Forecasting is determining what is going to happen in the future by analyzing what happened in the past and what is going on now. It is a planning tool that helps business people in their attempts to cope with the uncertainty of what will might and might not occur – it relies on past and current data and analysis of trends.
Company management, government departments, economists and investors utilize forecasting to decide how to allocate their resources, prepare reports, or plan for anticipated expenses. As far as companies are concerned, this is mainly based on predicted demand for its goods or services.
Economists, for example, might estimate some variable of interest rates at a specific date in the future. Forecasting is similar to prediction, which is a more general term.
The Economist made the following comment regarding forecasting: “Best guesses about the future. Despite complex economic theories and cutting-edge econometrics, the forecasts economists make are often badly wrong. Indeed, following economic forecasts has been likened to driving a car blindfolded, following directions given by a person who is looking out of the back window.”
Forecasting is also used in predicting the weather, for example, in hydrology it involves determining at what levels rainfall will be at specific future dates.
There is one thing all forecasters have in common – they all agree that the future is unpredictable. Any forecast they make always comes with a clear warning that what they are providing are only calculated guesses, and that things may turn out quite differently.
According to BusinessDictionary.com, forecasting is:
“A planning tool that helps management in its attempts to cope with the uncertainty of the future, relying mainly on data from the past and present and analysis of trends.”
Forecasting just calculated guesses
Despite the complex theories and state-of-the-art econometrics that forecasters use today, their predictions are often completely wrong. In fact, following economic forecasts is similar to driving a car with your eyes closed, following the directions of a passenger who is looking out of the back window.
There are two main approaches to forecasting – the Qualitative Method and the Quantitative Method. This image show two approaches for forecasting demand.
Regarding attempting to make predictions about the future, movie mogul Sam Goldwyn once said: “Never prophesy, especially about the future.”
Budgeting vs. forecasting
Budgeting and forecasting are commonly linked together, but they are not the same.
– Budgeting: a budget is a detailed financial outline of what the company thinks is going to happen over a future period – usually the next twelve months. It includes details on the business’ expenses, revenues, cash flow and financial position.
This information is included in a company’s financial reports. Depending on the size of the business, there may be a budgeting process – usually performed later in the year.
The majority of budgets are static and are set for the firm’s financial year. Some commercial enterprises use a continuous budget, which is adjusted during the year as business conditions change.
– Forecasting: this is a projection of what is going to happen at a much higher level, and includes revenue items, overall expenses, and other business components. Forecasts may be short- or long-term.
Short-term forecasts are generally done for operational reasons, while long-term ones, which project over a number of years, provide data for a longer-term business plan.
Put simply, budgeting includes a plan for where a company wants to go, while forecasting gives us an indication where it is actually heading.
While a budget estimates how much revenues and expenses a business may incur over a future period, forecasting estimates the business’ financial outcomes by gathering and analyzing historical data.
Laozi (died 531 BC), also known as Lao-Tzu, was an ancient Chinese writer and philosopher. He is reputed to be the author of the ‘Tao Te Ching’ and the founder of philosophical Taoism. (Image: thefamouspeople.com)
Advantages of forecasting
– Helps Predict the Future: it helps give management a general idea of what to expect. This provides the company with a sense of direction which will allow it to function better in the marketplace.
– Good for Customers: if a company is able to predict demand, it is more likely to always make sure its products are available – there is a greater chance that orders will be met and goods will be delivered on time.
– Keeps a Company up-to-date: businesses that forecast regularly are forced to think ahead all the time. This helps them anticipate changing market trends. Keeping up with the times makes us better able to compete with our rivals.
– Learn from Past Experience: gathering and analyzing past data helps people remember what worked and what didn’t. Learning from experience makes us stronger, and increases our chances of making a profit.
– Stay on Top of Costs: if you can predict future demand, you will know what production levels to plan for in future. You can use this information to more accurately determine whether you will need more or fewer workers.
– Receiving Financing: if a company needs a loan for a planned project, the lender will need information about the future, such as sales, profits, etc., before it will consider approving the loan.
Charles Franklin Kettering (1876-1958) was an American engineer, businessman, inventor and holder of 186 patents. He was a founder of Delco Electronics Corporation, and was head of research at General Motors from 1920 to 1947. (Image: thefamouspeople.com)
Types of forecasting methods
– Qualitative Methods: these are subjective and are based on the judgment and opinion of experts or consumers. When no past data is available, qualitative methods are used for making medium-to-long-range decisions. Market research is a type of qualitative forecasting method.
– Quantitative Methods: in these, future data is forecast as a function of past data. These methods are appropriate when we have past numerical data, and when we can reasonably assume that some of the data patterns are likely to continue in the future. Quantitative methods are generally used for making short-term and medium-term decisions.
– Average Method: forecasts of all future values equal the mean of the historical data. This method is appropriate with any type of data where past data is available. If we let historical data be denoted by yT, then we can write the forecasts as:
Even though the time-series notation has been used here, it is also possible to use the average approach for cross-sectional data. Then the forecast for unobserved values is the average of the observed values. (Image: otexts.org)
– Naïve approach: said to be the most cost-effective prediction model, it provides a benchmark against which other, more sophisticated models may be compared. This approach is only appropriate for time-series data. With the naïve approach, the forecasts are equal to the last observed value.
– Drift Approach: this is a variation on the naïve approach. It allows forecasts to increase or decrease over time, where the drift (amount of change over time) is set to be the average seen in the historical data. Hence, the forecast for T + h is given by:
This is like drawing a line between the first observation and the last, and extrapolating it into the future. (Image: Wikipedia)
– Seasonal Naïve Method: accounts for seasonality by setting each forecast to be equal to the last observed value in that season. For example, the prediction value for all future months of May will be equal to all previous May values. The forecast for T + h is:
Where m = seasonal period, and K is the smallest integer greater than (h – 1)/m. (Image: Wikipedia)
The seasonal naïve approach is especially useful for data that has a particularly high level of seasonality.
‘Financial Forecasting’ in other languages: Prévisions financières (French), Pronóstico financiero (Spanish), Previsão financeira (Portuguese), previsioni finanziarie (Italian), Finanzprognosen (German), финансовое прогнозирование (Russian), 財務予測 (Japanese), 财务预测 (Chinese), peramalan keuangan (Indonesian), वित्तीय पूर्वानुमान (Hindi), التنبؤ المالي (Arabic), ekonomiska prognoser (Swedish), økonomiske prognoser (Norwegian), finansielle prognoser (Danish), financiële prognoses (Dutch), and prognozowanie finansowe (Polish).
Video – forecasting methods overview
This Avercast LLC video has an overview of some basic forecasting methods.