Lecture 6

Forecasting Annual Revenues

Dr S. Makurumidze GBS CUT 1

 Forecasting
• A proper forecast combines a statistical projection of the past with expected
changes in the future. The lecture will show how to create statistical models
for projecting past behavior into the future and will demonstrate how to
recognize when past trends have changed.
• Forecasts of both annual and seasonal revenues are essential to planning a
company’s future.

Dr S. Makurumidze GBS CUT 2

 Importance of forecasting
✓ Forecasts help CFOs arrange financing for capital expenditures in plants and
facilities, plan month-to-month borrowing to meet payrolls and maintain
inventories, and invest surplus cash in short-term securities. They help CFOs
prepare financial plans and better cope with whatever the future brings.
✓ Forecasts help operations managers acquire manpower, equipment, and materials in
time to manufacture goods or provide services when customers want them. When
demands are greater than expected, companies may need to work overtime to satisfy
customers, hire temporary workers to serve customers, or reorder products so as
not to run out of stock and lose sales. Conversely, when demands are less than
expected, inventories of finished goods can pile up, the cost of holding inventories
may increase, facilities may sit idle, and workers may be sent home.
Dr S. Makurumidze GBS CUT 3
 Cont-
✓ Forecasts help sales managers keep customers happy by meeting their demands
promptly. Marketing managers can better adjust prices and develop selling strategies.
✓ • Investors decide to buy or sell stocks and other financial securities according to
their expectations of a company’s future success in the marketplace. These
expectations are partly based on forecasts.
✓ Forecasts of a company’s future earnings are important to the decisions of banks
and other lenders to grant or to refuse to make loans for capital investments.

Dr S. Makurumidze GBS CUT 4

 Regression Models
• They are popular for making both mid- and long-range forecasts.
• Regression models are equations that describe the relationship between dependent values,
such as annual sales, and one or more independent variables, such as time, advertising
budget, and the average personal income of buyers.
• They are useful for making statistical projections of past behavior for several months or
quarters to several years into the future.
• Regression models include linear and several kinds of curvilinear equations that express the
trends of historical data.
• Time will be considered as the single independent variable and express annual sales as a
function of time.

Dr S. Makurumidze GBS CUT 5

 Cont-
• Time is a composite proxy for such factors as population, personal income, inflation, and
other demographic and economic factors that are directly related, in a causal sense, to a
company’s annual sales.
• However multivariate regression models express Annual Sales Revenues as a function of a
number of such variables.
• A regression equation expresses the trend of the data. A forecast is made by extrapolating or
projecting the past trend forward, into the future. IF an equation is a valid model of the past
trend and IF the trend does not change in the future, the past and future values will all
scatter randomly about the trend line. Note the IF conditions carefully.
• The technique can be applied to financial statements variables as well as the ratios.
Dr S. Makurumidze GBS CUT 6
 Steps in creating regression models
• Once the data has been collected from records of the past, the steps for developing regression models to
project the past trend into the future include the following:
✓ Identify the type of equation that is most suitable for fitting the trend of the data.
✓ Evaluate the equation’s parameters—that is, determine the values of the coefficients of a regression equation
for fitting the data.
✓ Validate the model—that is, show that the model reproduces the data’s trend.
✓ Determine the model’s accuracy.
✓ Use the model to project future values of interest.
✓ Determine the accuracy of the forecast future values.
✓ Present the results in useful, management-quality formats

Dr S. Makurumidze GBS CUT 7

 Cont-
• Time-series models are another way to use time as the independent variable in a
forecasting model. These are autoregressive models, and they are better suited than
regression models for short-term forecasts for tactical purposes. Typical
applications include managing inventories of items that turn over quickly, as in
supermarkets, or following the daily movement of monetary exchange rates. They
can be adjusted for changes in trends and seasonality.
• Forecasting is an important management tool with many applications. For service
facilities, such as banks, supermarkets, hospital emergency rooms, toll bridges, and
information networks, the dependent variable of forecasting models can be
something as simple as the arrival of customers, which can be people, cars, or bytes
of data. These vary widely during a single day.
Dr S. Makurumidze GBS CUT 8
 Adjusting for future changes in past trends
• The basic premise in using statistical projections of past behavior as forecasts of the future is
that past trends and seasonal behavior will continue unchanged.
• If the projections are relatively short term (e.g., a few weeks or months) and conditions are
relatively stable, the projections should be accurate enough to be useful as forecasts. For long-
term forecasts, however, statistical projections of the past are best treated as the starting point for
forecasting the future.
• Making adjustments for future changes in past behavior uses various types of judgmental models,
such as the Delphi technique and sales force estimates, as well as large-scale economic models of
national and international economies.
• Spreadsheets provide many statistical and charting tools that simplify the selection and creation
of forecasting models. They make it easy to create tables and charts that present results in
convincing form.
Dr S. Makurumidze GBS CUT 9
 Linear Regression models
• To develop a linear regression model for forecasting, consider the annual
sales of Tak Limited.
• To simplify the regression equation, the actual years are replaced by the
values of X (i.e., by the number of years).

Dr S. Makurumidze GBS CUT 10

 Identify the type of Equation that best fit the
trend of data
• Identifying the trend is best done by creating a scatter plot, and examining how well
different types of equations fit the data.
• To create this chart, use the mouse to select the data in the Cells and then select
Excel’s ChartWizard. Select the “XY (Scatter)” chart type.
• Accept the default chart sub-type to plot the data points without connecting lines.
✓ Create the Scatter Plot by choosing the XY (Scatter) Chart Type.
✓ Create the Scatter Chart by making sure that the data range is correct and the series
of data are in columns.

Dr S. Makurumidze GBS CUT 11

 Evaluating the parameters of the linear
regression model
• The general equation for a straight-line or linear relationship between two
variables is
• Y = a + bX + e
• where Y = the dependent variable (annual sales)
• X = the independent variable (here the year number)
• a = the value of Y when X = 0 (called the Y-intercept) and b = the rate of
change of Y with respect to X (i.e., the slope of the line).
Dr S. Makurumidze GBS CUT 12
 Using the Model’s Parameters to Forecast
• Use the model to forecast or “fit” values of Y to values of X.

Dr S. Makurumidze GBS CUT 13

 Calculate the errors
• The next step is to calculate the errors. Errors are the differences between the data
values of the dependent variable Y and the values of Y forecast by the model.
• Statisticians also call them deviations or residuals. By convention, errors are
calculated by subtracting the forecast values from the data values rather than vice
versa. Select cells and find the differences and copying the formula to the rest of the
cells.
• Note that individual errors can be either positive or negative and their average is
exactly zero.

Dr S. Makurumidze GBS CUT 14

 Validation of the Model
• Model validation is an important step and a valid model for projecting the past trend forward must be a valid
model of the past.
• If a model does not follow the trend of the data for the past, it is not a valid model of the past—that is, it is
an invalid model because it does not satisfy the basic idea of using past data to forecast the future by
projecting the past trend forward.
• Invalid models lead to invalid projections and should be rejected.
• Even valid models lead to erroneous projections if the past trend changes and projected values are not
adjusted for the change. Using past history to forecast the future therefore consists of two essential steps:
✓ Creating a statistical model of the past that can be projected forward and,
✓ adjusting projected values for any changes in the past trend that can be anticipated

Dr S. Makurumidze GBS CUT 15

 Cont-
• For a model to be valid, the data values must scatter randomly above and below the trend line on a scatter diagram and the
average error must be zero.
• The key word here is “randomly.” and distinction must be made between a systematic and a random scattering about the
trend line.
• Analyzing the errors provides a more sensitive and useful test of randomness and model validity than simply looking at a
scatter diagram. Errors are the differences between the data and fitted values.
• Thus a valid model must satisfy each of two conditions:
✓ The average error is zero and,
✓ the errors scatter randomly rather than systematically about the average of zero.
• The first condition is automatically satisfied for the linear regression model if the spreadsheet entries are correct.
• The second condition may or may not be satisfied. Therefore, you need to check the error pattern to see if its scatter is
random or systematic.

Dr S. Makurumidze GBS CUT 16

 Cont-
• One way to examine whether or not the errors are random or systematic is
by scanning through the cells.
• When the errors starts out largely positive get successively smaller and take
on negative values as one moves down the column until a minimum value is
reached near the center and then get successively larger as one continues to
move down the column to a maximum at the end this is systematic
behavior, not random, and the model is therefore not valid.

Dr S. Makurumidze GBS CUT 17

 Random error
• Random error is referred to as “noise”, because it blurs the true value (or the
“signal”) of what’s being measured.
• Some common sources of random error include:
❖ natural variations in real world or experimental contexts.
❖ imprecise or unreliable measurement instruments.
❖ individual differences between participants or units.
❖ poorly controlled experimental procedures.

Dr S. Makurumidze GBS CUT 18

 Measuring the Model’s Accuracy
• A model’s accuracy or precision is limited by the random scatter in the data,
and a future value might be more than or less than what the model predicts.
• Determining how far off the mark our forecasts might be is important for
determining how much safety stock or how much extra service capacity we
should provide to ensure that we are able to satisfy our customers promptly,
for example, or to estimate the risk for breaking even on an investment.
• To evaluate a model’s accuracy, we calculate its standard error of estimate.

Dr S. Makurumidze GBS CUT 19

 standard error of estimate
σ(𝒀𝒅𝒂𝒕𝒂 −𝒀𝒇𝒄𝒔𝒕 )𝟐
• 𝑺𝑬𝑬 = 𝒅𝒇

• The number of degrees of freedom equals the number of sets (the number
of pairs) of data values minus the number of model parameters we’ve
estimated in the model.
• The coefficient of correlation (R) is calculated by the entry
=CORREL(Cell:Cell,Cell:Cell). This value for R is converted to the
coefficient of determination (R2 ) by squaring.

Dr S. Makurumidze GBS CUT 20

Using LINEST to Develop a Linear Regression
Model
• Select 2 columns and 5 rows, type in the formula(1st row & 1st column cell):
• =LINEST(Y values;X values;;Tab button[TRUE])
• Simultaneously press Ctrl + Shift then ‘ENTER’
Slope Intercept
Standard error of the slope Standard error of the intercept
R2-Coefficient of Standard error of the y
determination estimate
F-Statistic-determinates Degrees of freedom df (n-
whether variable is by chance. parameters)
Dr S. Makurumidze GBS CUT
Regression sum of squares (SS Residual sum of squares (SS of 21

regression) residual)
 Quadratic Regression Models
• Quadratic regression models are similar to linear regression models but
include the square of the independent variable as a third term in the
equations. Depending on one’s choice of symbols for the parameters, the
general form of the equation for a quadratic regression model can be written
as either
• Y = a + bX + cX2 or Y = b0 + b1 X + b2 X2
• The subscripts on the coefficients in equation indicate the power of the
independent variable X associated with it.
Dr S. Makurumidze GBS CUT 22
 Cont-
• Although mathematically, a quadratic equation expresses the dependence of the
variable Y on a single independent variable, X, a spreadsheet, however, treats the
squared value of independent variable as a second independent variable.
• It is the squared value, of course, that deflects the trend line from a straight-line
path. If its coefficient is positive, the deflection is upward to higher values of Y; if
negative, the deflection is downward to lower values.
• Click on the data and repeat the steps for adding a linear trend line, but choose a
second-order polynomial as shown in the Add Trendline dialog box. Use the option
tab to display the equation and R-squared value on the chart.

Dr S. Makurumidze GBS CUT 23

 Using LINEST to Develop a Quadratic
Regression Model
• Insert an additional Column for X2.
• With the mouse, select appropriate Cells and type =LINEST(D6:D16,B6:C16,1,1) (typical
cells), and press Ctrl/Shift/ Enter. The result is shown in the 3-column/5-row matrix labeled
“LINEST Output for Quadratic Model.” The values in Cells would be the values of c, b, and a.
• Use the model’s parameters to make forecasts, enter as follows: =$F$23+$E$23*B6+$D$23*C6
in Cell E6 and copy the entry,
• Calculate the errors by finding the difference.
• To validate the model, first show that the average error is zero by summing the errors then show
that the errors scatter randomly rather than systematically (error pattern at lower right).

Dr S. Makurumidze GBS CUT 24

 Cont-
• Comparing the quadratic to the linear model, you should note, first of all,
that the systematic behaviour of the errors with the linear model has been
eliminated and the errors scatter more or less randomly about the mean value
of zero.
• Comparison the quadratic regression model to the linear regression model, in
terms of the standard error of estimate for the quadratic model and the
coefficient of determination.

Dr S. Makurumidze GBS CUT 25

 LINEST output meaning
b2 b1 bo
Standard error of b2 Standard error of b1 Standard error of the
intercept
R2-Coefficient of Standard error of the model Standard error of the
determination intercept
F-Statistic-determinates Degrees of freedom df (n- #N/A
whether variable is by parameters)
chance.
Regression sum of squares Residual sum of squares (SS #N/A
(SS regression) of residual)

Dr S. Makurumidze GBS CUT 26

 Exponential Regression Model (follows FV
model)
• A common business example of a curvilinear trend is the exponential curve for the increase in the value of
money with time when the principal and interest are reinvested at a compound rate of interest. Curves for
such behavior are concave upwards; the increase in value from one year to the next gets greater each year
because of the increasing size of the accumulated funds on which interest is paid. The general equation for
such behavior is:
• F = P(1 + i)n
• where F = future value, after n periods from the start P = present value of deposit or investment (i.e., the
value of F when n = 0) i = periodic rate of interest (e.g., the annual rate of interest, compounded annually)
and n = number of interest-bearing periods (e.g., the number of years in the future).
• The formula is used in financial analysis to project present values to the future or, by using its inverse, to find
the present value of a stream of future cash flows. Besides its use for calculating future financial values,
equation is also useful for projecting many other business trends where the rate of change is a percentage of
the base value

Dr S. Makurumidze GBS CUT 27

 Re-writing the FV formula
• For the purposes of forecasting the equation can be rewritten as follows:
• Y = ABX
• Y is the dependent variable (for instance the annual sales revenue) whose value depends on X
(where X is the year or year number). Comparing with the previous equation (F = P(1 + i)n ), Y
corresponds to the future value of money in the previous equation, and X to the number of
interest-bearing periods.
• Equating X to zero, Y=A, the parameter B in equation would correspond to one plus the rate of
increase per unit change of X—that is, to 1+i in the previous equation. Copy the spreadsheet for
the linear model for analyzing the use of an exponential model to fit the data.
• Choose the exponential model, shown in the Add Trendline dialog box. Use the Option Tab to
display the equation and R-squared value on the chart.

Dr S. Makurumidze GBS CUT 28

 Using LOGEST to Evaluate an Exponential
Model’s Parameters
• To fit a set of data values to an exponential regression equation, we need to evaluate the two
parameters A and B.
• Once we have determined the value of B, we can subtract one from it to find the relative
rate of change (e.g., the percentage rate of increase or decrease).
• Excel provides the LOGEST function for evaluating the parameters A and B in the
exponential regression model.
• Its syntax (language rule) is:
• =LOGEST(range of known y values, range of known x values, 1, 1)
• The parameters of the exponential model are evaluated by selecting Cells and entering the
LOGEST rule.
Dr S. Makurumidze GBS CUT 29
 LOGEST Output meaning -Y = ABX
B A
Standard error of B Standard error of A
R^2 Standard error of the y estimate
F-Statistic Degrees of freedom
Regression sum of squares (SS Residual sum of squares (SS of
regression) residual)

Dr S. Makurumidze GBS CUT 30

 End of the Lecture

Dr S. Makurumidze GBS CUT 31