Certified

Management
Accountant
 Part 1 : Financial Planning,
Performance and Control

Section B : Planning, Budgeting,

and Forecasting

Topic 3 : Forecasting Techniques

 Forecasting Techniques
• Quantitative Methods:
When planning for the future, a company faces some degree of uncertainty and will
rely on a variety of quantitative methods to help it make better decisions.
This content focuses on quantitative methods in three areas:
– Data analysis :
• Involves analyzing a given set of data to establish the relationship and/or pattern in
the data.
• These analyses can be used to predict the outcome based on a given set of
conditions such as with regression analysis or they can be used to forecast the
outcome based on an established pattern.
– Model building :
• Involves creating a mathematical model that establishes the relationship between
different factors.
• Learning curve analysis is one type of model that is used to determine how the
amount of time required to produce a product changes as the number of units
produced changes.
– Decision theory :
• Deals with uncertainty by looking at various potential outcomes that can happen in
the future, along with the likelihood of these outcomes occurring. Expected value is
one method that deals with uncertainty. 3
 Forecasting Techniques
• Regression Analysis:
– Linear regression analysis is a statistical method used to determine the impact one variable (or a
group of variables) has on another variable.
– It provides the best, linear, unbiased estimate of the relationship between the dependent
variable (Y) and one or more independent variables (X or X’s).
– Linear regression often is used by management accountants to analyze cost behavior (i.e.,
determine the fixed and variable portions of a total cost) or to forecast future events such as
sales levels.
– The assumptions underlying linear regression are:
• Linearity : The relationship between the dependent variable and the independent variable(s) is linear.
• Stationary : The process underlying the relationship is stationary. This assumption is often called the
constant process assumption.
• The independent variables (X’s) in multiple regression analysis are independent of each other. There
is no multi-colinearity .
– Regression analysis creates a linear equation based on the relationship between a dependent
variable and one or more independent variables.
• The dependent variable (Y) is the value being forecast, such as sales or total costs.
• The independent variables (X’s) are the factors that are assumed to influence or drive the variations
seen in the dependent variable.
• It is assumed that the relationship between the dependent variable and the independent variable
remains constant (hence the linear relationship).

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 Forecasting Techniques
• Regression Analysis:
– There are two main types of regression analysis:
• Simple regression analysis : which uses only one independent variable.
• Multiple regression analysis : which uses two or more independent variables.
– Regression analysis equations systematically reduce estimation errors and are therefore also
called least square regression.
– Regression analysis fits a line (the regression line) through data points—a line that minimizes
the difference between the line (prediction) and the data point (actual).
– The statistical formula that the regression is based on produces the least amount of error
between these two items.

Quarter Marketing Sales Marketing Sales Marketing Sales

Costs $000 $000 Costs $000 $000 Costs $000 $000
Year 1 Year 2 Year 3
Q1 50 48000 100 89000 40 62000
Q2 30 40000 90 105000 90 130000
Q3 40 62000 80 73000 70 80000
Q4 60 75000 110 105000 50 50000
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 Forecasting Techniques
Sales
140000

120000
Annual Sales (Y)

100000

80000

Sales
60000

40000

20000

0
0 20 40 60 80 100 120
Marketing Budget (X) 6
 Forecasting Techniques

𝑌 = 𝑎 + 𝑏𝑋
where:
• Y = annual sales; it is the dependent variable to be forecast.
• a = amount of Y when X = 0. This value is also called the Y intercept.
• b = slope of the line, also known as the regression coefficient.
It represents the “impact” X has on Y. For every 1 unit change in X.
• X = value for the independent variable (in this case, marketing costs) .

Intercept = 18444809 Slope = 861 Marketing Cost = 75000

𝑌 𝑆𝑎𝑙𝑒𝑠 = 18444809 + 861 𝑿 75000

Y (Sales) = 83019809

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• Regression analysis also provides a number of objective benchmarks that allow users to evaluate
the reliability of the regression equation. Three common measures are :
R-squared, T-value, and standard error of estimate (SE).
– R-squared :
• R-squared (goodness of fit or coefficient of determination) is a value between 0 and 1 indicating the
degree to which changes in a dependent variable can be predicted by changes in independent
variables.
• It is the percentage of the variation in the dependent variable accounted for by the variability in the
independent variable.
• A regression with an R-squared value closer to 1 has more explanatory power than a regression with
an R-squared value closer to 0. Graphs of regressions.
• The R-squared value in previous example is 0.7127. This means that approximately 71.27% of the
variation in sales is accounted for by variation in marketing costs.
– T-value :
• T-value measures whether an independent variable (X) has a valid, long-term relationship
to a dependent variable. Generally.
• The T-value should be more than 2. A variable with a low T-value indicates little or no
statistically significant relationship between the independent and dependent variables,
and the variable should be removed from the regression because it can lead to
inaccurate forecasts.
– Standard Error of Estimate :
• The SE measures the dispersion around the regression line and allows the user to assess the accuracy
of the predictions, That is, a user can build a confidence interval around the estimate.

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 Forecasting Techniques
• Multiple Linear Regression :-
• In simple linear regression analysis was used to estimate the impact that the amount of money spent on
marketing would have on the company’s sales.
• Based on the results of the analysis, the R-squared is only 0.7127. That means only 71.27% of the variation in
sales can be explained by changes in marketing expenditures, and the remaining 28.73% (100% – 71.27%) is
explained by changes in other factors that are not included in the regression model.
• In forecasting sales, an organization needs to take into consideration not only its marketing efforts but other
factors, such as the economic conditions, its competitors’ actions, its pricing strategy, and so on.
• All of these other factors can be incorporated into a multiple regression model, where they become the
additional independent variables that can help to explain the other 28.73% in sales variation that cannot be
explained by marketing expenditures.

𝑌 = 𝑎 + 𝑏1𝑋1 + 𝑏2𝑋2 + 𝑏3𝑋3 + 𝑏4𝑋4

• In addition to the R-squared, T-value, and standard error of the estimate, evaluating a multiple regression model
requires the user to evaluate the correlation between the independent variables (X’s) to assure the lack of
multicolinearity.
• A correlation matrix of the independent variables is used to accomplish this.
• As a general rule of thumb, as long as the correlation between any two independent variables is 0.7 or below,
there is no problem.
• If the correlation between two of the independent variables is 0.7 or above, then one must be eliminated and
the regression analysis must be run again.

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 Forecasting Techniques
• Benefits and Shortcomings of Regression Analysis:
– Regression analysis gives management accountants an objective measure to use in evaluating the
precision and reliability of estimations.
– It is important to prepare a graph of the data prior to using regression analysis and to determine
whether any unusual data points, called outliers, are present.
– Regression analysis can be influenced strongly by outliers, which may result in an estimation line
that is not representative of most of the data.
– If present, each outlier should be reviewed to determine whether it is due to a data recording error,
a normal operating condition, or a unique and nonrecurring event.
– Regression analysis requires a collection of data points—preferably 30 or more—to be accurate.
– In the case of analyzing cost behavior, this linear assumption can be problematic if it is expected that
costs decline due to learning curves or when there are different relevant ranges of activity that
cause costs to shift.
– Regression analysis also assumes that past relationships between dependent and independent
variables will hold into the future.
– When using regression analysis as a forecasting tool, it is important to evaluate or make adjustments
for changes in the relationship between the variables over time. For example, clear knowledge that
one part of a variable cost element is increasing makes the b coefficient less reliable for future
periods.
– When using the results of a regression analysis to make any prediction, it is important to remember
that the dependent variables used for the prediction must fall within the range of the data set used
to establish the regression line.

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 Forecasting Techniques
• Time Series Analysis:
– Time series analysis is an regression analysis which time is used as independent variable.
– Four components combine to provide the overall pattern in a time series analysis :
Trend, Cycle, Seasonality, and irregular variation

 Trend : Gradual Shift to higher (up-solping) or lower (down-sloping)

 Cycle: Cyclical Fluctuations explained by a cycle in the overall economy
 Seasonality : Variable within fiscal or calendar year.
 Irregular Variation : random variability in time series (noise)
• Smoothing
– Smoothing us an analytical method that levels out the random fluctuation from the irregular
component of time series.
– Smoothing generally provides a high level of accuracy for short-range forecasts..
– There are three smoothing methods :
Moving Average, Weighted moving average, Exponential smoothing
Moving Average :
Using the average of the most recent data value set of a given time period
𝑀𝑜𝑠𝑡 𝑅𝑒𝑐𝑒𝑛𝑡 𝐷𝑎𝑡𝑎 𝑉𝑎𝑙𝑢𝑒𝑠 𝑓𝑜𝑟 𝑛
𝑀𝑜𝑣𝑖𝑛𝑔 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 =
𝑛
Example : Timmy Co. Sales for the last 3 years : $172, $185, $192

(172:185:192)
𝑀𝑜𝑣𝑖𝑛𝑔 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 = = $183 Million 11
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 Forecasting Techniques
Weighted Moving Average :
Assumes that the most recent data has more power of prediction than data that came before.
Each prediction has a weight as a fraction of a whole so that all the weighting equal 1.
Example : if the weight for the pervious data is : 0.2 & 0.3 & 0.5

Weighted moving Avg = 0.2(172) + .03 (185) + 0.5 (192) = $185.9

Exponential Smoothing
Uses a weighted average of past times series, selecting only one weight – that of the most recent set
of data.

Ft+1 = aYt + (1 – a)Ft

Ft+1 = Forecasting for the next period
a = Smoothing constant (0<=a<=1)
Yt = Actual for current period
Ft = Forecasting for the current period
Example : if a= 0.2, Y2 = 180, F2 = 150

F3 = 0.2 X 180 + 0.8 X 150 = 156

**Exponential Smoothing technique working well when time series is stable 12
 Forecasting Techniques
Learning Curve Analysis
• Learning curve analysis is a systematic method for estimating costs based on increased learning by
the business, group, or individual, which allows them to become more efficient at completing
tasks.
• As a result, costs will decrease as learning increases. However, this happens only to a certain point,
and then costs level off.
• The learning curve is sometimes also called the experience curve.
• Calculation of the learning curve is based on the learning rate, which is the percentage by which
average time decreases from the previous level as output doubles.
• The learning curve can be measured in two ways:
1. Incremental unit-time learning model (also called the Crawford method)
2. Cumulative average-time learning model (also called the Wright method).
• The cumulative average-time learning model (Wright method) is the generally accepted model.
• Typical decreases in time based on learning range from 10% to 20% each time production doubles.
• A learning curve for a 20% reduction is called an 80% learning curve; a 10% reduction arises from a
90% curve.
• Because of their different approaches, the incremental unit-time and cumulative average-time
methods produce different results for the same data.
• The incremental method is considered more appropriate for large-scale, complex operations, while
the cumulative method is considered to be simpler
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• Incremental Unit-Time Learning Model
– The incremental unit-time learning model measures increased efficiency by adding the
incremental time for each unit to the previous total time.
– Average time per unit is then calculated by dividing total time by the number of units.

80% Incremental Unit learning Model

Widget Hours for this widget Total hours Avg time per widget
(X) (Y) C=a+Y C/X
1 10 (a) 10 10
2 8 (10*.8) 18 9
4 6.4 (8*.8) 31.42* 7.855
8 5.12 (6.4*.8) 53.7 13.425
– Notice that the learning curve levels off. Learning increases efficiency up to a certain point, at
– which productivity reaches equilibrium and then levels off.

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• Cumulative Average-Time Learning Model
• Calculates cumulative total time by multiplying the incremental unit by the cumulative average
time per unit.

80% Cumulative Average-Time learning Model

Widget Cumulative Avg time Cumulative total time Individual time for
(X) (A) T xth widget
(A* X)
1 10 10 10
2 8 (10*.8) 16 8
4 6.4 (8*.8) 25.6 7.855
8 5.12 (6.4*.8) 40.96 13.425

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 Forecasting Techniques
• Benefits of Learning Curve Analysis :
– Companies use learning curves to make a number of decisions, including setting prices.
A company may set a price lower than the initial costs of production in order to gain
market share, based on the assumption that as learning increases, production costs will
decrease.
– Some companies use learning curve analysis when evaluating performance, because it
expects an individual’s productivity to increase with the individual’s learning curve.
– Learning affects quality and improves productivity
• Limitations of Learning Curve Analysis :
– The learning curve approach is not as effective when machinery performs repetitive
tasks, such as robotics. It is most appropriate for labor-intensive contexts that involve
repetitive tasks, long production runs, and repeated trials.
– The learning rate is assumed to be constant in the calculations, but actual declines in
labor time are not constant. The analyst needs to update projections based on the
observed progression of learning.
– Conclusions might be unreliable because observed changes in productivity actually may
be due to factors other than learning, such as a change in the labor mix, the product
mix, or some combination of the two.

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 Forecasting Techniques
• Expected Value :
• When a company is trying to forecast its sales for the upcoming year, the
results can vary depending on the economic conditions.
• IF the economy is booming, the company’s sales may be higher, but if the
economy is in a recession, the company’s sales will likely be lower.
• Thus, future sales are considered to be a random variable because their
outcome is uncertain.
• After creating sales forecasts based on various economic conditions and
assigning a probability for the likelihood of each economic scenario, the
company can lay out the sales forecasts and probabilities for the various
scenarios in a table.
Expected Value (EV) = 𝑆 𝑋 𝑃𝑋
EV = expected value
Σ = sum of the variables that follow in the equation
S = amount associated with a specific outcome
Px = probability associated with a specific outcome
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 Forecasting Techniques
Economic condition Sales Forecast Probability
Boom $ 3,000,000 0.10
Average $ 2,000,000 0.80
Recession $ 600,000 0.10

Expected sales = $3,000,000(0.1) + $2,000,000(0.8) + $600,000(0.1) = $1,960,000

• In this example, given the uncertainties associated with the economic
conditions, the company expects its sales, on average, to be $1,960,000 for the
upcoming year.
• It is important to note that this is not the actual outcome the company will see
in the upcoming year. The expected value simply represents the long-run
average of the outcome (in this case, sales) based on the given uncertainties
(represented by the probability assigned to the different outcomes).

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• Benefits and Limitations of Expected Value
– The expected value technique helps an organization determine the average
outcome of an event when faced with uncertainties.
– These averages often help the organization decide whether it should undertake
certain actions.
• For example:
– An organization may be presented with an investment option with a 60% chance of
making a profit of $300,000 and a 40% chance of incurring a loss of $500,000. The
calculation of the expected value of this investment reveals that the expected
profit is:
– Expected Profit : ($300,000 × 0.6) + (−$500,000 × 0.4) = −$ 20,000
– In other words, this investment is expected to lose, on average, $20,000.
– Given this information, it would not be a good idea for the organization to pursue
this investment.
– However, the expected value calculation is only as good as the estimated potential
outcomes for each scenario and the probability assigned to each scenario.
– IF any of these assumptions is unreliable, then the expected value that is calculated
cannot be trusted in making sound decisions.
– Expected value analysis assumes that the decision maker is risk neutral.
– IF the decision maker is either a risk taker or risk averse, then the expected value
model would not be appropriate. 19
 Forecasting Techniques
• Sensitivity Analysis. :
– Decision maker use sensitivity analysis to help decide what changes in a given situation
(called “state of nature”) are most likely to produce a particular outcome (called
“payoff”).
– Sensitivity analysis can be used to study impacts on qualitative as well as quantitative
“state of nature” and “payoff”.
– Sensitivity analysis is a type of “What if analysis” because it is conducted by changing a
specific variable and determining how sensitive the outcome is to changes in input.

Alternative probabilities for economic conditions

Economic Sales Forecast Original Alternative Alternative
condition Probability Probability 1 Probability 2
Boom $ 3,000,000 0.10 0.6 0.1
Average $ 2,000,000 0.80 0.3 0.2
Recession $ 600,000 0.10 0.1 0.7

Expected sales original = $3,000,000(0.1) + $2,000,000(0.8) + $600,000(0.1) = $1,960,000

Expected sales A1 = $3,000,000(0.6) + $2,000,000(0.3) + $600,000(0.1) = $2,460,000
Expected sales original = $3,000,000(0.1) + $2,000,000(0.2) + $600,000(0.7) = $1,120,000
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 Forecasting Techniques
• Benefits of senitivity analysis
– Sensitivity analysis shows managers how susceptible the outcomes of decision are to
change in any parameter or estimate.
– Managers should be aware of the mutual relationships between different parameters or
estimates
– Sensitivity analysis can be used to estimate the impact on the outcome of decisions of
occurrences that may or may not happen. This is sometimes called the “What-If-
approach”
• For Example : What if workers strike and hold up production? What will be
the impact on the bottom line?

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End of Topic
Mr. Tamer Bedir
tamerbedir_81@yahoo.com
00966541553318

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