Monday, July 16, 2012

Business Forecasting

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.

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