What is Forecasting?
Forecasting refers to the practice of predicting what will happen in the future by taking into consideration events in the past and present. Basically, it is a decision-making tool that helps businesses cope with the impact of the future’s uncertainty by examining historical data and trends. It is a planning tool that enables businesses to chart their next moves and create budgets that will hopefully cover whatever uncertainties may occur.
Budgeting vs. Forecasting
One thing that is definitely true is that budgeting and forecasting are both tools that help businesses plan for their future. However, the two are distinctly different in many ways. Let’s consider the following points:
- Budgeting involves creating a statement that consists of numerous financial activities of a company for a specific period, such as projected revenue, expenses, cash flow, and investments. It is usually not conducted solely by one department, say, the finance department, because it requires input from other departments in order to come up with a holistic and detailed report. Therefore, the budgeting process takes time to complete. The company uses the budget to guide it in its financial activities.
- While budgets are usually made for an entire year, forecasts are usually updated monthly or quarterly. Through forecasting, a company is able to adjust its budget and allocate more funds to a department, as needed, depending on what is foreseen. In summary, budgets depend on the forecast.
Businesses choose between two basic methods when they want to predict what can possibly happen in the future, namely, qualitative and quantitative methods.
1. Qualitative method
Otherwise known as the judgmental method, qualitative forecasting offers subjective results, as it is comprised of personal judgments by experts or forecasters. Forecasts are often biased because they are based on the expert’s knowledge, intuition, and experience, and rarely on data, making the process non-mathematical.
One example is when a person forecasts the outcome of a finals game in the NBA, which, of course, is based more on personal motivation and interest. The weakness of such a method is that it can be inaccurate.
2. Quantitative method
The quantitative method of forecasting is a mathematical process, making it consistent and objective. It steers away from basing the results on opinion and intuition, instead utilizing large amounts of data and figures that are interpreted.
Features of Forecasting
Here are some of the features of making a forecast:
1. Involves future events
Forecasts are created to predict the future, making them important for planning.
2. Based on past and present events
Forecasts are based on opinions, intuition, guesses, as well as on facts, figures, and other relevant data. All of the factors that go into creating a forecast reflect to some extent what happened with the business in the past and what is considered likely to occur in the future.
3. Uses forecasting techniques
Most businesses use the quantitative method, particularly in planning and budgeting.
The Process of Forecasting
Forecasters need to follow a careful process in order to yield accurate results. Here are some steps in the process:
1. Develop the basis of forecasting
The first step in the process is developing the basis of the investigation of the company’s condition and identifying where the business is currently positioned in the market.
2. Estimate the future operations of the business
Based on the investigation conducted during the first step, the second part of forecasting involves estimating the future conditions of the industry where the business operates and projecting and analyzing how the company will fare.
3. Regulate the forecast
This involves looking at different forecasts in the past and comparing them with the actual things that happened with the business. The differences in previous results and current forecasts are analyzed, and the reasons for the deviations are considered.
4. Review the process
Every step is checked, and refinements and modifications are made.
Sources of Data for Forecasting
1. Primary sources
Information from primary sources takes time to gather because it is first-hand information, also considered the most reliable and trustworthy sort of information. The forecaster himself does the collection, and may do so through things such as interviews, questionnaires, and focus groups.
2. Secondary sources
Secondary sources supply information that has been collected and published by other entities. An example of this type of information might be industry reports. As this information has already been compiled and analyzed, it makes the process quicker.
Thank you for reading CFI’s guide to forecasting. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: