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You are on page 1of 114

Forecasting

This section is 30% of the Part 1 Exam

Section A is the largest part of the exam

Primary areas of review include:

Planning and budgeting concepts

Budget methodologies including types of budgets

Budgeting questions

Forecasting techniques

Learning curves

Probability

Risk, uncertainty and expected value

Sensitivity analysis

Top-Level planning and analysis

Concepts

Planning

Formal or informal

Short-term, long-term, intermediate

Production planning

Project planning

be done, how it should be done, when it

should be done, where it should be done

and who should do it.

Planning is done for both financial (usually

through a budget) and nonfinancial items

(production).

Budgeting

consider external influences that will impact the

companys operations and budgets such as:

Industry: rivals, the companys competitive position

in the industry, nature of the industry, etc.

Country or international environment: domestic and

international political risk, impact of globalization

within the industry, possibility of war or

expropriation, etc.

Macro-environment: the macroeconomic and social

factors that will effect the entire industry or overall

economy such as: economic growth, levels of interest

rates, inflation or deflation, environmental protection

laws, national tax policy, etc.

Objectives

The bases of the planning process are the goals

and objectives of the company. Without these,

there can be no efficient or effective planning.

its goals and objectives.

organizational level and goals at the divisional

level.

The objectives do not need to be agreed to by

each employee, but they do need to be

accepted by everyone.

This means that even if an employee does not agree

with the plan, they still need to act in accordance with

the plan.

Goals

Objectives and goals must be:

Prioritized,

Clearly stated,

Specific, and

Communicated to employees.

to their efficiency and effectiveness

Effectiveness is whether the goal was

reached.

Efficiency is whether it was reached using the

fewest resources.

Long-term (strategic) plans five years or

more. Based on long-term objectives and tend not

to be specific or detailed. More what is to be done

rather than how it is to be done.

Made by companys top management

Looks at strategies, objectives and goals of the

company, and internal/external factors affecting the

company

years. Implement specific parts of the strategic

plan.

Made by upper and middle managers

Contd

less than 1-year in time. Relate

usually to production, materials

requirements, staffing, cash flows

and the income statement.

Developed by middle or low level

managers

Primary basis for budgets

Provide the basis to develop programs,

policies and performance expectations

required to achieve the companys long-

Single-purpose plans plans for a

specific project.

Standing-purpose plans these

plans are used multiple times for a

recurring project or effort.

Contingency planning this is

planning for disruptions to the

business. Also called disaster

recovery planning.

Evaluation

Planning, budgeting, and performance evaluation

are interrelated and inseparable. The process is:

1. Management develops the plan consisting of goals,

objectives and a proposed action plan for the future

2. The plan developed by management leads to the

formulation of the budget. The budget expresses

managements plans in quantitative terms.

3. Budgets can lead to changes in plans and strategies

because they provide feedback to the planning

process. Managers may revise their plans based on

this feedback. This back and forth exchange may occur

for several iterations before the plans and budgets are

adopted.

Evaluation Contd

Planning, budgeting, and performance

evaluation are interrelated and inseparable. The

process is (contd):

4. Once the plans and budgets are finalized, the

company implements the plans to achieve its goals.

5. Actual results are compared to the plan. The budget

is a control tool.

6. Sometimes this control will result in the revision of

prior plans and goals or in formulation of new plans,

changes in operations and revisions to the budget.

7. Changed conditions during the year will be used in

planning for the next period.

Budgeting

A budget is a quantitative (numerical) expression

of the companys plans and objectives.

The Master Budget is the final, complete

budget for the upcoming time period.

However, the master budget is composed of many,

smaller budgets that are developed for departments,

divisions, and individual products.

Operating budgets are used to identify the resources that will

be needed by the individual units to carry our planned

activities

Financial budgets identify the sources and uses of fund for the

budgeted operations

Advantages of Budgets

When properly developed and administered,

budgets:

Provide coordination and communication among

organization units and activities

Provide a framework for measuring performance

Provide motivation for managers and employees to

achieve the companys plans

Promote the efficient allocation of organizational

resources

Provide a means for controlling operations

Provide a means to check on progress toward the

organizations objectives

Characteristics of Successful

Budgeting

The process must start with the companys plans

The budget needs management support at all

levels.

The people who are responsible for delivering the

budget must have input into the development of

the budget. This gives them a sense of ownership

over the budget.

The budget should be seen as motivational.

The budget should be an accurate representation

of what is expected to occur.

The budget should be flexible to allow for changes

in the business environment during the year.

Contd

representation of the expected future

events.

Budgeting should not be rigid that it forces

actions to be taken without review by

appropriate management

The budget should be coordinated among all

departments and divisions in the company.

The time period included in the budget

should match the purpose of the budget.

A budget is generally prepared for a set period of

time, usually one year, and it matches the company

fiscal year.

Budgets can also be prepared on a continuous basis.

This is called a rolling budget or continuous budget.

Advantages of this approach are:

Budgets are no longer done just once a year.

A budget for the next full period (usually 12 months) is

always in place.

The budget is more likely to be up-to-date, since the

addition of a new quarter or month will often lead to

revisions in the existing budget.

Managers are more likely to pay attention to budgeted

operations for the full budget period.

Budget

The budget should be prepared by the people

who are most knowledgeable about the different

parts of the budget.

Top management should not be involved in the

detailed production budget for each month.

Those who know how much things actually cost need

to be consulted in the development of the budget.

impacted by the budget are involved in the

development of the budget.

This helps them feel that the budget is able to be

accomplished.

The budget should also be more realistic.

Budget cont.

Top management still has a role in the budget

process at all levels, even if they do not prepare

the budget at all levels.

They need to set the goals and objectives that the

company is trying to achieve in the upcoming period.

And they need to communicate these objectives to

everyone in the organization.

are working towards that common objective and goal.

They need to provide support and information so that

people have the needed information to budget.

Process

The process for developing the budget is:

1. An appropriate authority, such as senior management

or a budget committee, set and communicate budget

guidelines.

2. Initial budget proposals are prepared by responsibility

centers.

3. Company managers, at all levels from responsibility

center managers to the CEO, negotiate, review and

approve the budget for submission to the board of

directors.

4. Revisions: after the budget is finally adopted, it should

be able to be changed if the assumptions upon which

it was built change significantly.

Process Contd

The process for developing the

budget are (contd):

5. Actual results should be compared to

the budget. This variance reporting is

done at all levels of the company.

6. Variance reports should be used at

every level of the company to identify

problem areas and to make

adjustments to operations.

Process

Best practice guidelines for the budgeting process

include the following:

Link development of the budget to corporate strategy

Communication is vital

Design procedures to allocate resources strategically

Managers should be evaluated on performance

measures other than meeting budget targets

Cost management efforts should be linked to budgeting

Strategic use of variance analysis

Reduce budget complexity and budget cycle time

Develop budgets that can be revised if necessary

Review the budget regularly during the year

Goal congruence is defined as aligning the

goals of two or more groups. As used in

planning and budgeting, it refers to the

aligning of goals of the individual managers

with the goals of the organization as a whole.

Budgetary slack is the difference between the

budgeted performance and the performance

that is actually expected. It is the practice of

underestimating budgeted revenues and

overestimating budgeted costs to make the

overall budgeted profit more achievable.

Contd

going to be accountable to meet may build

budgetary slack into their budgets in order to

make sure their budgets are achievable without

any risk of failure.

Budget slack has advantages and disadvantages:

On the positive side, it can provide managers with a

cushion against unforeseen circumstances. This can

limit their exposure to uncertainty and reduce their

risk aversion.

On the negative side, it misrepresents the true profit

potential of the company and can lead to inefficient

resource allocation and poor coordination of activities

within the company.

Costs

Standard costs are the expected cost for labor,

materials, or overhead to produce one unit of

product (how much it should cost to produce)

To calculate the standard cost, the company

needs to know the expected level of

production and usage of the different inputs.

There are a number of ways to calculate this:

Activity analysis

Historical data

Target costing

Strategic decisions

Benchmarking

As with the budget, the standards need to be

set by the correct people.

Authoritative standard setting standards

are set from above.

Employees do not feel ownership or a

commitment to these standards because they

may see them as unrealistic.

are involved in the standard setting process.

More support from the employees and a greater

commitment to meet the standards because they

were part of setting them.

The standard amount and cost of material that is

used in the production of one unit is impacted by:

Quality the higher the quality of material, the more it will

cost. Lower quality materials may cost less but may require

more materials, as there may be more materials that do

not meet the required quality standards.

Quantity the amount needed for production will depend

on how much is needed for each unit (for example, how

thick should the covering be) and how many units are to be

produced.

Price obviously the price of the input purchased will

impact the standard cost. This is also connected to the

quantity purchased (discounts) and quality of what is

purchased.

Standards

As with materials, the standard cost

for labor will depend on:

Quantity of labor this is also

connected to the question of the cost of

labor vs. the cost of capital.

Price of labor the more skilled

(experienced) the labor the more costly

it is. However, more skilled labor may be

able to complete the job more quickly or

at a higher quality.

Establishing Overhead

Standards

Overhead standards are generally based on

normal operating conditions, normal volume, and

desired efficiency. The total overhead costs come

from the budgeted factory overhead costs.

These are

divided by a predetermined level

of activity to calculate a standard overhead rate.

In relation to the allocation rate, the company

must decide what activity to use for its budgeted

amount of the activity level.

The traditional method uses machine hours or direct

labor hours

Establishing Overhead

Standards Contd

The allocation rate is established for the full year.

The budgeted overhead rate for the year

multiplied by each months budgeted activity level

will be used to calculate the monthly budgeted

overhead.

In general, a company has four choices to

determine the output level. Two relate to what the

plant can supply; and two relate to the demand for

the plants output. These are called denominatorlevel capacity concepts, because they describe the

denominators that can be used in the calculation

of per unit overhead costs.

Denominator Level

Supply Denominator

Level Concepts

Concepts

if the company produces at its maximum level with no

idle time or downtime and no decreases in sales

demand.

Practical (currently attainable) capacity

theoretical level reduced by allowances for idle time

and downtime but not for a decrease in sales demand.

Master budget capacity utilization the amount of

output expected based on expected demand

Normal capacity utilization the level of activity

achieved in the long run, accounting for seasonal and

cyclical changes in sales demand. This is the

preferable method.

Budget Methodologies

The development of an annual budget for a

large corporation may take many months to

complete.

Important concepts for the budgeting process are:

One of the most important things in the process of

developing the budget is involving all of the correct people

(participative budgeting)

bottom-up budgeting: the budget is developed by starting at

the lowest levels in the operations systems and building

revenues and costs from there.

A budget manual details the budget process.

A planning calendar is the document that sets forth all of the

deadlines, policies and procedures of the budgeting process.

There are a number of budgets that

will need to be prepared. Some of

them need to be prepared in a

specific order.

This is because some of the budgets

build on each other.

The sales budget is the first budget

prepared.

The cash budget is the last budget

prepared.

This is the budget that must be completed first.

Everything else the company will do during the

year is based on how many units they expect to

sell.

This is also the hardest budget to do, because

it based on the decisions and factors not

controlled by the company:

Consumers

Competitors

The economy

After the sales budget is completed, the

company can prepare the production budget.

This budget is based on:

The expected level of sales,

Whether the company wants to change the level

of inventory,

Any decisions about outsourcing production (if the

company will buy finished products or parts from

an external supplier).

during the year the units will be produced.

Once the production budget is set, the

company can create a number of other budgets

that are based on the level of production:

Direct materials budget

Labor budget

Overhead budget

Ending inventory budget

Cost of goods sold budget

these budgets will likely cause a change in

another.

Following Budgets

There are also a lot of other budgets

that need to be prepared

Selling and marketing budget,

General and administrative budget,

Accounting and finance budget,

Research and development budget, and

Any budget for other type of revenue or

expense that the company has during

the budgeted period.

The cash budget is the last budget

prepared because all other budgets go

into this budget.

This budget will be prepared on a monthly

basis.

By preparing it on a monthly basis the

company can identify any future cash

shortages before they happen.

Better planning for cash shortages will make

the cost of borrowing lower.

Budgets

The operating budget is the budgeted income

statement and its supporting budget schedules.

It is made up of all the revenue budget and the production,

purchasing, marketing, and research & development

budgets.

and statement of cash flows, cash budget and capital

budget.

These budgets are what the companys financial

statements will look like next year if reality exactly

matched the budgeted amounts.

By looking at them now, the company can see what the

ratios will be like, and if they would be in violation of any

covenants or loan agreements.

This is the budget for large, capital expenditures

(property, plant and equipment).

Because these are large expenditures, the capital

budget is often prepared years in advance.

The company will need to plan for the financing of

these purchases.

budgeting process that we have discussed

leading to the forecasted financial statements.

Top management is very heavily involved in this

budget because it is connected to their long-term

plans.

The individual budgets that make up

the operating and financial budgets

together make up the master

budget.

The master budget is a summary of

managements operating and

financial plans for the period,

expressed as a set of financial

statements.

Flexible Budgeting

Flexible budgeting is the process of producing

budgets for different levels of activity.

This makes the evaluation process better and

more useful.

The master budget is a static budget. It is

produced for one level of activity, and if actual sales

are different, it is not as useful to make actual vs.

budget comparisons.

Flexible budgeting allows better comparisons

because there is a budget for what income should

have been at the level of sales that actually occurred.

available.

Project Budget

A project budget is a budget for a specific project.

As such, the time frame of the budget may be very

short or more long-term, depending upon the

length of the project.

Project budgets are different from the master

budget and the flexible budget.

The master budget or the flexible budget covers a

distinct time span. In contrast, a project budget covers

an identifiable project that has its own time span.

spans and should be viewed as special

commitments.

Life-Cycle Budgeting

This is a budget not for a specific time

period, but for a specific product.

It traces all of the costs and revenues from

the design of the product, through

production and includes after sale costs

that the company will incur.

This provides a more accurate pricing for

the product because the design, preproduction and post-production costs also

need to be covered by the selling price.

Activity-Based Budgeting

Activity-based budgets are prepared based on the

resource consumption and related costs to

perform the budgeted activities.

Activities that drive the costs are identified

A budgeted level of activity for each of these drivers is

determined based on a budgeted level of production

Budgets are developed based on budgeted activity

levels.

clear relationship between resource consumption

and output. Preparing an activity-based budget

brings out information about opportunities for cost

reductions and elimination of wasteful activities.

Zero-Based Budgeting

This system starts each year with a blank page,

and all items are created new for the year.

In incremental budgeting, the prior periods budget

is just increased by 10%, or some determined amount.

All expenses need to be accounted for and

justified.

By looking at every expense each year, management

should be able to eliminate non-value adding expenses

and try to find cheaper alternatives.

Loop

The budget report is the comparison between the

budgeted amount and the actual result. (This is

also variance analysis and is covered in more

detail in that material).

The steps in the control loop are:

Establish the budget, or standard,

Measure the actual performance,

Analyze and compare actual results with the budget,

Investigate unexpected variances,

Devise and implement needed corrective actions,

Review and revise the standards as needed.

Budgeting Questions

Budgeting Question

Formulas

In this topic, there are three common

categories of numerical questions

that are asked. If you are

comfortable with what these

questions as and the formula or

concept behind it, these questions

will be easy.

These categories of questions are

looked at on the following slides.

In this question, the question will ask What

would the flexible budget have been?

You will generally be given the master budget at

a specific level of output and the actual level of

output will be different.

You need to determine what income (or whatever

is asked) should have been according to the

flexible budget.

Remember that the variable cost per unit does not

change as the level of production changes, and

That the total fixed cost does not change as production

level increases.

Produce?

In this question you need to answer how many

units the company must purchase or produce in

order to have enough inventory for the

expected level of sales and the required ending

inventory balance.

The units can come from one of two places:

1. Beginning inventory (which will be given), or

2. Purchased or produced (what is being asked)

1. The sales or production for the period, and

2. The desired ending inventory balance.

The formula to solve this type of question is:

Units needed for the current period

+ Units needed for ending inventory

= Total number of Units needed

Units in beginning inventory

= Units needed to be purchased or produced

This formula works for both units purchased

(finished goods) and units produced (a production

company).

Question

In this question they give you a series of

information about when credit sales are

collected and when payments are made and

about bad debts.

These questions are not mathematically

difficult, but require you to read the question

carefully to determine when the monies are

collected and paid.

We recommend that you structure your answer in a

table format with a column for each month. By

recording what is sold, collected, paid (whatever is

asked for) in a table, it makes it very easy to

calculate the answer to the question.

Forecasting Techniques

Forecasting

This is the attempt to determine what

the future result will be.

Usually uses some sort of

mathematical model or formula.

The prediction is only as good as the

models representation of reality

Time Series Analysis

Causal Forecasting

In time series analysis we are

looking at patterns over time. There

are four patterns:

Trend

Cyclical

Seasonal

Irregular

Trend Pattern

This is a gradual shifting to a higher or lower

level over time. It may not be constant and

consistent, but over time the trend is visible.

Cyclical Pattern

more than one year is a cyclical fluctuation.

This cycle is usually due to the cycles of the

economy.

Seasonal Pattern

This is like the cyclical pattern, but

the fluctuations are due to the

seasons of the year, rather than the

business cycle.

These fluctuations usually occur

within a one year time period.

If they occur within one day, such as a

business that has its busiest time of the

day at the same time each day, it is

called a within-the-day seasonal

component.

Irregular Pattern

If the pattern is not repeating, it is

called a random pattern.

Because of the randomness of the

fluctuations, it is difficult to use

historical results to predict future

results.

There are two main ways in which

the information over time may be

used to predict future results:

1. Smoothing

2. Trend projection

Smoothing

Attempts to eliminate the random

fluctuations that occur over time

Works well when there is no

significant trend, cyclical or

seasonal effect

Does not work well when there are

long-term trends (upwards or

downwards) or cycles

Smoothing

Contd

Moving average the most recent data for a

certain number of periods is used, and each period

is given the same weight in the calculation

Weighted moving average the most recent

data for a certain number of periods is used, but

the data from more recent periods is given more

weight in the calculation.

Exponential smoothing the next periods

expected value is calculated using the last periods

expected value (as forecasted using exponential

smoothing) and the last periods actual value.

Exponential Smoothing

Uses two values:

1. The last periods expected value, as calculated using

exponential smoothing

2. The last periods actual value

determined weighting

The last periods actual value is given a weight of

alpha ()

. This is between 0 and 1 (usually it is between 0 and .4)

. This is also called the smoothing constant

weight of 1-

If is given a value of 1, the projection will be

based only on the actual result of the last period

If is given a value of 0, the projection will be

based only on the projected result of the last

period

When values fluctuate greatly, we want to use a

lower value for

The accuracy of this process is measured by the

error, called the Mean Squared Error. We want

an that will minimize this error.

Trend Projection

consistently, smoothing will not work

In this case we use trend projection.

Trend projection is done by means of simple

regression analysis

Simple regression analysis makes two

assumptions:

Variations in the value we are forecasting (the

dependent variable) are a result of changes in the

other variable (the independent variable) - i.e., the

passage of time, if a time series

The relationship between the value we are

forecasting and the other, independent, variable is

linear.

This process determines the line of best fit through

the values over time. This line minimizes the total

differences between the line and the actual values

for each period.

Before doing this, we need to make sure that the

value we are forecasting and the other, independent, variable are truly related to each other

This is done through correlation analysis, and the

correlation coefficient (represented by R or r)

1 means a perfect negative relationship

0 means no relationship, so trend analysis would not be

meaningful.

Other Measures

The standard error of the estimate

measures the range within which the

expected result will fall, with a certain level

of confidence

The coefficient of determination (r2)

measures the percentage of the change in

the dependent variable that is explained by

changes in the independent variable

You do not need to be able to calculate

these, but you need to know what they are.

Series

Over time, dollar values may increase

simply because of inflation. In looking at

future projections, we need to know how

much of past increases were a result of an

increase in quantity and how much were a

result of inflation.

Nominal dollars are measured in current

year dollars

Real dollars are measured in a base year

dollars and have had inflation taken out.

Dollars

Any conversion needs to use some sort of price

index or other measure of inflation

Real Value =

Nominal Value

Current Year Index / Previous Years Index

Or

Nominal Value

1 + Inflation Rate

Causal Forecasting

This is used when we know that the value we

are calculating is affected by another variable;

for instance, the level of sales is affected by

the level of advertising expenditures.

If there is a cause and effect and a linear

relationship, we can use projection.

In simple linear regression, there is only

one independent variable (the cause)

In multiple linear regression, there is more

than one independent variable.

The formula that is used in regression analysis to

calculate y (the expected value), for a given value

of x (the independent variable) is:

y = ax + b +

Where y = the dependent variable (the expected value)

a = the slope of the line (called the variable coefficient)

b = the y-intercept of the line, or the value of y when x =

0 (called the constant coefficient)

x = the independent variable

= the error term (the distance between the regression

line and an actual data point)

Regression Analysis

Assumptions

The model makes the following assumptions:

The relationship between x and y is linear,

The error term has a value close to 0 and is normally

distributed,

The variance of the error term is constant,

Errors in different samples are not related to each other,

The independent variable is not related to the error

term.

scope that a measurement was made incorrectly

and there is always some amount of randomness.

Benefits of Regression

Analysis

The benefits of regression analysis

are:

It is numerical and quantitative this

makes conclusions easier to draw

It may be used to forecast the fixed and

variable portions of costs that contain

both fixed and variable components.

Thus, it can be used in budgeting.

Limitations of Regression

Analysis

The limitations of regression analysis are:

Historical data is required if there is no data,

regression analysis cant be used

If there have been changes in the environment or

situation since the data was collected, it will not

work

If the independent variable chosen is not

appropriate (i.e., there is a low correlation between

the independent variable and the dependent

variable), the resulting forecast may be invalid

The conclusions are valid only for the range covered

Learning Curves

Learning Curves

Learning curves are used to describe the fact that

people are able to accomplish a repetitive task

more quickly the more they do it

For example, if something takes 1 hour to do the

first time, and only 40 minutes to the second time,

there has been a learning curve

There are two learning curve models:

Cumulative average time learning model

Incremental unit time learning model

of decisions, such as calculating the cost of a job.

The average time per unit for all units

produced decreases by some percentage

every time production doubles

If the learning curve is 70% and 2 units take 4

hours, it will take 70% of twice that amount of

time (5.6 hours) to make 4 units (4 2 .70).

For 4 units, it takes on average 1.4 hours (5.6 4)

to make 1 unit, which is 70% of the average time

required per unit to produce half as many units.

7.84 hours (5.6 2 .70).

This is an average time of .98 hours per unit,

which is 70% of the average time per unit for half

as many units.

cont.

required for the total number of units is as follows:

Initial time * (2 * LC) * (2 * LC) * (2 * LC)

Where:

Initial time is the amount of time required for the first

lot, first batch or first unit

LC = the learning curve percentage (as a decimal)

each time that the production quantity doubles.

Learning Model

In this model, the amount of time needed to

produce the last unit decreases by the learning

curve per-centage each time the production

quantity doubles, so each unit produced takes less

time than the last.

Without a financial calculator, it is possible to

calculate only the amount of time that will be

required to produce the last unit of each group of

doubled units (the 2nd, 4th, 7th, 16th, etc. units). It is

not possible to calculate the total number of

hours required to produce all the units.

The amount of time required for the last unit is:

Initial time * LC * LC * LC . . .

learning curve analysis:

Make or buy decisions analysis of the cost to make

In calculating the cost of a contract over its life,

learning curve analysis can lead to better bidding.

In determining a breakeven point, if learning is not

considered, the result may be overstatement of the

number of units required to break even.

Standard costs can be adjusted regularly to recognize

the fact that learning causes labor costs to decrease.

In capital budgeting, labor costs can be projected more

accurately over the life of the capital investment.

Production and labor budgets can be adjusted to

accommodate learning curves.

More effective evaluation of managers.

Limitations of Learning

Curves

It is only applicable in a situation in which

experience leads to improvement (labor

intensive tasks)

We assume that the learning curve rate is

constant, when in reality it probably is not

We assume that all increases in

productivity are due to the learning

process, when there may be other factors

causing the productivity increase

Probability

Probability

The probability of an event happening is the

chance that it will happen.

The probability of a single event happening

must be between 0 (no chance of it occurring)

and 1 (it is certain to occur)

There are two basic requirements of

probability:

The probability values assigned to each of the

possible outcomes must be between 0 and 1

The probable values assigned to all of the possible

outcomes must total 1

Conditional Probability

The conditional probability is the

probability of an event (Event B)

occurring, given that (assuming

that) another event (Event A) has

already occurred

It is shown as P(B|A), read as the

probability of B given A

Joint Probability

Joint probability is the probability of one or more

events all occurring one after another.

It is calculated as the probability of each

individual event multiplied together.

If the occurrence or nonoccurrence of one event

does not change the probability of the

occurrence of the other event, the two events

are said to be independent.

If the occurrence of one event means that

another event cannot occur, the two events are

said to be mutually exclusive.

Probability

Example:

The probability of sales being $1,000,000 in Year 1 is

30%.

Assuming that sales are $1,000,000 in Year 1, there

is a 40% probability that sales will be $1,500,000 in

Year 2.

The Conditional Probability that sales will be

$1,500,000 in Year 2, assuming that they are

$1,000,000 in Year 1, is 40%.

The Joint Probability that sales will be $1,000,000 in

Year 1 and $1,500,000 in Year 2 is (30% * 40%), or

12%.

Methods of Assigning

Probability

There are three main ways of determining the

probability of an event:

Classical method each outcome has an equal

chance of occurring.

Relative frequency method this method may be

used when there is factual information from which the

frequency can be determined, such as past

information or a sample (also called Objective Method)

Subjective method this is used when there is no

past information or sample to use and the decision

maker simply assigns probabilities as they seem

reasonable

Variables

A random variable is a variable that can have any

value within a range of values that occurs

randomly and can be described using probabilities.

Discrete random variables are variables that must

have a whole number value (for example, 1, 7 or

193). These variables may not be shown as a

continuous line.

Continuous random variables may have any value,

whole or fractional. As such, 17.392 is a possible

result for a continuous random variable, but not for

a discrete variable.

Expected Value

In expected value we are trying to determine

what the expected result will be in a situation

of uncertainty.

This is done by multiplying each of the possible

outcomes by the likelihood (probability) of that

outcome occurring. All of the results are then

added together to determine the expected

value.

The expected value is a weighted average of

all the possible values, weighted according

to their probabilities.

The variance and standard deviation both

Deviation

give us an idea of the variability of the

The variance is the sum of the squares of all

the differences or deviations from the

mean (average), weighted according to their

probabilities. (The variances are squared to

eliminate negative values.)

The standard deviation is the positive square

root of the variance. Because it is the square

root of the variance and the variance contains

squared numbers, the standard deviation is

measured in the same units as the values.

distributed around the mean (average) in a

bell shaped curve

The curve may be tall and narrow or short

and flat or anything in between

The standard deviation is a measure of the

dispersion of the values.

A high standard deviation means that the

results are highly variable and a low

standard deviation means the results do

not vary much.

In a normal distribution

68% of the expected values will be

within one standard deviation of the

mean.

95% of the expected values will be

within two standard deviations of the

mean.

99.7 of the expected values will be

within three standard deviations of the

mean.

Value

Risk is a situation in which there is a chance

of the result being different from the

expected outcome it exists when we are

not 100% certain of the result.

Risk is measured using the variance and the

standard deviation

It exists when we have no way of determining

what the expected result is using historical

information or other data. The probability

distribution must be determined subjectively.

The coefficient of variation measures the

risk for each unit of expected return.

It is calculated as follows:

Standard Deviation

Expected Return

The higher the coefficient of variation,

the riskier the investment.

Measures of central tendency are

values typical of a set of data.

The mean is the average of a set of

numbers.

The median is the halfway value if raw

data is arranged in numerical order

from lowest to highest.

The mode is the most frequently

occurring value. If all values are unique

(different from each other), no mode

exists.

Sensitivity Analysis

In sensitivity analysis the company is trying to

determine which variables influence the end result

the most.

By running the model with different variables, the

company can identify the variables whose

fluctuations cause the greatest change in the

fluctuation of the result.

Sensitivity analysis can be used with linear

programming to see how the optimal solution to

the objective function will change if a coefficient in

the objective function or if the right-hand value of

one of the constraint functions is changed.

Analysis

Pro-forma Financial

Statements

Pro-forma financial statements contain

projected amounts that are expected if a

particular course of action is followed.

see what the financial statements of the firm will

look like if something that is under consideration or

forecasted actually happens.

evaluate the effect on the companys finances if a

particular sales forecast is realized

Used to perform other what if scenarios

They include a pro forma income statement, a pro

forma statement of financial position (balance sheet)

and a pro forma cash flow statement.

Statements contd

Pro forma financial statements are used internally

for five general purposes:

1. compare the companys anticipated performance with its

target performance and with investor expectations.

2. To perform what if analysis, to forecast the effect of a

proposed change.

3. determine in advance what the companys future

financing needs will be.

4. To prepare various cash flow projections using different

assumptions in order to forecast the various capital

requirements to maximize shareholder value.

5. determine if the company will remain in compliance with

the required covenants on its long-term debt

Various approaches to financial forecasting are

used, depending upon the situation. The three

primary approaches used are:

Experience Because sales, expenses or earnings have

grown at a particular rate in the past, we assume they

will continue growing at that rate in the future. This

leads to trend projections.

Probability We assume something will happen in the

future because the laws of probability indicate it will.

Correlation Because there has been a high correlation

in the past between one factor and another factor, we

use what we know about the first factor to forecast the

second factor.

Sales Forecasting

information has limited value.

Historical sales growth rates need to be

adjusted for any known factors that will affect

future sales. Future sales depend upon many

events that occur in the future. Examples

include:

State of domestic and international economy

Growth prospects for the market in which the

company operates

The companys product line

The companys marketing effort

Sales Forecasting

contd

negative business issues:

if the companys market expands more than the

company expects it to, the company will not be able

to meet the added demand and will lose customers to

its competitors

If the forecasted sales are too high, then the company

could end up with excess capacity and inventory

about the future along with historical information

and not simply rely on a forecast made using

regression analysis or any of the other

forecasting techniques

company will need additional funds:

Accounts receivable increase in proportion to sales

growth

Company may need new production equipment

expected asset increase:

1. Spontaneous liability increase (whereby accrued

liabilities increase because of increased activity)

2. Profits from the additional sales

3. External sources such as borrowing or the issuance

of securities

contd

will be required depends upon several

factors:

Companys rate of sales growth

Companys capital intensity ratio (amount

of assets required per dollar of sales)

Companys spontaneous liabilities-to-sales

ratio

Companys net profit margin

Companys retention ratio

Planned changes in policies and procedures

(management decisions)

contd

about 30 days in the future and is based on

actual data (i.e. expected receipts from actual

accounts receivable etc.) rather than on

projected data.

Medium-term forecasting covers periods up to

one year in the future. Long-term forecasting

covers multiple years.

The Forecasted Financial Statement method is

a method of forecasting the additional funds

needed that is well suited to medium- and

long-term use. It is not the only method, but it

is the most flexible method and the one

The forecasted financial statement method

(FFS) is an approach to forecasting future

financing needs.

The key points regarding this approach are:

It requires a company to forecast a complete set of

financial statements including the income

statement, balance sheet, and statement of cash

flows

All the sources of financing are forecasted including

existing debt and equity

The difference between forecasted total assets,

liabilities and equity is the additional funds needed

(a plug on the balance sheet)

contd

entire balance sheet and income statement.

The pro forma balance sheet and income

statement can then be used to create the pro

forma statement of cash flows.

The steps in forecasting using the FFS method

are:

1. Analyze historical ratio such as cash to sales,

inventory to sales, accounts payables to sales,

etc

2. Forecast the income statement

3. Forecast the balance sheet

4. Construct a pro forma statement of cash flows

Developing the financial forecast alone is not

meaningful unless it is also analyzed to

determine whether the firms forecasted

financial situation meets the firms targets.

If not, the changes will be need to both the forecast

and the operating plans that led to the forecast

The pro forma financial statements will need to be

redone

Part of the analysis is an analysis of financial ratios.

Ratio analysis is used to compare the firms actual

ratios and projected ratios with target ratios as well as

the latest industry average ratios.

Contd

analysis of forecasted financial statements include:

Current ratio = total current assets/total current assets

Inventory turnover = annual cost of sales/inventory

Days sales in inventory = 365 / inventory turnover OR

average inventory / (cost of

goods sold/365)

Accounts receivable turnover = annual credit sales /

accounts receivable

Days sales in receivables = 365 / accounts receivable

turnover OR average

accounts receivable /(annual

credit sales / 365)

Contd

analysis of forecasted financial statements include

(contd):

Interest coverage ratio = EBIT / interest expense

Asset turnover = net sales / total assets

Debt to equity ratio = total liabilities / total equity

Gross profit margin = gross profit / net sales

Net profit margin = net income1 / net sales

Return on assets = net income1 / total assets

Return on equity = net income1 / total equity

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