(This video chapter begins at 09:17 and ends at 11:00. Click on the blue dot at the 09:17 timestamp to play the video for this module.)

Advanced Forecasting Techniques

Forecasting is essential to assessing how much the budget should be. Various techniques and tools can be used to help forecast costs. While no technique is a guarantee, using a standard tool will help you be more consistent in forecasting.

Our focus quote for this module:

“If you have to forecast, forecast often.” –Edgar R. Fiedler

In this module, the following forecasting techniques will be discussed:

• Using the average
• Regression analysis
• Extrapolation
• Forma financial models

Using averages helps in forecasting. That is our next topic.

Using the Average

Taking the average of actual yearly numbers can help to forecast what the next budget could be. Of course, you may need to factor in economic data like inflation or increases in taxes. Averaging the numbers is an easy process when using a spreadsheet program.

You can use information from the past five years and average them. You can also average the percent change between the years to determine how much to increase the new budget for the new term.

Regression Analysis

Regression analysis is a statistical tool used to find the relationships between variables. This tool is used to predict future values. Using this tool as a method of forecasting requires knowledge in statistics. You may not use this tool yourself, but understanding that this is a forecasting tool could help you find resources and experts when needed.

Extrapolation

Extrapolation is a mathematical tool using historical data to determine what will happen in the future. Using this tool as a method of forecasting requires knowledge in advanced mathematics. You may not use this tool yourself, but understanding that this is a forecasting tool could help you find resources and experts when needed to make forecasts.

Formal Financial Models

When determining capital budgets, there are formal financial models used by accounting to determine certain numbers. Having a basic understanding of what is calculated and how they are determined, will give you the ability to hold meaningful discussions with employees and managers that deal with this on a regular basis.

The following are some formal models:

• Accounting rate of return
• Net present value
• Profitability index
• Internal rate of return
• Modified internal rate of return
• Equivalent annuity

Practical Illustration

Karen had gathered the data and information needed to create a budget, but when it came to forecasting how much the budget should be, she needed some assistance. She asked a colleague explain what methods could be used to create a budget. The first method was to use an average. This was simply taking past budgets and averaging out the figures to create the new budget. Karen knew that wouldn’t work very well, as the old budgets were ineffective. The next method was regression analysis. Again, this method relied on previous values, so Karen decided not to use it. The same problem applied to extrapolation. In the end, Karen decided that the best method for her needs would be to gather the budget team and create Formal Financial models. This process would create a dialogue that could be used to determine relevant values based on actual needs. Karen used this method and created an effective budget.