Career Development

Q&A: What Is Forecasting? Definition, Methods and Examples

February 22, 2021

Forecasting is an important tool for making informed business decisions. Regardless of the size and profile of a company, forecasting helps the organization's management anticipate trends in important business indicators, such as sales expectations or customer behavior. Forecasting is a valuable asset but it requires specific skills and correct data. This article will help you better understand what forecasting is, how it works and how it can be an asset for your organization.

What is forecasting?

Forecasting is a method of making informed predictions by using historical data as the main input for determining the course of future trends. Companies use forecasting for many different purposes, such as anticipating future expenses and determining how to allocate their budget.

The data used for forecasting methods can either come from primary sources or secondary sources.

  • Primary sources: Primary sources provide first-hand information, collected directly by the person or organization that is doing the forecasting. The data is usually collected from various questionnaires, focus groups or interviews and, although all the information is difficult to gather and centralize, the direct way of acquiring the data makes primary sources the most trustworthy ones.
  • Secondary sources: Secondary sources provide information that has already been gathered and processed by a third-party organization. Receiving the data in an organized and compiled way makes the forecasting process quicker.

Related: Economic Demand: Definition, Determinants and Types

Why is forecasting important?

Being able to accurately predict future trends and events is useful in many contexts, including business management. Forecasting is important because it can be used for:

Estimating the success of a new business venture

When starting a new business, proper forecasting can reveal crucial information that may determine the company's future success. Forecasting reveals some of the risks and uncertainties that a new business faces and can offer an entrepreneur the right tools to anticipate elements such as the strength of the competition, demand potential for a product or service and future industry development.

Estimating financial necessities

Estimating a company's future financial requirements is one of the most important uses of forecasting. It can help a company determine its financial future by estimating future sales, the capital needed for future product development, the costs of future expansions and other estimated expenses that are used to estimate future costs.

Ensuring the company's operational consistency

Proper forecasting can reveal important information regarding future earnings and spending. By having an estimate of the funds going in and out of the organization over a certain period of time, the company's management can make more efficient and accurate plans for the future.

Helping managers make the right decisions

A significant proportion of management decisions are made by relying on accurate forecasting. Most businesses, regardless of size, face several potential uncertainties — such as seasonal rises and falls in sales, changes in personnel and changes in raw material prices — depending on the exact nature and purpose of the organization. Forecasting plays a major role in providing managers with the information they need to make informed decisions regarding the company's future.

Increasing a business venture's odds of success

The success of a business often depends on fine margins and correct fund allocation. Forecasting can predict important metrics, like the amount of needed raw materials, the right budget for each company department and the number of future sales. These figures help management allocate funds and resources and prioritize one product or service over another, depending on the type of company and the forecasted data.

Formulating effective plans for the future

All planning implies the use of forecasts, making forecasting a very important element of formulating realistic and helpful plans. Any form of planning, from short-term to long-term, is heavily reliant on forecasting, creating a direct link between accurate forecasting and adequate planning.

Promoting workplace cooperation

Gathering and analyzing the data required for forecasting typically requires coordination and collaboration between all the company's department managers, as well as other employees. This makes the whole process a collaboration, increasing team spirit and cohesion.

Helping an organization improve

Forecasting gives managers information that they can use to spot any weakness in the organization's processes. By discovering potential shortcomings ahead of time, the company's managers have the proper tools to correct any weakness before they affect the profits.

Related: How To Perform a Risk Analysis

How forecasting works

Forecasting is usually a collaboration between a company or department manager and a designated forecaster. Before forecasts are made, they need to work together and attempt to answer the following questions:

What is the goal of the forecast?

This determines the required level of accuracy and helps identify the most appropriate forecasting techniques. A broad decision, like deciding whether or not to enter a new market, can be done by roughly estimating the future size of that market. On the other hand, a more delicate decision, such as determining the right budget for each department, requires a more detailed and accurate approach.

What are the main components and variables of the forecasted system?

Before making a forecast, all different elements of the system that needs to be forecasted need to be reviewed and their relative values analyzed. Depending on the required forecast, this can imply an in-depth analysis of any relevant elements of the sales system, distribution system, marketing process, production system and other elements being studied.

How important are past events to future estimations?

Major changes occurring from the time in the past when the data was gathered can diminish the forecast's relevance. The implementation of new products, strategies, sales channels, as well as new industry developments, have the potential of making data gathered in the past obsolete and irrelevant.

Methods of forecasting

There are four main forecasting methods that you can use to determine future values, revenues, expenses, costs, trends and other similar indicators. They are:

  • Straight-line method: This is the easiest forecasting method, both to learn and to follow. It's typically used by financial analysts to determine future revenues based on past trends and figures.
  • Moving average: This technique analyzes the underlying pattern of a dataset to estimate future values. The most widely-used types are the three-month and the five-month moving average.
  • Simple linear regression: It is especially useful when analyzing the connection between different variables, to get a more accurate prediction.
  • Multiple linear regression: It is mainly used for forecasting revenues, in situations where two or more independent variables are needed for a projection.

Related: The 5-Step Strategic Management Process

Skills for investors

Forecasting is a major part of any investment, from the stock market and investment banking to real estate investments, venture capitalism, network marketing, business ownership and so on. The most important skills needed by investors to make accurate forecasts are:

Business skills

Properly understanding the business climate and the market is a valuable asset for any kind of investment. Whatever the type and objective of the investment, the accuracy of the investor's forecast depends on their understanding of the bigger picture, helping them determine the most useful forecasting method and technique for each situation.

Technical skills

Before an investor can make an accurate and relevant forecast, they need to have the technical knowledge required to identify relevant data, group it and draw useful conclusions.

Data management skills

Data is the base of all forecasts, so an investor needs to be able to identify, sort and manage all the relevant data before getting an insight on potential future developments. This implies improving the quality of acquired data by discovering and controlling for any anomalies but also using the data to create realistic models for future events.

Communication skills

Proper communication and interpersonal skills are valuable assets for any investor. Communication is needed at every step of a forecast, from data gathering to explaining the results of the forecast to third parties. An investor will use their communication skills for interacting with relevant business units, securing funding for investments and communicating the outcome of the forecast to relevant people, such as partners and company CEOs.

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