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.