Three Critical Forecasting Questions
Financial forecasting should be undertaken only after careful evaluation of the expected costs and benefits. In short, expenditures for financial forecasting should be scrutinized as closely as expenditures for inventory, equipment, or labor. In deciding whether to go ahead with a particular forecast, management needs to focus on three critical questions.
Estimating Accuracy of a Forecast
How much accuracy can reasonably be expected from this forecast? Before any forecasting process is undertaken, a business decision should be made as to how much accuracy can reasonably be expected from it. A business decision is exactly what is required in allocating expensive resources to any project. Whether or not they have had extensive training in statistics, economics, and computer science, managers should have detailed knowledge of the organization’s business and the variable or variables to be forecasted. Their experience, knowledge, and foresight should enable managers to estimate the level of accuracy that might reasonably be achieved by employing sophisticated and expensive forecasting techniques as opposed to naive and inexpensive forecasting efforts.
If senior management cannot make these assessments, a detailed study of the financial variable in question is recommended; until that study is done, no attempt should be made to forecast that variable’s future behavior. (A naive forecasting technique is one in which simplistic or uninformed assumptions are made regarding a given variable. An example would be assuming that the value of the U.S. dollar relative to the Japanese yen will remain the same over the next 6 months. What this kind of variable requires is not a naive assumption about its stability but in-depth analysis using a financial model designed to assess the influences of all likely factors in the dollar yen relationship.)
The Cost-benefit Trade-off
What is the cost-benefit trade-off involved in obtaining a more accurate forecast? It is possible to obtain more accurate forecasts of some financial variables if more effort is expended. This effort could include talking to more people to collect more data or acquiring more sophisticated computer technology to speed up the forecasting process. The criterion for evaluating the cost benefit trade-off involved in undertaking a forecast is common to any business decision: Do the benefits of the greater forecasting effort justify its extra cost? If it is likely that the benefit from the extra forecasting activity will exceed the extra cost, then the forecasting activity should be expanded. Otherwise, it should not be expanded. If senior management cannot answer this question with confidence, it should not commit additional resources to the forecasting activity. In this case, the resources would be more beneficially spent in a concentrated effort to better understand in what business the firm is engaged and the forces that affect it.
Meeting the Criteria for Timeliness
How does the forecast meet the three criteria for timeliness? Careful consideration of the timeliness of a forecast is just as important as an assessment of its accuracy and cost. The question of timeliness can be broken into three issues.
First, how timely is the forecast? As events change and new information becomes available, forecasts must be updated. Managers should always ask:
How frequently will these forecasts need to be updated? Obviously, the cost of updating the forecast should be weighed against the potential benefit of increased accuracy.
Second, timeliness has to do with how far into the future the forecast should go. Does the decision to be made require a 1-year or a 10-year forecast? It is generally true that long-range forecasts are more difficult to make than short-range forecasts.
Third, the analyst will have to decide on the level of data detail necessary (e.g., whether to use monthly, quarterly, or yearly data). Another decision is how often to review the forecast.
Senior managers must think through these three aspects of timeliness.
For example, how frequently are decisions based on forecasts of some financial variable actually made? If large expenditures for a new plant and equipment require the approval of an investment committee of senior managers that meets for this purpose once per quarter, then forecasts of relevant financial variables need to be updated quarterly. Frequently, major business decisions, such as investment in a new plant and equipment or entry into new markets, are based on aggregate forecasts; in other words, a long-range forecast of market growth and average profit margin is enough. In most cases, it does not make a lot of sense to forecast revenues and expenses month by month for 10 years and to update these forecasts frequently.
The Need for Business Planning
Being lucky and in the right place at the right time play some role in business success, but not the leading role. More crucial to business success is the careful evaluation of resources and alternatives, the selection of goals for the future, and a strategy for achieving those goals systematically. Successful business managers plan where they want their firm to be at some time in the future and take action to execute that plan. Business planning is a proven way to achieve profitability and growth.
Planning helps managers control their firm. Actual results can be compared with planned results, and necessary operational changes can be implemented quickly. Without a plan, a manager would have to make a subjective judgment as to the necessity of an operational change.
Dealing with Uncertainty
That the future is uncertain is certain. A single financial variable can have a variety of consequences. This is what defines risk, and risk is a strong reason for firms to forecast. Having good forecasting procedures generally improves the quality of predictions about financial variables.
Risk is a basic fact of business life, and no amount of forecasting will ever eliminate it. For some financial variables, no amount of effort will improve the quality of forecasts. For example, research suggests that it is not possible to forecast future values that are determined by supply and demand in rigorously competitive markets (e.g., interest rates and the prices of securities,
commodities, and currencies).
Businesses Re-evaluate Their Forecasting Activities
There was a marked rise in the use of sophisticated forecasting techniques during the 1970s and the early 1980s. This increased use of quantitative, computer-based forecasting was part of a larger movement among U.S. businesses toward more sophisticated planning processes. Because a great deal of these planning data and their related forecasts are proprietary and highly sensitive, it is not easy to assess the benefits of this movement objectively. But it is clear from such popular business publications as Business Week that serious reassessment of the benefits of computer-based forecasting has occurred in some influential business circles during the mid-1980s.
What is a Financial Forecast?
To avoid confusion, it is important to define clearly what is meant by the term forecasting. It is also important to distinguish forecasting from activities such as planning and modeling, which are related to forecasting but nevertheless are separate managerial functions.
A forecast is a prediction about a condition or situation at some future time. Much of human activity is based on forecasts. We routinely listen to weather forecasts on the radio to help us plan future activities. Forecasting is an important part of our lives.
Business decisions, and especially financially related business decisions, depend heavily on forecasts of future events. Decisions to lend money or borrow money depend on forecasts of future cash flow and future expected returns. For example, when John agrees to lend Mary some money, it is assumed that John expects to be repaid. This document is about the techniques financial managers use to predict the likely future values of financial variables such as revenues, expenses, and cash balances.
Some managers use the terms forecasting, planning, and modeling interchangeably to describe a large, involved process by which the firm decides what it wants to accomplish and how it intends to accomplish it. Other managers have much more specific, detailed processes in mind when they use these same terms.
As has been noted, forecasting is a process by which predictions are made about some future condition. Planning is a process by which a firm develops a scheme to accomplish something. A plan can be very broad in nature and may have nothing to do with forecasting. Suppose, for example, management has already decided to modernize one of the company’s plants and wants to establish a planning group to plan the modernization. The group’s job will be not to forecast the effect of the decision but to implement the modernization program.
The planning process frequently depends on forecasts. If the planning group had been charged with the review of the basic plant modernization decision, then it would have had to rely heavily on forecasting. The group would need to evaluate estimates (forecasts) of the cost of modernization, estimates of the increased productivity (lower operating expenses) it would make possible, and so forth. Planning usually involves forecasting.
When the planning process is complex, it is common to reduce the plan to a financial model, a simplified representation of a complex process. Because financial issues usually involve numbers, it is common for financial planning to be reduced to structured numerical models that are given such names as budgets, pro forma balance sheets, and income statements.
Financial Forecast and Projections
Business entities need to plan for the future, must consider alternative management strategies and prepare capital and operating budgets, and must also consider alternative funding and cash budget possibilities. An important part of the planning process is the preparation of prospective financial statements that attempt to predict the outcome of the business entitys activities in future periods.
PREPARATION OF PROSPECTIVE FINANCIAL STATEMENTS
The preparation of prospective financial statements requires considerable knowledge of the business and the factors that are likely to determine its future results. The following key factors related to future results must be considered in the preparation of such statements:
Factors related to the specific entity Factors related to the industry Factors related to the market Factors related to the economy
Factors Related to the Specific Entity
The principal cost elements of the entity doing business must be considered. Depending on the entity, these elements may include such costs as payroll and benefits, needed employees, raw materials, products the entity sells, freight or shipping, and advertising.
Another consideration is the availability of resources. For example, are the expert, specialized, or skilled workers available to meet the needs of the entity under the plan as initially proposed? Are the raw materials and/or products for resale available? Can the delivery system be organized to accomplish the task? Are the company physical facilities sufficient for the uses and for the capacities contemplated?
Factors Related to the Industry
Factors related to the industry in which the entity is operating must be considered. Is the industry one in which companies are very competitive? Are competitive industries emerging? Is obsolescence emerging within the industry? Are there regulatory considerations and requirements? Is new technology being introduced into the industry? What are the economic conditions within the industry?
Factors Related to the Market
Market factors must be considered. What are the trends in business or consumer demand related to the services or goods being sold by the entity? Are competitive companies emerging, perhaps with new or different products? Is unique marketing required? Are there pricing developments to be factored into the forecast?
Factors Related to the Economy
Numerous factors related to the economy must be considered. What are the economic conditions in the country? What are critical economic trends? Is the economy inflationary, deflationary, or stable? What is the trend with regard to labor availability? What are the financing considerations in relation to the economy? What are interest rates? Are there significant factors related to long-term versus short-term financing? Is a public stock offering a possible financing option?
ATTESTATION SERVICES PROVIDED FOR FINANCIAL FORECASTS AND FINANCIAL PROJECTIONS
Forecasts and projections are important in an organization. They are also of great interest to financial analysts and others in the business environment who make decisions about future business behavior. Because of outsider interest, public accountants are engaged to provide professional services. There are three types of engagements that a certified public accountant may undertake in relation to financial forecasts and projections:
Examination: An accountant evaluates the preparation, underlying support, and presentation of the financial statements, and expresses an opinion on them Applying agreed-upon procedures: Users establish the nature and scope of the engagement, and only the results of the procedures performed are provided Compilation: An accountant prepares the prospective statements from information and assumptions provided, and no assurance is given
Examination
When the examination is of a financial projection, the accountants must determine whether the hypothetical condition or course of action (which will not necessarily occur) is consistent with the purpose of the projection. The accountants must evaluate the support underlying assumptions in the same manner as is done for a forecast.
Upon completion of a financial forecast examination, assuming the accountants have collected sufficient evidence to provide a reasonable basis for the standard report to be issued, that report will state in part:
In our opinion, the accompanying forecast is presented in conformity with guidelines for presentation of a forecast established by the American Institute of Certified Public Accountants, and the underlying assumptions provide a reasonable basis for management forecast.
Upon completion of a financial projection examination, the standard report would include a description of the hypothetical assumption and the opinion would state that the underlying assumptions provide a reasonable basis for management forecast assuming the occurrence of the hypothetical assumption.
Benefits of Budgeting
The budgeting process enables a company to determine next year’s:
Financial targets, including revenue, margin, profit, cash flow, and debt levels.
Operating targets and key performance indicators, including inventory turns, product and service quality, supplier effectiveness, sales closing rate, and customer satisfaction.
Developing financial targets is critical to a well-designed annual operating strategy and performance incentive framework. A strong budgeting process also provides a direct link to the organization’s overall strategy, management buy-in on strategic goals, and the identification of the assumptions that drive the budget.
Static budgeting limits your options
In an ideal world, companies that use successful budget processes can reap the benefits of good budgeting. In reality, few companies do. Many companies do not realize all the benefits of good budgeting because they consider their budgeting season a one-time event. These companies do not reopen their budgets until the following budget season.
By following a static budgeting process, you lose two major opportunities. You are unable to reassess budgeting assumptions and to adjust operating and compensation strategies in response to changing business conditions.
You can’t revise your assumptions
When creating a static budget, management essentially makes its best educated guess about next year’s performance. The prediction is based on certain assumptions. As economic, market, competitive, and operating events unfold, the assumptions prove to be either right, wrong, or somewhere in between.
Sometimes management’s assumptions totally miss the mark, leaving the organization vulnerable to risk. As a result, the original operating budget might look like a very poor educated guess by Month 4.
You can’t adjust your strategies
If you base your budget on incorrect assumptions, your operating strategies might be addressing targets that should now be of lower priority. Your company might also need to adjust its compensation strategy. If the company will not meet its key performance targets, low employee morale might occur when employees anticipate that they might receive reduced variable pay at the end of the period.
Static budgeting in action
To see how static budgeting holds a company back, consider the example of a small regional retailer of high-end apparel.
Company’s objectives The company developed a plan that focused on three objectives: annual revenue growth of 20%, customer satisfaction of 99.99%, and maintaining its premium brand image. The company considered earnings an important afterthought, based on the company’s previously high margins relative to its peers and the strong economy.
Management set the annual operating budget and strategy with these three high-level objectives in mind. An annual bonus plan drove compensation and tied employees to the objectives (33.3% for each target).
Changing economic conditions As the year progressed, economic conditions unexpectedly began to sour. As a result, the customer base began shifting to discounters, reducing revenue. By midyear, employees lost faith in the annual budget and feared that they wouldn’t receive their bonuses.
Company’s response to decreasing revenue To combat decreasing revenue (and to help meet bonus targets), management promoted certain products. However, the company did not substantially lower prices in order to protect the store’s premium image, which a brand consultant measured quarterly. To ensure strong customer satisfaction (also measured quarterly by a consultant), the company continued its lenient return policy.
End-of-year results Not surprisingly, operating results quickly deteriorated. By the end of the fiscal year, the company had an enormous loss. Even so, many employees received partial bonuses for meeting customer satisfaction and brand perception targets. Because of aggressive discounting, the company achieved a portion of its revenue target, causing incentive payouts despite the company’s large operating loss. After the year was over, management laid off 10% of the workforce in an attempt to cut costs.
Analyzing the company’s situation Why did this company pay bonuses despite a poor operating year that resulted in huge losses? Was the original plan and operating strategy flawed? Though it’s highly simplified, this case illustrates how a static budgeting process can weigh down a company. The section “Integrated budgeting in action” addresses how this company could have adjusted its strategy midstream if it had a more flexible budgeting process.
What is integrated budgeting?
Integrated budgeting is a flexible budgeting framework that integrates forecasting within the budgeting process. By using integrated budgeting, you can respond to changing business conditions throughout the year and avoid the pitfalls of a static budgeting process. Integrated budgeting consists of five elements.
Classification of performance targets Management needs to prioritize financial and operating targets. The company should treat primary targets as relatively immovable during the fiscal year, regardless of changing business conditions. Secondary targets can be modified, exchanged, or even eliminated in order to support primary targets.
Operating reviews Operating reviews are the heart of integrated budgeting. Conducted on a quarterly basis, operating reviews provide the key stakeholders in the budget process with a forum to assess results and realign targets, strategies, and compensation.
Budget reforecasting Integrated budgeting relies on reforecasting that uses the rolling budget and forecast to assess operating results. Stakeholders can use the rolling budget and forecast to see the variances from the budget targets to actual results and to analyze the causes of any variances. This tool also provides the workspace where you can conduct a “look-ahead forecast” to analyze the effects of changing certain assumptions or targets for the remainder of the fiscal year.
Realigned operating strategy After you develop a look-ahead forecast, management should reevaluate operating strategy to focus on meeting new objectives.
Realigned compensation The critical missing link in aligning strategy to performance is often compensation. If the organization bases management and employee compensation at least partly on enterprise or business unit performance, performance goals should be reset after the operating review.
To avoid renegotiating compensation targets, management should change compensation targets selectively. In general, if the organization is not meeting key performance targets, management must stick to these targets and allow flexibility only for top performers.
Integrated budgeting in action
To see how a company can benefit from using integrated budgeting, consider again the example of the small regional retailer of high-end apparel discussed in the “Static budgeting in action” section. What would management have done if they used a robust and flexible budgeting process rather than a static budgeting process?
The five integrated budgeting elements provide a structure for comparing what the company did using a static budgeting process with what they could have done if they used an integrated budgeting process.
Classification of performance targets
Static budgeting The company’s original priorities were aggressive revenue, customer satisfaction, and a strong brand image. Though they are worthy, these goals required tradeoffs that resulted in poor operating performance. Management needed to decide which of these goals were primary and secondary so that the company could make midstream adjustments.
Integrated budgeting At the beginning of the year, the retailer could have classified brand image and customer satisfaction as primary goals and revenue growth as a secondary goal.
Operating reviews
Static budgeting Management continually adjusted operating strategies by implementing new promotions at the local level without considering all of the causes of the revenue shortfall. Management also did not focus on remedial actions that it could have taken in response to the revenue shortfall.
Integrated budgeting The retailer could have conducted operating reviews on a quarterly basis. During the Quarter 1 review, after assessing the economic situation, management could have upgraded operating income to a secondary goal that had a higher priority than that of revenue growth.
Budget reforecasting
Static budgeting Despite the dramatic change in business conditions, the retailer did not formally adjust targets in response. The static budget became a relic, as opposed to being a key management tool.
Integrated budgeting The retailer could have used a rolling budget and forecast to determine the causes of key variances. Obvious causes were the economy and competitors that were stealing business with copycat apparel lines. Management could have revised the look-forward forecast to reflect a weaker economy. To spur revenue growth, management could have developed several new marketing strategies that did not compromise brand image or customer satisfaction.
Realigning operating strategy
Static budgeting Management did not comprehensively adapt its operating strategy to respond to changing business conditions. The retailer implemented program strategies locally, focusing on achieving secondary targets at a high cost.
Integrated budgeting The retailer could have implemented new competitive and marketing strategies based on the operating review reforecast. After evaluating the reforecasted budget, management could have cut costs by reducing the workforce by 2%, cutting the bottom 2% of performers.
Realigning compensation
Static budgeting Because the company used a static compensation plan, employees focused on meeting targets that were not in the company’s best interest.
Integrated budgeting For the last three quarters, the company could have modified compensation by using a “60/40 plan” with compensation based on the following: 30% on customer satisfaction, 30% on brand image, 20% on operating income, and 20% on revenue growth. Quarter 1 bonuses could have been paid under the old plan to eliminate renegotiating. Management could give a select group of high achievers (the top 10%) concessions to ensure continued motivation.
Benefits of integrated budgeting
By using the integrated budgeting approach, the apparel retailer could gain many benefits.
Focus Instead of chasing multiple and often conflicting performance targets, the retailer would have had the flexibility to refocus on the core targets (brand image and customer satisfaction) that were achievable during the economic downturn. Management would have been able to more effectively consider the tradeoffs between targets, which might have helped stem a large operating loss that led to layoffs.
Workforce alignment The average employee’s variable compensation would have been better aligned with the company’s overall performance.
Fairness Employees would not have been completely demotivated by the poor economic conditions (particularly top employees, who would have enjoyed more compensation flexibility). Likewise, the company would have likely paid out deservedly smaller bonuses, which makes sense when operating results are poor.
Innovation By conducting quarterly operating reviews, management could have reviewed reforecasted budgets in order to determine the causes of variances. A more intelligent forecast of future activity could have been built. The operating review would have become a forum for innovation, where key players discuss the challenges of the business climate and create strategies to overcome the challenges.
Build better budgets
The integrated budgeting approach provides a method that you can use to lead your company’s response to ever-changing business conditions. By adding forecasting to the budgeting process, your company can successfully adapt to the situations that defy the initial budgeting assumptions.
Common Forecasting Pitfalls
In each of the components of the forecasting process, you might come face to face with pitfalls. Recognizing the potential problems and overcoming them are crucial steps to developing a sound forecast.
Information capture
Collecting the wrong information Some forecasts are based on the wrong information. For example, sales pipeline data from sales representatives is often the source of forecasting information. Because sales representatives are generally optimistic about their potential sales, this data can lead to an overly high forecast.
Not collecting the right information Many companies don’t think through what the true “leading indicators” are for their products. Management might miss large pieces of the forecasting puzzle if it doesn’t capture all relevant data. For example, a regional construction materials company might base its forecast on recent sales trends. Instead, the company should closely monitor new construction builds, demographics, and the number of new building permits.
Information aggregation
Storing information After the correct information is captured, financial analysts need to aggregate all of the collected information. If you use only some of the information in the forecast, the forecast will not be a good basis for decision-making. For example, if a company bases hiring decisions only on product sales data and doesn’t consider that the products are nearing the end of their product life cycle, the company might make the wrong decisions. This company’s monthly forecast should include aggregated data for both product sales and product life cycle.
Analysis
Making the analysis too simple Techniques such as trend analysis, seasonality analysis, and pipeline forecasting are good tools to use when building a forecast. However, if you rely on them exclusively, you might build weak forecasts that cannot support good decision-making.
Making the analysis too complex Analyzing too many variables can inundate management with too much information. If you give management forecasts for too many types of information, management might experience “analysis paralysis.” Forecast only the key top-line financial metrics. Generally, if you create a well-done revenue forecast, all the other pieces will fall into place.
Reporting
Neglecting management’s needs You must keep the primary end user of the forecast — management — in mind when you develop the forecast. Different management teams have different forecast requirements as far as style, detail, and timing. Financial analysts should be sensitive to management’s requirements and ensure that the forecasting approach is tailored to support management’s decision-making.
Analyze your forecasting process
By taking the following steps, you can identify the issues that plague your current forecasting process and avoid the common forecasting pitfalls.
- Map your current forecasting process Ask yourself: Where do I obtain the data from? In what form do I aggregate the data? Do I use separate reports? How often are reports developed? Who develops the reports? What techniques do the reports use?
- Analyze the effectiveness of prior forecasts Ask yourself: Has there been a major variance (either positive or negative) from one period to the next? What factors caused the variances? Are these variances now considered part of the analysis approach? If not, why not? Is there data that would assist with forecasting that’s not readily available? What is management’s opinion of forecasts? Does management use forecasts to support decision-making, or does management make decisions based on intuition?
- Define the gaps in your forecasting process Order the gaps according to significance.
- Develop an action plan For companies that have a sound forecasting approach, an action plan might involve only a few tweaks to the forecasting process, the data gathered, or the analytical techniques used. For other companies, an action plan might require a complete re-engineering of the forecasting process. You might need to use new tools for information capture, aggregation, analysis, and reporting.
A stronger forecasting process
By analyzing your forecasting process, you can avoid the pitfalls that plague many forecasting approaches and strengthen your forecasting process. You will develop better forecasts and be able provide your organization with the comprehensive forecasts it needs.
