Research Methodology Question Bank

Statistics for Managers
Using Microsoft® Excel

4th Edition
Chapter 15
Time-Series Forecasting and

Index Numbers
Statistics for Managers Using Microsoft Excel, 4e © 2004 Prentice-Hall, Inc. Chap 15-1
Chapter Goals
After completing this chapter, you should be
able to:
 Develop and implement basic forecasting models
 Identify the components present in a time series
 Use smoothing-based forecasting models, including
moving average and exponential smoothing
 Apply trend-based forecasting models, including linear
trend and nonlinear trend
 complete time-series forecasting of seasonal data
 compute and interpret basic index numbers
The Importance of Forecasting
 Governments forecast unemployment, interest

rates, and expected revenues from income taxes
for policy purposes
 Marketing executives forecast demand, sales, and
consumer preferences for strategic planning
 College administrators forecast enrollments to plan
for facilities and for faculty recruitment
 Retail stores forecast demand to control inventory
levels, hire employees and provide training
Time-Series Data
 Numerical data obtained at regular time

intervals
 The time intervals can be annually, quarterly,
daily, hourly, etc.
 Example:
Year: 1999 2000 2001 2002 2003
Sales: 75.3 74.2 78.5 79.7 80.2
Time-Series Plot
A time-series plot is a two-dimensional
plot of time series data
 the vertical axis U.S. Inflation Rate

measures the variable 16.00
of interest 14.00
Inflation Rate (%)
12.00
10.00
8.00
 the horizontal axis 6.00
corresponds to the 4.00
2.00
time periods 0.00
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
Year
Time-Series Components
Time Series
Trend Seasonal Cyclical Irregular

Component Component Component Component
Trend Component
 Long-run increase or decrease over time

(overall upward or downward movement)
 Data taken over a long period of time
Sales
Statistics for Managers Using Microsoft Excel, 4e © 2004 Prentice-Hall, Inc.

Time Chap 15-7
Trend Component
(continued)
 Trend can be upward or downward

 Trend can be linear or non-linear
Sales Sales
Time Time
Downward linear trend Upward nonlinear trend
Seasonal Component
 Short-term regular wave-like patterns

 Observed within 1 year
 Often monthly or quarterly
Sales
Summer
Winter
Summer
Winter Spring Fall
Spring Fall
Time (Quarterly)
Cyclical Component
 Long-term wave-like patterns
 Regularly occur but may vary in length
 Often measured peak to peak or trough to
trough
1 Cycle
Sales
Year
Irregular Component
 Unpredictable, random, “residual” fluctuations

 Due to random variations of
 Nature
 Accidents or unusual events
 “Noise” in the time series
Multiplicative Time-Series Model
for Annual Data
 Used primarily for forecasting

 Observed value in time series is the product of
components
Yi  Ti  Ci  Ii
where Ti = Trend value at year i
Ci = Cyclical value at year i
Ii = Irregular (random) value at year i
Multiplicative Time-Series Model
with a Seasonal Component
 Used primarily for forecasting

 Allows consideration of seasonal variation
Yi  Ti  Si  Ci  Ii
where Ti = Trend value at time i
Si = Seasonal value at time i
Ci = Cyclical value at time i
Ii = Irregular (random) value at time i
Smoothing the
Annual Time Series
 Calculate moving averages to get an overall

impression of the pattern of movement over
time
Moving Average: averages of consecutive

time series values for a
chosen period of length L
Moving Averages
 Used for smoothing

 A series of arithmetic means over time
 Result dependent upon choice of L (length of
period for computing means)
 Examples:
 For a 5 year moving average, L = 5
 For a 7 year moving average, L = 7
 Etc.
Moving Averages
(continued)
 Example: Five-year moving average
 First average:
Y1  Y2  Y3  Y4  Y5
MA(5) 
5
 Second average:
Y2  Y3  Y4  Y5  Y6
MA(5) 
5
 etc.
Example: Annual Data
Year Sales Annual Sales

1 23
60
2 40
50
3 25
4 27 40 …
5 32 Sales 30
6 48 20
7 33
10
8 37
9 37
0 …
1 2 3 4 5 6 7 8 9 10 11
10 50 Year
11 40
etc… etc…
Calculating Moving Averages
5-Year
Average Moving
Year Sales Year Average
1 2  3  4  5
1 23 3 29.4 3
5
2 40 4 34.4
3 25 23  40  25  27  32
5 33.0 29.4 
4 27 5
6 35.4
5 32 7 37.4
6 48 8 41.0
7 33 9 39.4
8 37 etc… … …
9 37
10 50  Each moving average is for a
11 40 consecutive block of 5 years
Annual vs. Moving Average
 The 5-year Annual vs. 5-Year Moving Average
moving average 60
smoothes the 50
data and shows 40
the underlying
Sales
30
trend
20
10
0
1 2 3 4 5 6 7 8 9 10 11
Year
Annual 5-Year Moving Average
Exponential Smoothing
 A weighted moving average

 Weights decline exponentially
 Most recent observation weighted most
 Used for smoothing and short term

forecasting (often one period into the future)
Exponential Smoothing
(continued)
 The weight (smoothing coefficient) is W

 Subjectively chosen
 Range from 0 to 1
 Smaller W gives more smoothing, larger W gives
less smoothing
 The weight is:
 Close to 0 for smoothing out unwanted cyclical
and irregular components
 Close to 1 for forecasting
Exponential Smoothing Model
 Exponential smoothing model
E1  Y1
Ei  WYi  (1 W )Ei1
For i = 2, 3, 4, …
where:
Ei = exponentially smoothed value for period i
Ei-1 = exponentially smoothed value already
computed for period i - 1
Yi = observed value in period i
W = weight (smoothing coefficient), 0 < W < 1
Exponential Smoothing Example
 Suppose we use weight W = .2
Time Forecast
Sales Exponentially Smoothed
Period from prior
(Yi) Value for this period (Ei)
(i) period (Ei-1)
1 23 -- 23 E1 = Y1
2 40 23 (.2)(40)+(.8)(23)=26.4 since no
3 25 26.4 (.2)(25)+(.8)(26.4)=26.12 prior
information
4 27 26.12 (.2)(27)+(.8)(26.12)=26.296 exists
5 32 26.296 (.2)(32)+(.8)(26.296)=27.437
6 48 27.437 (.2)(48)+(.8)(27.437)=31.549 Ei 
7 33 31.549 (.2)(48)+(.8)(31.549)=31.840 WYi  (1  W )Ei1
8 37 31.840 (.2)(33)+(.8)(31.840)=32.872
9 37 32.872 (.2)(37)+(.8)(32.872)=33.697
10 50 33.697 (.2)(50)+(.8)(33.697)=36.958
etc. etc. etc. etc.
Sales vs. Smoothed Sales
 Fluctuations
have been
60
smoothed
50
40
 NOTE: the Sales
30
smoothed value in
20
this case is
generally a little low, 10
since the trend is 0
upward sloping and 1 2 3 4 5 6 7 8 9 10
Time Period
the weighting factor
Sales Smoothed
is only .2
Forecasting Time Period i + 1
 The smoothed value in the current

period (i) is used as the forecast value for
next period (i + 1) :
Ŷi1  Ei
Exponential Smoothing in Excel
 Use tools / data analysis /

exponential smoothing
 The “damping factor” is (1 - W)
Trend-Based Forecasting
 Estimate a trend line using regression analysis

Time  Use time (X) as the
Period Sales independent variable:
Year (Y)
(X)
Ŷ  b0  b1X
1999 0 20
2000 1 40
2001 2 30
2002 3 50
2003 4 70
2004 5 65
(continued)
 The linear trend forecasting equation is:

Time
Year Period Sales Ŷi  21.905  9.5714 Xi
(X) (Y)
Sales trend
1999 0 20
80
2000 1 40 70
60
2001 2 30 50
sales
40
2002 3 50 30
20
2003 4 70 10
0
2004 5 65
0 1 2 3 4 5 6
Year
(continued)
 Forecast for time period 6:
Time
Period
Ŷ  21.905  9.5714 (6)
Year Sales
(X) (y)  79.33
1999 0 20 Sales trend
2000 1 40 80
70
2001 2 30
60
2002 3 50 50
sales
40
2003 4 70 30
2004 5 65 20
10
2005 6 ?? 0
0 1 2 3 4 5 6
Year
Nonlinear Trend Forecasting
 A nonlinear regression model can be used when
the time series exhibits a nonlinear trend
 Quadratic form is one type of a nonlinear model:
Yi  0  1Xi  2 X  i 2
i
 Compare adj. r2 and standard error to that of

linear model to see if this is an improvement
 Can try other functional forms to get best fit
Exponential Trend Model
 Another nonlinear trend model:
Yi  β β
Xi
0 1 εi
 Transform to linear form:
log(Yi )  log(β0 )  Xi log(β1 )  log( ε i )
Exponential Trend Model
(continued)
 Exponential trend forecasting equation:
log(Ŷi )  b0  b1Xi
where b0 = estimate of log(β0)
b1 = estimate of log(β1)
Interpretation:
(β̂1  1)  100% is the estimated annual compound
growth rate (in %)
Model Selection Using
Differences
 Use a linear trend model if the first differences

are approximately constant
(Y2  Y1 )  ( Y3  Y2 )    ( Yn  Yn-1 )
 Use a quadratic trend model if the second

differences are approximately constant
[(Y3  Y2 )  ( Y2  Y1 )]  [(Y4  Y3 )  ( Y3  Y2 )]
   [(Yn  Yn-1 )  ( Yn-1  Yn-2 )]
Model Selection Using
Differences
(continued)
 Use an exponential trend model if the

percentage differences are approximately
constant
(Y2  Y1 ) (Y3  Y2 ) (Yn  Yn-1 )
 100%   100%     100%
Y1 Y2 Yn-1
Autoregressive Modeling
 Used for forecasting

 Takes advantage of autocorrelation
 1st order - correlation between consecutive values
 2nd order - correlation between values 2 periods
apart
 pth order Autoregressive models:
Yi  A 0  A1Yi-1  A 2 Yi-2     A p Yi-p  δi
Random
Error
Autoregressive Model:
Example
The Office Concept Corp. has acquired a number of office
units (in thousands of square feet) over the last eight years.
Develop the second order Autoregressive model.
Year Units
97 4
98 3
99 2
00 3
01 2
02 2
03 4
04 6
Autoregressive Model:
Example Solution
 Develop the 2nd order Year Yi Yi-1 Yi-2
table 97 4 -- --
98 3 4 --
 Use Excel to estimate a 99 2 3 4
regression model 00 3 2 3
Excel Output 01 2 3 2
Coefficients 02 2 2 3
I n te rc e p t 3.5 03 4 2 2
X V a ri a b l e 1 0.8125 04 6 4 2
X V a ri a b l e 2 -0 . 9 3 7 5
Ŷi  3.5  0.8125Yi1  0.9375Yi2
Autoregressive Model
Example: Forecasting
Use the second-order equation to forecast

number of units for 2005:
Ŷi  3.5  0.8125Yi1  0.9375Yi2

Ŷ2005  3.5  0.8125(Y2004 )  0.9375(Y2003 )
 3.5  0.8125(6 )  0.9375(4 )
 4.625
Autoregressive Modeling Steps
1. Choose p (note that df = n – 2p – 1)

2. Form a series of “lagged predictor” variables
Yi-1 , Yi-2 , … ,Yi-p
3. Use Excel to run regression model using all p
variables
4. Test significance of Ap
 If null hypothesis rejected, this model is selected
 If null hypothesis not rejected, decrease p by 1 and
repeat
Selecting A Forecasting Model
 Perform a residual analysis

 Look for pattern or direction
 Measure magnitude of residual error using
squared differences
 Measure residual error using MAD
 Use simplest model
 Principle of parsimony
Residual Analysis
e e
0 0
T T
Random errors Cyclical effects not accounted for
e e
0 0
T T
Trend not accounted for Seasonal effects not accounted for
Measuring Errors
 Choose the model that gives the smallest
measuring errors
 Sum of squared errors  Mean Absolute Deviation

(SSE) (MAD)
n n
SSE   (Yi  Ŷi ) 2
 Y  Ŷ
i i
i1
MAD  i1
n
 Sensitive to outliers
 Not sensitive to extreme
observations
Principal of Parsimony
 Suppose two or more models provide a

good fit for the data
 Select the simplest model
 Simplest model types:
 Least-squares linear
 Least-squares quadratic
 1st order autoregressive
 More complex types:
 2nd and 3rd order autoregressive
 Least-squares exponential
Forecasting With Seasonal Data
 Recall the classical time series model with
seasonal variation:
Yi  Ti  Si  Ci  Ii
 Suppose the seasonality is quarterly
 Define three new dummy variables for quarters:
Q1 = 1 if first quarter, 0 otherwise
Q2 = 1 if second quarter, 0 otherwise
Q3 = 1 if third quarter, 0 otherwise
(Quarter 4 is the default if Q1 = Q2 = Q3 = 0)
Exponential Model with
Quarterly Data
Yi  β β β2 β3 β4 εi
Xi Q1 Q2 Q3
0 1
βi provides the multiplier for the ith quarter relative

to the 4th quarter (i = 2, 3, 4)
 Transform to linear form:

log(Yi )  log(β0 )  Xilog(β1 )  Q1log(β2 )
 Q2log(β3 )  Q3log(β4 )  log( ε i )
Estimating the Quarterly Model
 Exponential forecasting equation:
log(Ŷi )  b0  b1Xi  b2Q1  b3Q2  b4Q3

where b0 = estimate of log(β0), so 10b0  β̂0
b1 = estimate of log(β1), so 10b1  β̂1
etc…
Interpretation:
(β̂1  1)  100% = estimated quarterly compound growth rate (in %)
β̂ 2 = estimated multiplier for first quarter relative to fourth quarter
β̂3 = estimated multiplier for second quarter rel. to fourth quarter
β̂ 4 = estimated multiplier for third quarter relative to fourth quarter
Quarterly Model Example
 Suppose the forecasting equation is:
log(Ŷi )  3.43  .017Xi  .082Q1  .073Q2  .022Q3
b0 = 3.43, so 10b0  β̂0  2691.53

b1 = .017, so 10b1  β̂1  1.040
b2 = -.082, so 10b2  β̂2  0.827
b3 = -.073, so 10b3  β̂3  0.845
b4 = .022, so 10b4  β̂ 4  1.052
Quarterly Model Example
(continued)
Value: Interpretation:
β̂0  2691.53 Unadjusted trend value for first quarter of first year
β̂1  1.040 4.0% = estimated quarterly compound growth rate
β̂2  0.827 Ave. sales in Q2 are 82.7% of average 4th quarter sales,
after adjusting for the 4% quarterly growth rate
β̂3  0.845 Ave. sales in Q3 are 84.5% of average 4th quarter sales,
after adjusting for the 4% quarterly growth rate
β̂ 4  1.052 Ave. sales in Q4 are 105.2% of average 4th quarter

sales, after adjusting for the 4% quarterly growth rate
Index Numbers
 Index numbers allow relative comparisons

over time
 Index numbers are reported relative to a Base
Period Index
 Base period index = 100 by definition

 Used for an individual item or measurement
Simple Price Index
 Simple Price Index:
Pi
Ii   100
Pbase
where
Ii = index number for year i
Pi = price for year i
Pbase = price for the base year
Index Numbers: Example
 Airplane ticket prices from 1995 to 2003:
Index
Year Price (base year
= 2000)
1995 272 85.0 P1996 288
1996 288 90.0 I1996   100  (100)  90
P2000 320
1997 295 92.2
1998 311 97.2
Base Year:
1999 322 100.6 P2000 320
2000 320 100.0 I2000   100  (100)  100
P2000 320
2001 348 108.8
2002 366 114.4
P2003 384
2003 384 120.0 I2003   100  (100)  120
P2000 320
Index Numbers: Interpretation
P1996 288  Prices in 1996 were 90%

I1996   100  (100)  90
P2000 320 of base year prices
P 320  Prices in 2000 were 100%

I2000  2000  100  (100)  100 of base year prices (by
P2000 320
definition, since 2000 is the
base year)
P 384  Prices in 2003 were 120%

I2003  2003  100  (100)  120 of base year prices
P2000 320
Aggregate Price Indexes
 An aggregate index is used to measure the rate
of change from a base period for a group of items
Aggregate
Price Indexes
Unweighted Weighted
aggregate aggregate
price index price indexes
Paasche Index Laspeyres Index
Unweighted
Aggregate Price Index
 Unweighted aggregate price index formula:
n
 i
P (t)
i = item
IU( t )  i1
n
 100 t = time period
P (0) n = total number of items

i
i1
IU( t ) = unweighted price index at time t

n
P
i 1
i
(t)
= sum of the prices for the group of items at time t
n
 i = sum of the prices for the group of items in time period 0

P (0)
i 1
Unweighted Aggregate Price
Index: Example
Automobile Expenses:
Monthly Amounts ($):
Index
Year Lease payment Fuel Repair Total (2001=100)
2001 260 45 40 345 100.0
2002 280 60 40 380 110.1
2003 305 55 45 405 117.4
2004 310 50 50 410 118.8
I2004 
 P 2004
 100 
410
(100)  118.8
P 2001 345
 Unweighted total expenses were 18.8%
higher in 2004 than in 2001
Weighted
Aggregate Price Indexes
 Laspeyres index  Paasche index
n n
P i
(t)
Q (0)
i P i
(t)
Q (t)
i
I 
(t)
L
i1
n
 100 I 
(t)
P
i1
n
 100
Pi1
i
(0)
Q (0)
i P i
(0)
Q (t)
i
i1
Q(i 0 ) : weights based on Q(i t ) : weights based on current

period 0 quantities period quantities
Pi( t ) = price in time period t

Pi( 0 ) = price in period 0
Common Price Indexes
 Consumer Price Index (CPI)

 Producer Price Index (PPI)
 Stock Market Indexes
 Dow Jones Industrial Average
 S&P 500 Index
 NASDAQ Index
Pitfalls in
Time-Series Analysis
 Assuming the mechanism that governs the time

series behavior in the past will still hold in the
future
 Using mechanical extrapolation of the trend to
forecast the future without considering personal
judgments, business experiences, changing
technologies, and habits, etc.
Chapter Summary
 Discussed the importance of forecasting

 Addressed component factors of the time-series
model
 Performed smoothing of data series
 Moving averages
 Exponential smoothing
 Described least square trend fitting and
forecasting
 Linear, quadratic and exponential models
Chapter Summary
(continued)
 Addressed autoregressive models

 Described procedure for choosing appropriate
models
 Addressed time series forecasting of monthly or
quarterly data (use of dummy variables)
 Discussed pitfalls concerning time-series
analysis

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Statistics for Managers

Using Microsoft® Excel

Time-Series Forecasting and

 Governments forecast unemployment, interest

 Numerical data obtained at regular time

 the vertical axis U.S. Inflation Rate

Trend Seasonal Cyclical Irregular

 Long-run increase or decrease over time

Statistics for Managers Using Microsoft Excel, 4e © 2004 Prentice-Hall, Inc.

 Trend can be upward or downward

 Short-term regular wave-like patterns

 Unpredictable, random, “residual” fluctuations

 Used primarily for forecasting

 Used primarily for forecasting

 Calculate moving averages to get an overall

Moving Average: averages of consecutive

 Used for smoothing

Year Sales Annual Sales

 The 5-year Annual vs. 5-Year Moving Average

Annual 5-Year Moving Average

 A weighted moving average

 Used for smoothing and short term

 The weight (smoothing coefficient) is W

 The smoothed value in the current

 Use tools / data analysis /

 The “damping factor” is (1 - W)

 Estimate a trend line using regression analysis

 The linear trend forecasting equation is:

 Compare adj. r2 and standard error to that of

 Another nonlinear trend model:

 Transform to linear form:

log(Yi )  log(β0 )  Xi log(β1 )  log( ε i )

 Exponential trend forecasting equation:

 Use a linear trend model if the first differences

 Use a quadratic trend model if the second

 Use an exponential trend model if the

 Used for forecasting

Ŷi  3.5  0.8125Yi1  0.9375Yi2

Use the second-order equation to forecast

Ŷi  3.5  0.8125Yi1  0.9375Yi2

1. Choose p (note that df = n – 2p – 1)

 Perform a residual analysis

 Sum of squared errors  Mean Absolute Deviation

 Suppose two or more models provide a

βi provides the multiplier for the ith quarter relative

 Transform to linear form:

log(Ŷi )  b0  b1Xi  b2Q1  b3Q2  b4Q3

b0 = 3.43, so 10b0  β̂0  2691.53

β̂ 4  1.052 Ave. sales in Q4 are 105.2% of average 4th quarter

 Index numbers allow relative comparisons

 Base period index = 100 by definition

 Simple Price Index:

P1996 288  Prices in 1996 were 90%

P 320  Prices in 2000 were 100%

P 384  Prices in 2003 were 120%

Paasche Index Laspeyres Index

P (0) n = total number of items

IU( t ) = unweighted price index at time t

 i = sum of the prices for the group of items in time period 0

Q(i 0 ) : weights based on Q(i t ) : weights based on current

Pi( t ) = price in time period t

 Consumer Price Index (CPI)

 Assuming the mechanism that governs the time

 Discussed the importance of forecasting