
Mean squared error (MSE)
Mean absolute percentage error (MAPE)
Forecast Accuracy
Forecast Error: Difference between the actual and
the forecasted values for period t.
=
Mean Forecast Error: Mean or average of the

forecast errors.

= + 1
MFE =

Forecast Accuracy
Mean Absolute Error (MAE): Measure of forecast accuracy that
avoids the problem of positive and negative forecast errors offsetting
one another.

=+1
MAE =

Mean Squared Error (MSE): measure that avoids the problem of

positive and negative errors offsetting each other is obtained by
computing the average of the squared forecast errors.
2
= + 1
MFE =

24
Forecast Accuracy
Mean Absolute Percentage Error (MAPE): Average of the absolute
value of percentage forecast errors.

=+1 100

MAPE =

25
Table 8.8: Computing Forecasts and Measures of
Forecast Accuracy Using the Average of All the
Historical Data as the Forecast for the Next Period
Forecast Accuracy
Compare the accuracy of the two forecasting methods by comparing
the values of MAE, MSE, and MAPE for each method
Nave Method Average of Past Values
MAE 3.73 2.44
MSE 16.27 8.10
MAPE 19.24% 12.85%
The average of past values provides more accurate forecasts for the
next period than using the most recent observation
Moving Averages and Exponential
Smoothing
Moving Averages
Forecast Accuracy
Exponential Smoothing
Forecast Accuracy
Moving Averages and Exponential Smoothing
Moving Averages
Moving averages method: Uses the average of the most recent k data
values in the time series as the forecast for the next period
Moving average forecast:

most recent k data values = + 1
+1 = =

+ 1 + + 1 +
=

Table 8.9: Summary of Three-Week Moving
Average Calculations
Figure 8.7: Gasoline Sales Time Series Plot and
Three-Week Moving Average Forecasts
Figure 8.8: Data Analysis Dialog Box
Figure 8.9: Moving Average Dialog Box
Figure 8.10: Excel Output for Moving Average
Forecast for Gasoline Data
Forecast Accuracy
The values of the three measures of forecast accuracy for the three-
week moving average calculations in Table 8.9:

=+1 24
MAE = = = 2.67
9
2
= + 1 92
MSE = = = 10.22
9

=+1 100 129.21

MAPE = = = 14.36%
9
Exponential Smoothing
Exponential smoothing uses a weighted average of past time series
values as a forecast
Exponential Smoothing Forecast:
+ 1 = + (1 )
Smoothing constant ( ) is the weight given to the actual value in
period t; weight given to the forecast in period t is 1 .
Illustration: Consider a time series involving only three periods of data: y1, y2,
and y3.
Let 1 equal the actual value of the time series in period 1; that is, 1 =
y1
Hence, the forecast for period 2 is:
2 = 1 + (1 ) 1
= 1 + (1 )1
= 1
Table 8.10: Summary of the Exponential Smoothing
Forecasts and Forecast Errors for the Gasoline Sales
Time Series with Smoothing Constant a = 0.2
Figure 8.11: Actual and Forecast Gasoline Time
Series with Smoothing Constant = 0.2
Figure 8.13: Exponential Smoothing Dialog Box
Figure 8.14: Excel Output for Exponential
Smoothing Forecast for Gasoline Data
Forecast Accuracy
Insight into choosing a good value for a can be obtained by
rewriting the basic exponential smoothing model as:
+ 1 = + a
If the time series contains substantial random variability, a small
value of the smoothing constant is preferred and vice-versa
Choose the value of a that minimizes the MSE
Using Regression Analysis for
Forecasting
Linear Trend Projection Using Regression Analysis as a Causal
Seasonality Forecasting Method
Seasonality without Trend Combining Causal Variables with Trend
and Seasonality Effects
Seasonality with Trend
Considerations in Using Regression in
Forecasting
Using Regression Analysis for Forecasting
Linear Trend Projection
Regression analysis can be used to forecast a time series with a linear trend
Simple linear regression analysis yields the linear relationship between the
independent variable and the dependent variable that minimizes the MSE
Use this approach to find a best-fitting line to a set of data that exhibits a linear
trend
The variable to be forecasted (y, the actual value of the time series period t) is
dependent variable
Trend variable (time period t) is the independent variable
Equation for the trendline: = 0 + 1 t
Figure 8.15: Excel Simple Linear Regression Output
for Trendline Model for Bicycle Sales Data
Trend equation for the bicycle sales time series:
= 20.4 + 1.1t
Substituting t = 11 into the above equation yields next years trend
projection, 11
11 = 20.4 + 1.1 (11) = 32.5
Thus, the linear trend model yields a sales forecast of 32,500 bicycles
for the next year
We can also use more complex regression models to fit nonlinear
trends
= 0 + 1 t + 2 2 + 3 3
Autoregressive models: Regression models such as this in which the

independent variables are previous values of the time series
= 0 + 1 1 + 2 2 + 3 3
Seasonality Without Trend
We can model a time series with a seasonal pattern by treating the
season as a dummy variable
Illustration:
Consider the data on the number of umbrellas sold in Table 8.5
The time series plot corresponding to this data in Figure 8.5 do not suggest any
long-term trend in sales
Closer inspection of the time series plot suggests that a quarterly seasonal pattern
is present
k - 1 dummy variables are required to model a categorical variable that has k levels
Thus, to model the seasonal effects in the umbrella time series we need 4 1 = 3
dummy variables
Illustration (continued):
The three dummy variables can be coded as follows:
1 if period t is a quarter 1
Qtr1t = 0 otherwise
Qtr2t = 0 otherwise
Qtr3t = 0 otherwise
General form of the equation relating the number of umbrellas sold to the
quarter the sales take place:
_( )= _0+ _1 "Qtr1 " _ + _2 "Qtr" 2_ + _3 "Qtr" 3_
Table 8.11: Umbrella Sales Time Series with
Dummy Variables
Seasonality with Trend
The time series contains both seasonal effects and a linear trend
Consider the data for the smartphone time series in Table 8.6
The time series plot corresponding to this data indicates that there is both
linear trend and seasonal pattern
The general form of the regression equation takes the form
= 0 + 1 Qtr1 + 2 Qtr2 + 3 Qtr3 + 4 t
Table 8.12: Smartphone Sales Time Series with
Dummy Variables and Time Period
The dummy variables in the equation for Smartphone Sales time
series provide four equations given time period t corresponds to
quarters 1, 2, 3, and 4
Quarter 1: Sales = 4.71 + 0.146t
Using Regression Analysis as a Causal Forecasting Method
The relationship of the variable to be forecast with other variables
may also be used to develop a forecasting model
Advertising expenditures when sales is to be forecast
The mortgage rate when new housing construction is to be forecast
Causal models: Models that include only variables that are believed
to cause changes in the variable to be forecast
Table 8.13: Student Population and Quarterly Sales
data for 10 Armands Pizza Parlors
Figure 8.16: Scatter Chart of Student Population
and Quarterly Sales for Armands Pizza Parlors
Figure 8.17: Graph of the Estimated Regression
Equation for Armands Pizza Parlors: y = 60 + 5x
Combining Causal Variables with Trend and Seasonality Effects
Regression models are very flexible and can incorporate both causal
variables and time series effects
Considerations in Using Regression in Forecasting
Whether a regression approach provides a good forecast depends
largely on:
How well we are able to identify and obtain data for independent variables
that are closely related to the time series
Part of the regression analysis procedure should focus on the selection of the
set of independent variables that provides the best forecasting model
Determining the Best Forecasting
Model to Use
Model to Use
A visual inspection can indicate whether seasonality appears to be a
factor and whether a linear or nonlinear trend seems to exist
For causal modeling, scatter charts can indicate whether strong
linear or nonlinear relationships exist between the independent and
dependent variables
If certain relationships appear totally random, this may lead you to
exclude these variables from the model
Model to Use
While working with large data sets it is recommended to divide your
data into training and validation sets
Based on the errors produced by the different models for the
validation set, we can pick the model that minimizes some forecast
error measure, such as MAE, MSE or MAPE
There are software packages that will automatically select the best
model to use
Ultimately the user should decide which model to use based on the
software output and his managerial knowledge

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Time Series Analysis and

Mean Forecast Error: Mean or average of the

Mean Squared Error (MSE): measure that avoids the problem of

Autoregressive models: Regression models such as this in which the

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