The Exponential Smoothing Model 3/3/03

This model has received widespread acceptance among American business

firms that employ sales forecasts for managerial planning and control Most
computer software pac!ages for inventory control use exponential smoothing for
forecasting Exponential smoothing is generally the most accurate of the time
series forecasting models
Exponential smoothing models use special weighted moving averages and a
seasonal factor that is multiplied by the weighted moving average to calculate the
forecast These weighted moving averages are referred to as smoothing statistics
The exponential smoothing models are an extension of the running average model
"enerally# exponential smoothing uses three smoothed statistics that are
weighted# so that the more recent the data# the more weight given the data in
producing a forecast These three averages are referred to as single# double# and
triple smoothing statistics and are running averages that are weighted in an
exponential declining method
Most forecasting systems use three separate forecasting e$uations% one
model called a constant model# a second called a linear model# and a third called a
$uadratic model The constant forecast uses only the single smoothed statistic and
is best when the time series has little trend The linear forecast model uses the
single and double smoothed statistics and is best when there is a linear trend in the
time series The $uadratic forecast model uses all three statistics&&single# double#
and triple smoothed
A forecasting system using the exponential smoothing model continually
evaluates forecasting accuracy and selects the forecasting e$uation with the most
accurate forecasting history 'f the e$uation no longer forecasts as accurately as
one of the other e$uations because the environment has changed# the system
automatically switches to the e$uation that will forecast best This automatic
switching of e$uations is called adaptive forecasting (ther adapting techni$ues
sometimes built into the model are adapting the weighing scheme )changing the
smoothing constant used* and smoothing past errors into future forecasts to reduce
bias 'f a forecast is consistently underforecasted# adding the average past error
into the forecast# will eliminate the bias An example of exponential smoothing is
given in both table 3&+ and Table 3&,
Table 3&+ is the retail department store sales for -hoenix from .anuary /0,1
to 2ecember /030 These values are used to establish an exponential smoothing
model to forecast future retail department store sales Table 3&, shows the
forecast4s results 5hen the actual sales for /03/ are compared with the
forecasted sales# it is clear that the model can accurately forecast future
department store sales

Table 3&+
DATA USED TO BUILD THE MODELS
(Phoenix Department Store Sales)
Date Actual Sales Date Actual
Sales
anuar!
"e#ruar!
March
April
Ma!
une
ul!
Au$ust
Septem#er
Octo#er
%o&em#er
Decem#er
anuar!
"e#ruar!
March
April
Ma!
une
ul!
Au$ust
Septem#er
Octo#er
%o&em#er
Decem#er
anuar!
"e#ruar!
March
April
Ma!
une
ul!
Au$ust
Septem#er
Octo#er
%o&em#er
Decem#er

'()*+
'+,+'
)'),*
)-))*
)+'+(
)'-).
).*''
))/',
'/'.'
)-)0.
)/,)'
+''*'
'()*+
'++(0
))0'.
))./*
)(+,+
))())
),-.'
))0/*
)./.)
)('//
-)-,'
(--.,
),00-
),'0'
)0'-'
)/-*'
)/00)
)0'.-
)())*
)(*+)
)*'(-
-..0(
ul!
Au$ust
Septem#er
Octo#er
%o&em#er
Decem#er
,/(0
anuar!
"e#ruar!
March
April
Ma!
une
ul!
Au$ust
Septem#er
Octo#er
%o&em#er
Decem#er
,/(/
anuar!
"e#ruar!
March
April
Ma!
une
ul!
Au$ust
Septem#er
Octo#er
%o&em#er
Decem#er
,/0.
anuar!
-.'''
-.00.
)/)+0
--+0-
*-**,
/-+*)
-.-*-
)0+'(
-/(+.
-()+0
-/'-*
-/+,+
--,,/
-++-+
-*.'(
-/.'+
+))./
,.+.+0

-(',-
-*/''
*+('0
*0*/0
*+('*
**0)'
*'.),
*(.(,
*-(./
*0(.,
(--..
,,//.(
*',+0
anuar!
"e#ruar!
March
April
Ma!
une
-0')/
0-).(
)-()0
)+)..
--(,,
-)/,(
-'(+*
-.'00
"e#ruar!
March
April
Ma!
une
ul!
Au$ust
Septem#er
Octo#er
%o&em#er
Decem#er
*)'+-
*//./
+.)((
+')-,
*+.''
*)'()
*0(--
**)/)
+'/-(
(-,0(
,'-,*,


Ta#le )1(
Department Store "orecast an2 Actual Sales

Actual "orecaste2 Error
3Error sales sales 4
t5,

an *-,+/6. *-)./6- ,-.6- .6'+
"e# *-()/6. *'*++6. 1',()6. 1)6/(
Mar +/--(6. +**'+60 1)/'.6' 1*6+-
Apr +/+'06. +(+--6, 1,/0)6/ 1'60*
Ma! +0)*/6. +0*..6* ,-,6* .6',
un +---06. +)+'*6/ 10''6, 1,6'0
ul */(-)6. *//.(6* ,+-6* .6'0
Au$ +)('(6. +)+-,6- 10*6+ 1.6,)
Sep *0-*)6. */,+)6- (,.6- ,6''
Oct +('*,6. +*/(06( 1,'('6) 1,60/
%o& (0,0.6. (0*.+6+ )'+6+ .6-'

The Smoothing -rocess
Each month all three smoothing statistics are updated by the most recent
month4s sales The process of updating is called smoothing because a fixed
percent# alpha )*# of the most recent sales is added to )/&* times the old single
smoothing statistic 6or example# if were 3 and sales were 7# a new single
smoothing statistic St
8/9
)7* would be calculated by ta!ing 37 : )/ & 3* times St&/
8/9
)7*
; St
8/9
)7* <ote that St&/
8/9
)7* refers to last month4s single smoothing statistic 'f t&=
were used in the statistic# it would refer to the statistic two months ago <ext
month4s statistic would be t : / The t in St
8/9
7 is the current statistic This is a
convenient notational techni$ue to designate what statistic is being referred to The
8/9 in St
8/9
does not refer to an exponential power# but rather identifies that this is the
single smooth statistic
St
8=9
)7* refers to the double smoothed statistic The )7* in both statistics
signifies that the statistic is calculated from the time series being examined )sales*
't was explained in >hapter = that to signify our forecast# we use t:/ The ? is
referred to as hat This signifies that the value under the hat is an estimate rather
than an actual value t:/ is an estimate of 7 The t:/ signifies that the e$uation is
the estimate for t# the current period plus /# which is next month The error of
estimation is calculated for next month by )t & 7t* 'n one month# 7t:/ will have
become 7t
The double smooth statistic is calculated li!e the single smooth statistic with
one exception% actual sales are replaced by the new single smoothing statistic
@ast month4s double smoothing statistic St&/
8=9
)7* is multiplied by )/&* and added to
St&/
8/9
)7*# giving St
8=9
)7* The box =# 8=9# indicates this is the double smoothing
statistic
The triple smoothing statistic continues the process The new triple
smoothed statistic is calculated by adding St
8=9
)7* to )/&* St&/
839
)7* The
smoothing process ta!es into account trend and cycles but ignores seasonality
Therefore# a seasonality variable is included in the forecasting e$uation To !eep
from confounding or combining seasonal effects and trends or cycles# we divide the
actual sales data )7t* by the seasonal factor for month t before it is used in the
smoothing process 'f the seasonal factor is signified by t# the single smoothed
statistic for seasonal data is calculated
(X)
S
) - (1 +
t
X
d = (X)
S
[1]
1 - t
t [1]
t

/ )=*
The procedure for calculating seasonal factors is given in an earlier section of this
chapter
The 6orecasting E$uations
The three forecasting e$uations are designed to generate forecasts that
follow three different patterns The constant e$uation models a flat# constant
pattern This forecasting e$uation is t:/ ; t:/)St
8/9
)7** 6igure 3&/A shows the
patterns of time series forecasted best by the constant e$uation


The linear e$uation is t:/ ; t:/8d/St
8/9
)7*&d=St
8=9
9 The patterns that this
e$uation models best are those showing a linear trend 'n the e$uation# d/ and d=
are lag factors The smoothing statistics lag the actual values The value of d/ is

) - (1
+ 2 = The lag for d= is

) - (1
+ 1 3 6igure =&/A also illustrates the
patterns of time series forecasted best by the linear e$uation The number of future
periods for which the forecast is being made is indicated by 'f we are forecasting
t:/# e$uals oneB if we are forecasting 7t:=# e$uals =B etc
The $uadratic forecasting e$uation is designed to forecast time series with
nonlinear trend The e$uation is as follows%
. (X)
S T
+ (X)
S T
- (X)
S T
=
X
[3]
t 3
[2]
t 2
[1]
t 1 1 + t 1 + t

1 )3*
T/# T=# and T3 are lag correction variables The calculation of lag coefficients
is somewhat mathematically complicated and is as follows%
) - 2(1
+ ) 5 - (6 + ) - 6(1
=
T
2
2 2
2
1

A )1*
) - 2(1
+ ) 4 - 2(5 + ) - 6(1
=
T
2
2 2
2
2

+ )A*
) - 2(1
+ ) 3 - (4 + ) - 2(1
=
T
2
2 2
2
3

, )+*
An example of exponential smoothing forecasting can be made using the
seasonal factors in figure =&/3 'f the initial smoothing statistics# after smoothing in
the 2ecember /0,/# were
190,000 = (X)
S
and , 185,000 = (X)
S
, 184,000 = (X)
S
[1]
t
[2]
1
[3]
t
3
and the smoothing constant ;/ and .anuary seasonal factor e$uals 30# the
.anuary /0,= forecasts would be%
>onstant%
152,000 = 0) .80(190,00 = (x))
S
( =
X
[1]
t 1 + t 1 + t

0 ),*
@inear%
156,444 = 205,553) - 9 .80(401,10 =
000)) 1.1111(85, - (190,000) .80(2.1111 =
(X))
S
(
d
- (X)
S d
( =
X
[2]
t 2
[1]
t 1 1 + t 1 + t

/0 )3*
Cuadratic%
)0*
158,705 = 2) .80(198,39 = 227,160) + 662,344 - 6 .80(633,56 =
184,000) x 1.23457 + 185,000 x 3,58025 - 190,000 x 8 .80(3.3456 =
X)
S T
+ X
S T
- X
S T
( =
X
[3]
t 3
[2]
t 2
[1]
t 1 1 + t 1 + t

//
'f actual sales for .anuary /0,= were /A0#00,# to ma!e a forecast for
6ebruary /0,=# the forecasting program would smooth in the .anuary sales%
190,887 = 171,000 + 19,887 =
) .9(190,000 + )
.80
159,097
( =
(X))
S
)( - (1 +
X
=
S
[1]
t
t
t [1]
t

/= )/0*
185,589 = 166,500 + 19,089 =
(185,000) + ) .1(190,887 =
(X)
S
) - (1 + (X)
S
= (X)
S
[2]
1 - t
[1]
t
[2]
t

/3 )//*
184,159 = 165,000 + 18,559 =
) .9(184,000 + ) .1(185,589 =
(X)
S
) - (1 + (X)
S
= (X)
S
[3]
1 - t
[2]
t
[3]
t

/1 )/=*
6ebruary forecasts would be#
>onstant%
156,527 = 7) .82(190,88
/A
@inear%
161,354 =
74) .82(1996,7 = 185,589)] (1.11111)( - 7) 11)(190,88 .82[(2.111
/+
Cuadratic%
165,271 = 4,159)] 1.23457(18 + 85,589) 3.580251(1 - 7) 68)(190,88 .82[(3.345
/,
Actual sales in 6ebruary /0,= were /0/#1=1
To forecast March /0,= sales# the program would smooth in the 6ebruary
sales and then ma!e a new forecast 6or April# )t:=*# the lag coefficients d/# d=# T/#
T=# and T3 would be calculated with ;=
"ardner )/03A* discusses various methods used to estimate initial
smoothing statistic values Ma!rida!is and Dibon )/00/* have loo!ed at the effect
that initial smoothing statistic values have on forecasting accuracy
Selecting Alpha
Alpha is selected by a simulation method Earious alphas between 0/ and
00 are used to forecast an initial period Fsually# the same years used to calculate
seasonal factors are also used to determine which alpha predicts best The
criterion for determining the alpha is accuracy Fsually the constant linear and
$uadratic e$uations are tested with various alphas The forecast with the lowest
error determines which alpha and model to use for future forecasts The larger the
alpha# the greater the weight of recent data and the less the weight of earlier data
The formula for determining the weight of data )past months* is )/&*
!
# where G is
the data4s age The weight of this month is e$ual to in the smoothing statistic
since !;/B the weight of this month in the smoothing statistics is )/&*
Theoretically# this way of calculating smoothing statistics is appropriate because the
most recent data have the greatest impact on the forecast

6igure 3&/+

6igure 3&/+ shows the weights for various values of alpha <ote how $uic!ly
the effects of past data diminish as alpha increases 5hen alpha e$uals /# the
data affect the smoothing statistic for eighteen months This is in contrast to an
alpha of 3# which only uses nine months of data to calculate the statistic
The initial values of the smoothing statistic also are often determined with
the initial data from which seasonal factors were calculated The procedure is to
start each of the three smoothing statistics at the earliest month4s sales value and
then to smooth in actual sales up to the period for which forecasts will be made
The resulting smoothing statistics are used to start forecasting Another way of
establishing smoothing statistics is to use the average monthly sales for all three
smoothing statistics as the initial smoothing statistic values A third procedure is to
forecast bac!wards the past values from a point in time&&this is called bac!casting
The firm then forecasts from the last bac!casted value to the present value The
forecasting system updates smoothing values )4s* each time new forecasts are
made
HroIe and Me4lard )/000* have suggested a maximum li!elihood approach
to estimating alpha The alpha used is an important part of building an accurate
forecasting model Jesearch has been done to determine the best alpha level )for
example# see <ewbold and Hos 8/0309 and "ardner 8/03A9*
>(JJE>T'<" H'AS
'f a forecast does not have an average error value of Iero over time# the
forecast is biased The forecast is consistently either an over&forecast or an under&
forecast Adding or subtracting a constant increases forecasting accuracy
Exponential smoothing models often include the addition of an exponentially
smoothed error term to the forecast to correct bias The process smooths the
errors# Kust as the actual data is smoothed An error smoothing statistic is
calculated Each time a forecast is made# an error is calculated by subtracting the
actual forecast# and the error is smoothed into the old error smoothing statistic
This error smoothing statistic is then added to the next forecast 'f the model
underforecasts# the errors are positive and the error smoothing statistic is also
positiveB so the next forecast will be increased 'f the forecasts are consistently
higher than the actual# the errors are negative# and the error smoothing statistic is
negative Thus# adding the error smooth statistic will reduce the next forecast
Fsually only the constant )single smoothed* error smoothing statistic is calculated#
and usually a small alpha# such as /# is used 5hen a forecast is biased over
time# it is most often or usually because the wrong model or wrong parameter
values are used Thus the forecaster should use a different model or different
parameter values when a bias exists Dowever# when the bias is small# the
forecaster may have the best model and best parameter values The error
correction smoothing statistic ma!es minor adKustments that modestly improve
forecasts >ipra )/00=* has suggested a method of ma!ing exponential smoothing
robust to outliers which reduces some bias errors
Advantages of Exponential Smoothing 6orecasting
The advantages of the exponential model are many Although the process
is somewhat tedious when done by hand# the process is straightforward and easy
when programmed for a computer Many computer programs have been written
that use exponential smoothing# and they are readily available >hapter //
discusses many computer programs that use exponential smoothing forecasting
models Exponential smoothing models adapt to environmental changes and are
self&correcting The firm with many products needs only one program with three
e$uations to forecast all its products4 sales The procedure has proved effective for
a wide spectrum of product forecasts (nly past data are usedB thus the problem
and expense of collecting external data are eliminated
SFMMAJL
Time series data contain lots of information about the sales processes of the
company Some factors hidden in the data are seasonality# trend# and cyclicality of
the sales Seasonality is dependant on the characteristics of the product and the
people buying it Managers attempt to decrease the seasonality of sales A time
series forecast can mathematically explain products4 seasonality and show how the
seasonality changes over time Trends and cycles also occur with sales Trends
can be modeled as linear# segmented to linear# or nonlinear )>yclical sales can be
modeled by an e$uation using sine or cosine functions*
These sales patterns ma!e up the underlying process of sales for the
company Each component of the sales pattern can be detected with the time
series data detection which more fully describes the underlying process of sales
Three approaches to brea!ing the time series data into components are )/* to plot
the data and estimate the components# )=* to do a spectral analysis on the data#
and )3* to use AJ'MA forecasting models )see >hapter 6our*
Two models explained in the chapter are the running average forecasting
techni$ue and the exponential smoothing model The running average forecast
calculates seasonal factors# which are multiplied by the average sales of the
previous three months to determine the monthly sales forecast A trend factor is
used to increase the accuracy of the running average method
The exponential smoothing techni$ue is a self&adKusting weighted running
averages model that uses a special weighted moving average factor and the
seasonal factor to calculate the forecast The three types of exponential smoothing
forecasts are the constant forecast# the linear forecast# and the $uadratic forecast
Each uses a different e$uation with a different weighted moving average
)smoothing statistic* Alpha values and bias correction factors adKust exponential
smoothing forecasts