Managing Financial Principles and Techniques

Explain the Various forecasting methods and techniques used for decision making purpose.
Include their advantages and disadvantages.
Forecasting
Forecasting is a prediction of what will occur in the future and it is an uncertain process.
It is a best estimated basted on certain assumptions about the conditions that are expected to apply. A
budget in contrast is a plan of what the organization is aiming to achieve and what it has set as a target.
A budget should be realistic and so it will be based to some extent on forecasts prepared. It has been
said that budgeting is more a test of forecasting skill than anything else and there is a certain amount of
truth in such a comment. Forecasts need to be made of sales volumes and prices, wages rates and
earnings, materials availability and prices, rates of inflation the cost of bought in services and the cost
of overhead items such as power. However it is not sufficient to simply add a percentage to last year's
budget in the hope of achieving a realistic forecast. It is an uncertainty the accuracy of a forecast is as
important as the outcome predicted by the forecast. This site presents a general overview of business
forecasting techniques as classified in the following :
Forecasting using Historical Data
Many techniques have been developed for using past costs incurred as the basis for forecasting future
values. These techniques range from simple arithmetic and visual methods to advanced computer based
statistical systems. With all techniques, however, there is the presumption that the past will provide
guidance to the future.
* The time period should be long enough to include any periodically paid costs but short enough to
ensure that averaging of variations in the level of activity has not occurred.
* The data should be examined to ensure that any non activity level factors affecting costs were
roughly the same in the past as those forecasts for the future. Such factors might include changes in
resources costs, strikes, and weather condition and so on. Changes to the past date are frequently
necessary.
* Appropriate choices of dependent and independent variables must be made.
Forecasting methods and techniques
* High low method: In method is used to identify the fixed and variable elements of cost that are semivariable. It selects the highest and lowest activity level, the inflation makes it difficult to compare costs
adjust by indexing up or down.
To calculate the High low method:
Total cost at high activity level- total cost a low activity level
Total units at high activity level-total units at low activity level
= Variable cost per unit (V).
* Linear regression Analysis : Liner regression analysis also know as the least square technique is a
statistical method of estimating cost using historical data from a number of previous accounting periods

Liner regression analysis is used to derive a line of best fit which has the general form y= a +bx,
where
Y, the dependent variable =total cosrt

X,the independent variable=the level of activity

A, the intercept of the line of the y axis=the fixed cost
B, the gradient of the line=the variable cost per unit of activity.
A Liner cost function should be assumed: This assumption can be tested by measures of
reliability such as the correction coefficient and the coefficient of determination which ought to
be reasonably close to 1.
Interpolation means using line of best fit to predict a value within the two extreme points of the
observed range.
Extrapolation means using a line of best fit to predict a value outside the two extreme points.
It must be assumed that the value of one variable y, can be predicted or estimated from the
value of one other variable x.

* Scatter Diagrams and Correlation: A scatter diagram is a toll for analyzing relationships between two
variables. One variable is plotted on the horizontal axis and the other is plotted on the vertical axis. The
pattern of their intersecting points can graphically show relationship patterns. Most often a scatter
diagram is used to prove or disapprove cause and affect relationship. While the diagram shows
relationship, it does not by itself prove that one variable causes the other. In addition to showing
possible cause and effected relationships a scatter diagram, can show that two variables are from a
common cause that is unknown or that one variable can be used as a surrogate for the other. By using
this method, we can get the cause and effect relationships and to search for root causes of an identified
problem.

Interpret the data: Scatter diagrams will generally show one of six possible correlations between
the variables:
Strong Positive Correlation: The value of Y clearly increases as the value of X increases
Strong Negative Correlation: The value of Y clearly decreases as the value of X increase
Weak Positive Correlation: The value of Y increases slightly as the value of x increases.
Weak Negative correlation: The value of Y decrease slightly as the value of X increase.
No correlation: There is no demonstrated connection between the two variables.

* Sales Forecasting: The sales budget is frequently the first budget prepared since sales is usually the
principal budget factor, but before the sales budget can be prepared a sales forecast has to be made.
Sales forecasting is complex and difficult and involves the consideration of a number of factors.
As bearing in mind those factors, management can use a number if forecasting methods, often
combining them to reduce the level of uncertainty.