Statistics for Management

Unit 13

Unit 13

Business Forecasting

Structure: 13.1 Introduction Learning objectives 13.2 Business Forecasting Objectives of forecasting in business Prediction, projection and forecasting Characteristics of business forecasting Steps in forecasting 13.3 Methods of Business Forecasting Business barometers Time series analysis Extrapolation Regression analysis Modern econometric methods Exponential smoothing method 13.4 Theories of Business Forecasting Sequence or time-lag theory Action and reaction theory Economic rhythm theory Specific historical analogy Cross-cut analysis theory 13.5 Utility of Business Forecasting Advantages of business forecasting Limitations of business forecasting 13.6 Summary 13.7 Terminal Questions 13.8 Answers to SAQs amd TQs Answers to self assessment questions Answers to terminal questions 13.9 References

13.1 Introduction
In the unit 12, Simple Correlation and Regression, you have studied about the techniques such as correlation and regression, which are used for
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investigating the relationship between two or more variables. In this unit 13, Business Forecasting, we will discuss about business forecasting, the methods available in forecasting, and the use of forecasting models in business improvement processes. The growing competition, rapidity of change in circumstances and the trend towards automation demand that decisions in business are not based purely on guesses and hunches but rather on a careful analysis of data concerning the future course of events. The future is unknown to us. Yet every day we are forced to make decisions involving future and therefore there is uncertainty. Great risk is associated with business affairs. All businessmen are forced to make forecast regarding business activities. Success in business depends upon successful forecasts of business events. In business or trade the importance of forecasting is so great, that when someone enters into the business world, he really enters the profession of forecasting. In recent times, considerable research has been conducted in this field. Attempts are being made to make forecasting as scientific as possible. Business forecasting as such is not a new development. Every businessman must forecast; even if his whole product is sold before production. Forecasting has always been necessary. What is new in the attempt to put forecasting on a scientific basis is to forecast by reference to past history and statistics rather than by pure intuition and guess-work. One of the most important tasks before businessmen and economists these days are to make estimates for the future. For example, a business man is interested in finding out his likely sales next year or as long term planning in next five or ten years so that he could adjust his production accordingly and avoid the possibility of either inadequate production to meet the demand or unsold stocks. Similarly, an economist is interested in estimating the likely population in the coming years so that proper planning can be carried out with regard to jobs for the people, food supply and so on. First step in making estimates for the future consists of gathering information from the past. In this connection we usually deal with statistical data which are collected, observed or recorded at successive intervals of time. Such data is generally referred to as time
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series. Thus, when we observe numerical data at different points of time the set of observations is known as time series. 13.1.1 Learning objectives By the end of this unit, you should be able to: Describe the meaning of business forecasting Distinguish between prediction, projection and forecast Describe the forecasting methods available Apply the forecasting theories in taking effective business decisions

13.2 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. 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. 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.
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13.2.1 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. 13.2.2 Prediction, projection and forecasting A great amount of confusion seem to have grown up in the use of words forecast, prediction and projection.

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Key Statistic A prediction is an estimate based solely on past data of the series under investigation. It is purely mechanical extrapolation. A projection is a prediction where the extrapolated values are subject to certain numerical assumptions. A forecast is an estimate which relates the series in which we are interested to external factors.

Forecasts are made by estimating future values of the external factors by means of prediction, projection or forecast and from these values calculating the estimate of the dependent variable. 13.2.3 Characteristics of business forecasting 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. 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. Period The forecasting can be made for long term, short term, medium term or any specific period. Estimation of future The business forecasting is to forecast the future regarding probable economic conditions. Scope The forecasting can be physical as well as financial.

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13.2.4 Steps in forecasting The forecasting of business fluctuations consists of the following steps: 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. The business fluctuations are based solely upon the application of mathematical formulae and are subject to serious error. 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. 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. 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.

13.3 Methods of Business Forecasting

Almost all businessmen make forecasting about the business conditions related to their business. In recent years scientific methods of forecasting have been developed. The base of scientific forecasting is statistics. To
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handle the increasing variety of managerial forecasting problems, several forecasting techniques have been developed in recent years. Forecasting techniques vary from simple expert guesses to complex analysis of mass data. Each technique has its special use, and care must be taken to select the correct technique for a particular situation. Before applying a method of forecasting, the following questions should be answered: 1. What is the purpose of the forecast and how is it to be used? 2. What are the dynamics and components of the system for which the forecast will be made? 3. How important is the past in estimating the future? The following are the main methods of business forecasting. i. Business barometers ii. Time series analysis iii. Extrapolation iv. Regression analysis v. Modern econometric methods vi. Exponential smoothing method 13.3.1 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, 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. There are three types of business barometers. They are barometers for: i. General business activities ii. Specific business or industry iii. Individual business firm
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Barometers relating to general business activities Barometers relating to general business activities are also known as general indices of business activities which refer to weighted or composite indices of individual index business activities. With the help of general index of business activity, long term trends and cyclical fluctuations in the economic activities of a country are measured. But in some specific cases, the long term trends can be different from general trends. These types of index help in the formation of a countrys economic policies. Business barometers for specific business or industry These barometers are used as the supplement of general index of business activity and these are constructed to measure the future variations in a specific business or industry. Business barometers concerning to individual business firm This type of barometer is constructed to measure the expected variations in a specific individual firm of an industry. The table 13.1 displays the merits and demerits of business barometers.
Table 13.1: Merits and demerits of business barometers method Merits The business barometer method is scientific and reliable and used by management for the purpose of various business decisions at different levels. Business barometer method helps in proper forecasting of future trends of a business. Demerits It is very difficult to construct indices of business activities.

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 past conditions and the forecasting based on these conditions may be erroneous. Separate indices are calculated for individual industry and firm which are entirely different from general indices.

The business barometers are the indicators of future business trends and help to forecast the speed of fluctuations. 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.

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13.3.2 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. The table 13.2 list the merits and demerits of time series analysis.
Table 13.2: Merits and demerits of time series analysis Merits It is an easy method of forecasting. By this method a comparative study of variations can be made. Reliable results of forecasting are obtained as this method is based on mathematical model. Demerits This method is expensive, difficult and time taking. This method deals with past data only. This method can only be used when the data for several years are available.

13.3.3 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 jumps 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.

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Some of these trend curves are explained below. Arithmetic trend The straight line arithmetic trend assumes that growth will be a constant amount each year. Semi-log trend It assumes a constant percentage increase each year. As the annual increment is constant in logarithm, this line will become a straight line when drawn on semi-log paper. Modified exponential curve The curve is given by:

y ab x
This relationship is referred to as an exponential function. It assumes that each increment of growth will be a constant percent of the previous one. Logistic curve This curve has both an upper asymptote and a lower asymptote. A curve of this type is well suited to describe the growth of industries as they pass through early periods of experimentation, rapid growth as the product is perfected and economics of scale make possible price reductions. The equation of the curve is given by:
y 1 ab x g or ab x g 1 y

Gompertz curve It is given by:

c ab c

In the logarithmic form, it is given by:

Logc Loga Logb c

To decide the curve to be used, it is helpful to obtain scatter diagram of transformed variable. The table 13.3 lists the merits and demerits of extrapolation method.

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Table 13.3: Merits and demerits of extrapolation method Merits This method is very useful to forecast the future demand and production. This method is widely used for the forecasting of business events because it is a simple method. We get pure and reliable results by this method, because it is a mathematical method. Demerits This method can be used under its own assumptions only. This method is not simple but technical, because of its mathematical formulation. The selection of trend curve is very difficult.

13.3.4 Regression analysis The regression approach offers many valuable contributions to the solution of the forecasting problem. It is the means by which we select from among the many possible relationships between variables in a complex economy, which will be useful for forecasting. Regression relationship may involve one predicted or dependent variable and one independent variable under simple regression, or it may involve relationships between the variable to be forecasted and several independent variables under multiple regressions. Statistical techniques to estimate the regression equations are often fairly complex and time-consuming. However, there are many computer programs now available that estimate simple and multiple regressions quickly. 13.3.5 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.
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The table 13.4 lists the merits and demerits of modern econometric methods.
Table 13.4: Merits and demerits of modern econometric methods Merits Accurate and reliable results are obtained under this method. It is a scientific method where computer technology is used. This method explains in detail and in quantitative terms the way in which various aspects of the economy are interrelated. Demerits This method is difficult and complicated. This method can be used only when adequate series of data is available. It is very difficult to construct growth model for every business activity.

13.3.6 Exponential smoothing method This method is regarded as the best method of business forecasting as compared to other methods. Exponential smoothing is a special kind of increasing exponential weighted average assigned to recent observation data and is found extremely useful in short-term forecasting of inventories and sales. Selection of different methods of forecasting The selection of an appropriate forecasting method depends on many factors, such as: Context of the forecast Relevance and availability of historical data Degree of accuracy desired Time period for which forecasts are required Cost benefit of the forecast to the company Time available for making the analysis The forecaster should use a technique that makes the best use of available data. Where a company wishes to forecast with reference to a particular product, it must consider the stage of the products life cycle.

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13.4 Theories of Business Forecasting

There are a few theories that are followed while making business forecasts. Some of them are: i. Sequence or time-lag theory ii. Action and reaction theory iii. Economic rhythm theory iv. Specific historical analogy v. Cross-cut analysis theory 13.4.1 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. Example 1 When government makes use of deficit financing, it leads to inflationary pressures; the purchasing power of people goes up. Therefore, the wholesale prices, the retail prices starts rising. With the rise in retail prices, the cost of living goes up and with it there is a demand for increased wages. Thus, one factor, that is, more money in circulation, has affected various fields of economic activity not simultaneously but successively. The table 13.5 lists the merits and demerits of sequence or time-lag theory.
Table 13.5: Merits and demerits of sequence or time-lag theory Merits This method is largely used for business forecasting because of the accuracy. Though this theory is based on statistical techniques, yet it is easy to understand. 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 Sikkim Manipal University Page No. 330 Demerits This method studies only the action not the reaction. 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.

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possible losses.

13.4.2 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 The table 13.6 lists the merits and demerits of action and reaction theory.
Table 13.6: Merits and demerits of action and reaction theory Merits This is better than other theories. By this theory more reliable results can be obtained because this theory gives attention to action and reaction of an event. Demerits The determination of normal level is very difficult. It is not necessary that reaction is equal to the action.

13.4.3 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. The table 13.7 lists the merits and demerits of economic rhythm theory.

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Table 13.7: Merits and demerits of economic rhythm theory Merits Forecasting is made on the basis of past conditions, hence they are more reliable. This method is helpful in long-term forecasting. Demerits The business events are not strictly periodic and prediction of business cycle on the basis of statistical method is not satisfactory. Past conditions are given more weightage than the present conditions.

13.4.4 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. Table 13.8: Merits and demerits of specific historical analogy
Merits It is an easy method. Demerits 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. It is very difficult to select the past period with the same business conditions like present.

As the future is forecasted on the basis of past business conditions, the forecasting is more reliable.

13.4.5 Cross-cut analysis theory This theory proceeds on the analysis of interplay of current economic forces. In this method, the combined effects of various factors are not studied. The effect of each factor is studied independently. Under this theory, forecasting is made on the basis of analysis and interpretation of present conditions because the past events have no relevance with present conditions. The table 13.9 lists the merits and demerits of cross-cut analysis theory.

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Table 13.9: Merits and demerits of cross-cut analysis theory Merits Present conditions are preferred than past. The effect of each factor is studied independently Demerits Independent analysis of individual facts is very difficult. Past facts are equally important for the purpose of forecasting, but in this method no weight-age is given to past facts. The forecasting made on the basis of this technique cannot be regarded as reliable.

Forecast is nearer to the accuracy as it is based on present conditions.

13.5 Utility of Business Forecasting

Business forecasting acquires an important place in every field of the economy. Business forecasting helps the businessmen and industrialists to form the policies and plans related with their activities. On the basis of the forecasting, the businessman can forecast the demand of the product, price of the product, condition of the market and so on. The business decisions can also be reviewed on the basis of business forecasting. 13.5.1 Advantages of business forecasting 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. 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. Useful to administration

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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. Basis for capital market The business forecasting helps in estimating the requirement of capital, position of stock exchange and the nature of investors. 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. Helpful in achieving the goals The business forecasting helps to achieve the objective of business goals through proper planning of business improvement activities. Facilitates control By business forecasting, the tendency of black marketing, speculation, uneconomic activities and corruption can be controlled. Utility to society With the help of business forecasting the entire society is also benefited because the adverse effects of fluctuations in the conditions of business are kept under control. 13.5.2 Limitations of business forecasting The business forecasting cannot be accurate due to various limitations which are mentioned below. i. The forecasting cannot be accurate, because it is largely based on future events and there is no guarantee that they will happen. ii. 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.

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iii. The underlying assumptions of business forecasting cannot be satisfied simultaneously. In such a case, the results of forecasting will be misleading. iv. 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. v. Factors responsible for economic changes are often difficult to discover and to measure. Hence, business forecasting becomes an unnecessary exercise. vi. The business forecasting does not evaluate risks. vii. 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. viii. Forecasting is not a continuous process. In order to be effective, it requires continuous attention. Self Assessment Questions 1. State whether the following statements are True or False. i. Forecast is an estimate based solely on past data of the series under investigation. ii. In time series analysis method a comparative study of variations can be made. iii. In exponential smoothing, old observations are given increasing exponential weightage.

13.6 Summary
In this unit, you have studied about the theory behind business forecasting and the objectives of forecasting. The steps involved in forecasting the trends and different forecasting methods available are also studied. Finally we have ended the unit by explaining the advantages and limitations of business forecasting.

13.7 Terminal Questions

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1. 2. 3. 4. 5. 6. 7.

What is business forecasting? Explain objectives of business forecasting. Give the names of theories of business forecasting. Explain the characteristics of business forecasting. Differentiate between prediction, projection and forecasting. Describe the limitations of business forecasting. Give any two criteria that can be used for choosing the suitable method of forecasting. 8. Critically examine the important theories of business forecasting.

13.8 Answers to SAQs and TQs

Answers to self assessment questions 1. i. False ii. True iii. False

Answers to terminal questions 1. 2. 3. 4. 5. 6. 7. 8. Refer section 13.2 Refer section 13.2.1 Refer section 13.4 Refer section 13.2.3 Refer section 13.2.2 Refer section 13.5.2 Refer section 13.3 Refer section 13.4

13.9 References
Richard I. Levin, David S. Rubin, (2008) Statistics for Management, Seventh Edition, PHI Learning Private Limited

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