Chapter 4

 

Additional Concepts in Budgeting

 

So far, we have emphasized simple approaches to preparing budgets, such as looking at relationships between account balances and sales. We also should have a clear understanding of past financial performance to help us predict future financial performance. Extending past trends and adjusting for what is expected is a common approach to preparing a forecast. However, we can improve forecasting by using several techniques. The first step is recognize certain fundamentals about forecasting:

 

1.      Forecasting relies on past relationships and existing historical information. If these relationships change, forecasting becomes increasingly inaccurate.

2.      Since forecasting can be inaccurate due to uncertainty, we should consider developing several forecast under different scenarios. We can assign probabilities to each scenario and arrive at our expected forecast.

3.      The longer the planning period, the more inaccurate the forecast. If we need to increase reliability in forecasting, we should consider a shorter planning period. The planning period depends upon how often existing plans need to be evaluated. This will depend upon stability in sales, business risk, financial conditions, etc.

4.      Forecasting of large inter-related items is more accurate than forecasting a specific itemized amount. When a large group of items are forecast together, errors within the group tend to cancel out. For example, an overall economic forecast will be more accurate than an industry specific forecast.