Business Forecasting
Business forecasting refers to
the analysis of past and present economic conditions with the object of drawing
inferences about probable future business conditions. The process of making
definite estimates of future course of events is referred to as forecasting and
the figure or statements obtained from the process is known as ‘forecast’
future course of events is rarely known. In order to be assured of coming
course of events, help is taken of an organised system of forecasting. The
following are two aspects of scientific business forecasting.
a)
Analysis of past economic conditions: For this purpose, the components of active
series are to be studied. The secular trend will show how the series has been
moving in the past and what its future course is likely to be over a long
period. The cyclic fluctuations would reveal whether the business activity is
subjected to boom or depression. The seasonal fluctuations would indicate the
seasonal changes in the business activity.
b)
Analysis of present economic conditions: The object of analysing present economic
conditions is to study those factors which affect the sequential changes
expected on the basis of the past conditions. Such factors are new inventions,
changes in fashion, changes in economic and political spheres, economic and
monetary policies of the Government, war. These factors may affect and alter
the duration of trade cycle. Therefore it is essential to keep in mind the
present economic conditions since they have an important bearing on the
probable future tendency.
Objectives of forecasting in
business: Forecasting is a part of human conduct.
Businessmen also need to look to the future. Success in business depends on
correct predictions. In fact when a man enters business, he automatically takes
with it the responsibility for attempting to forecast the future.
To a very large extent, his success or failure would depend upon the
ability to successfully forecast the future course of events. Without some
element of continuity between past, present and future, there would be little
possibility of successful prediction. But history is not likely to repeat
itself and we would hardly expect economic conditions next year or over the
next ten years to follow a clear cut prediction. Yet, frequently past patterns
prevail sufficiently to justify using the past as a basis for predicting the
future.
A businessman cannot afford to base his decisions on guesses.
Forecasting helps a businessman in reducing the areas of uncertainty that
surround management decision making with respect to costs, sales, production,
profits, capital investment, pricing, expansion of production, extension of
credit, development of markets, increase of inventories and curtailment of
loans. These decisions cannot be made off-hand. They are to be based on present
indications of future conditions.
However, we should know that it is impossible to forecast the future
precisely. There is a possibility of occurrence of some range of error in the
forecast. Statistical forecasts are the methods in which we can use the
mathematical theory of probability to measure the risks of errors in
predictions.
Characteristics of business
forecasting
a)
Based
on past and present conditions: Business forecasting is based on past and present economic condition
of the business. To forecast the future, various data, information and facts
concerning to economic condition of business for past and present are analysed.
b)
Based
on mathematical and statistical methods: The process of forecasting includes the use of statistical and
mathematical methods. By using these methods, the actual trend which may take
place in future can be forecasted.
c)
Period:
The forecasting can
be made for long term, short term, medium term or any specific period.
d)
Estimation
of future: The business
forecasting is to forecast the future regarding probable economic conditions.
e)
Scope:
The forecasting can
be physical as well as financial.
Steps in forecasting
The
forecasting of business fluctuations consists of the following steps:
a)
Understanding
why changes in the past have occurred: One of the basic principles of statistical forecasting is that the
forecaster should use the data on past performance. The current rate and
changes in the rate constitute the basis of forecasting. Once they are known,
various mathematical techniques can develop projections from them. If an
attempt is made to forecast business fluctuations without understanding why
past changes have taken place, the forecast will be purely mechanical.
b)
Determining
which phases of business activity must be measured: After understanding the reasons of
occurrence of business fluctuations, it is necessary to measure certain phases
of business activity in order to predict what changes will probably follow the
present level of activity.
c)
Selecting
and compiling data to be used as measuring devices: There is an independent relationship
between the selection of statistical data and determination of why business
fluctuations occur. Statistical data cannot be collected and analysed in an
intelligent manner unless there is a sufficient understanding of business
fluctuations. It is important that reasons for business fluctuations be stated
in such a manner that is possible to secure data that are related to the
reasons.
d)
Analysing
the data: Lastly, the
data are analysed in the light of understanding of the reason why change
occurs. For example, if it is reasoned that a certain combination of forces
will result in a given change, the statistical part of the problem is to
measure these forces, from the data available, to draw conclusions on the
future course of action. The methods of drawing conclusions may be called
forecasting techniques.
Methods of Business Forecasting: The following are the main methods of
business forecasting.
a)
Business
barometers
b)
Time
series analysis
c)
Extrapolation
d)
Regression
analysis
e)
Modern
econometric methods
f)
Exponential
smoothing method
Business barometers: Business indices are constructed to study
and analyse the business activities on the basis of which future conditions are
predetermined. As business indices are the indicators of future conditions, so
they are also known as “business barometers” or ‘economic barometers’. With the
help of these business barometers the trend of fluctuations in business
conditions are made known and by forecasting a decision can be taken relating
to the problem.
The construction of business
barometer consists of gross national product, wholesale prices, consumer
prices, industrial production, stock prices, and bank deposits. These
quantities may be converted into relatives on a certain base. The relatives so
obtained may be weighted and their average is computed. The index thus arrived
at in the business barometer.
Merits and demerits of
business barometers method
Merits
|
Demerits
|
The business barometer method is
scientific and reliable and used by management for the purpose of various
business decisions at different levels.
|
It is very difficult to construct indices of business activities.
|
Business barometer method helps in
proper forecasting of future trends of a business.
|
In most of the cases, the business
barometers provide inaccurate, incomplete and inconclusive forecasting due to
index numbers prepared on the basis of incorrect and inadequate data.
|
The business barometers are the
indicators of future business trends and help to forecast the speed of
fluctuations.
|
The business barometers are the
indicators of past conditions and the forecasting based on these conditions
may be erroneous.
|
This method helps to find solutions of
various business problems such as development of market, capital investment,
exploration of new consumer market and so on.
|
Separate indices are calculated for
individual industry and firm which are entirely different from general
indices.
|
Time series analysis: Time series analysis is also used for the purpose of making business
forecasting. The forecasting through time series analysis is possible only when
the business data of various years are available which reflects a definite
trend and seasonal variation. By time series analysis the long term trend,
secular trend, seasonal and cyclical variations are ascertained, analysed and
separated from the data of various years.
Merits and demerits of time
series analysis
Merits
|
Demerits
|
It is an easy method of forecasting.
|
This method is expensive, difficult and time taking.
|
By this method a comparative study of variations can be made.
|
This method deals with past data only.
|
Reliable results of forecasting are obtained as this method is based
on mathematical model.
|
This method can only be used when the data for several years are
available.
|
Extrapolation: Extrapolation is the simplest method of business forecasting. By
extrapolation, a businessman finds out the possible trend of demand of his
goods and also about the future price trends. The accuracy of extrapolation
depends on two factors:
i)
Knowledge about the fluctuations of the figures
ii)
Knowledge about the course of events relating to the problem under
consideration
Thus,
there are two assumptions on which extrapolations are based:
i)
There is no sudden jump in figures from one period to another
ii)
There is regularity in fluctuations and the rise and fall is uniform
In
extrapolation, we assume that the variable will follow the established pattern
of growth. For the purpose of business forecasting, it is to determine
accurately the appropriate trend curve and the values of its parameters.
Merits and demerits of
extrapolation method
Merits
|
Demerits
|
This method
is very useful to forecast the future demand and production.
|
This method
can be used under its own assumptions only.
|
This method
is widely used for the forecasting of business events because it is a simple
method.
|
This method
is not simple but technical, because of its mathematical formulation.
|
We get pure
and reliable results by this method, because it is a mathematical method.
|
The
selection of trend curve is very difficult.
|
Regression analysis: Refer
to Regression analysis chapter
Modern econometric methods: Econometric techniques, which originated in the eighteenth century,
have recently gained in popularity for forecasting. The term ‘econometrics’
refers to the application of mathematical economic theories and statistical
procedures to economic data in order to verify economic theorems. Models take
the form of a set of simultaneous equations. The values of the constants in
such equations are supplied by a study of statistical time series, and a large
number of equations may be necessary to produce an adequate model.
At
the present time, most short-term forecasting uses only statistical methods
with little qualitative information. However, in the years to come when most
large companies develop and refine econometric models of their major business,
this tool of forecasting will become more popular.
Merits and demerits of
modern econometric methods
Merits
|
Demerits
|
Accurate
and reliable results are obtained under this method.
|
This method
is difficult and complicated.
|
It is a
scientific method where computer technology is used.
|
This method
can be used only when adequate series of data is available.
|
This method
explains in detail and in quantitative terms the way in which various aspects
of the economy are interrelated.
|
It is very
difficult to construct growth model for every business activity.
|
Theories of Business Forecasting
There
are a few theories that are followed while making business forecasts. Some of
them are:
a. Sequence or time-lag theory
b. Action and reaction theory
c. Economic rhythm theory
d. Specific historical analogy
e. Cross-cut analysis theory
Sequence or time-lag theory: This is the most important theory of
business forecasting. It is based on the assumption that most of the business
data have the lag and lead relationships, that is, changes in business are
successive and not simultaneous. There is time-lag between different movements.
The table 13.5 lists the merits and demerits of sequence or time-lag theory.
Merits and demerits of
sequence or time-lag theory
Merits
|
Demerits
|
This method
is largely used for business forecasting because of the accuracy.
|
This method
studies only the action not the reaction.
|
Though this
theory is based on statistical techniques, yet it is easy to understand.
|
This method
cannot be regarded as accurate because by using statistical techniques the
results can be up to the truth but not an accurate one.
|
Time-interval
between two events can be ascertained.
|
|
Government
can use this technique for the purpose of economic stability of the economy
by exercising control over possible losses.
|
Action and reaction theory: This theory is based on the following two assumptions.
Every
action has a reaction
Magnitude
of the original action influences the reaction
Thus,
if the price of rice has gone up above a certain level in a certain period,
there is a likelihood that after some time it will go down below the normal
level. Thus, according to this theory a certain level of business activity is
normal or abnormal; conditions cannot remain so for ever. Thus, we find four
phases of a business cycle. They are:
i.
Prosperity
ii.
Decline
iii.
Depression
iv.
Improvement
Merits and demerits of
action and reaction theory
Merits
|
Demerits
|
This is
better than other theories.
|
The
determination of normal level is very difficult.
|
By this
theory more reliable results can be obtained because this theory gives
attention to action and reaction of an event.
|
It is not
necessary that reaction is equal to the action.
|
Economic rhythm theory: The basic assumption of this theory is that history repeats itself and
hence assumes that all economic and business events behave in a rhythmic order.
According to this theory, the
speed and time of all business cycles are more or less the same and by using
statistical and mathematical methods, a trend is obtained which will represent
a long term tendency of growth or decline. It is done on the basis of the
assumption that the trend line denotes the normal growth or decline of business
events.
Merits and demerits of
economic rhythm theory
Merits
|
Demerits
|
Forecasting
is made on the basis of past conditions, hence they are more reliable.
|
The
business events are not strictly periodic and prediction of business cycle on
the basis of statistical method is not satisfactory.
|
This method
is helpful in long-term forecasting.
|
Past
conditions are given more weightage than the present conditions.
|
Specific historical analogy: History repeats itself is the main foundation of this theory. If
conditions are the same, whatever happened in the past under a set of
circumstances is likely to happen in future also. A time series relating to the
data in question is thoroughly scrutinised and from it such period is selected
in which conditions were similar to those prevailing at the time of making the
forecast but it is largely dependent on past data. The table 13.8 lists the
merits and demerits of specific historical analogy.
Merits and demerits of
specific historical analogy
Merits
|
Demerits
|
It is an
easy method.
|
In this
theory, the forecasting is based on guess work, not on a scientific method
because the past and present conditions are rarely found to be similar.
|
As the
future is forecasted on the basis of past business conditions, the
forecasting is more reliable.
|
It is very
difficult to select the past period with the same business conditions like
present.
|
Advantages of business
forecasting
a)
Helpful
in increasing profit and reducing losses: Every business is carried out with the
purpose of earning maximum profits, so by forecasting the future price of the
product and its demand the businessman can predetermine the production cost,
production and the level of stock to be determined. Thus, business forecasting
is regarded as the key of success of business.
b)
Helpful
in taking management decisions: Business forecasting provides the basis for management decisions,
because in present times the management has to take the decision in the
atmosphere of uncertainties. Also, the business forecasting explains the future
conditions and enables the management to select the best alternative.
c)
Useful
to administration: On
the basis of forecasting, the government can control the circulation of money.
It can also modify the economic, fiscal and monetary policies to avoid the
adverse effects of trade cycles. So, with the help of forecasting, the
government can control the expected fluctuations in future.
d)
Basis
for capital market: The
business forecasting helps in estimating the requirement of capital, position
of stock exchange and the nature of investors.
e)
Useful
in controlling the business cycles: The trade cycles cause various depressions in business such as sudden
change in price level, increase in the risk of business, increase in
unemployment and so on. By adopting a systematic business forecasting, the
businessman and government can handle and control the depression of trade
cycles.
f)
Helpful
in achieving the goals: The
business forecasting helps to achieve the objective of business goals through
proper planning of business improvement activities.
g)
Facilitates
control: By business
forecasting, the tendency of black marketing, speculation, uneconomic
activities and corruption can be controlled.
Limitations of business forecasting:
The
business forecasting cannot be accurate due to various limitations which are
mentioned below.
a.
The
forecasting cannot be accurate, because it is largely based on future events
and there is no guarantee that they will happen.
b.
The
business forecasting is generally made by using statistical and mathematical
methods. But the use of these methods cannot claim to be able to make uncertain
future certain.
c.
The
underlying assumptions of business forecasting cannot be satisfied
simultaneously. In such a case, the results of forecasting will be misleading.
d.
The
forecasting cannot guarantee the elimination of errors and mistakes. The
managerial decision will be wrong if the forecasting is done in a wrong way.
e.
Factors
responsible for economic changes are often difficult to discover and to
measure. Hence, business forecasting becomes an unnecessary exercise.
f.
The
business forecasting does not evaluate risks.
g.
The
forecasting is made on the basis of past information and data and relies on the
assumption that economic events are repeated under the same conditions. But
there may be circumstances where these conditions are not repeated.
h.
Forecasting
is not a continuous process. In order to be effective, it requires continuous
attention.