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Accuracy & Error in Financial Forecasting

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  • 0:00 What Is a Financial Forecast?
  • 0:54 Inaccuracies
  • 2:14 When a Forecast Is Too High
  • 2:56 When a Forecast Is Too Low
  • 3:36 When the Financial…
  • 3:59 Lesson Summary
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Lesson Transcript
Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

After reading this lesson, you will see just how much impact a financial forecast has on the potential growth of a company. Learn how inaccuracies develop and why forecasting too much or too little can have negative consequences.

What Is a Financial Forecast?

How do companies plan for the future? How much product should you make? Should you hire new people or cut back?

Many companies perform a financial forecast analysis so they can decide how to proceed in the near future. We define a financial forecast as a company estimating or predicting what its future income and expense will be. This includes:

  • How many products the company expects to sell
  • How much money it costs to make those products
  • How much money the company will earn from these sales

A company will then operate based on this financial forecast. For example, a toy store called RoboToys may forecast that in the next year, it will sell 5,000 units of its robotic toys. The company will then prepare to meet this forecasted demand. It may purchase new production machines so it can produce that many toys.

Inaccuracies

Inaccuracies come in when this financial forecast does not match what really happens. An overestimation or underestimation can both make a company suffer. Where do these inaccuracies and errors come from?

Some companies try to use complicated metrics and other complicated statistical methods to try and forecast their future financial earnings. Often times, when the method is overly complicated, it takes the focus away from the important aspects of the forecast and thus introduces more errors. Also, it's difficult to get an accurate financial forecast for new businesses as they don't have past financial data to gauge from.

Sometimes a company might forget a key factor that will affect their prediction. For example, in 2014, the Chief Financial Officer of Walgreen's forecasted that their pharmacy would make $8.5 billion. Two months later, he cut that by over a billion dollars, shocking investors and ending in his pressured resignation. Apparently the forecast had not included an increase in cost of a lot of their common generic drugs.

Let's look at three scenarios, one where the forecast is too high, another where the forecast is too low, and one where the forecast is just right. We'll see what happens in all three scenarios. We'll stick with the toy company introduced in the beginning.

When a Forecast Is Too High

RoboToys has a financial forecast for 5,000 sold robotic toys for the next year. The company spends money to purchase equipment so it can produce that many units of the robotic toy. It also hired more employees in anticipation of this new demand. But, after the year is over, the company finds that it now has a warehouse full of 2,000 unsold robotic toys. The company ended up selling only 3,000 robotic toys.

Because the company's financial forecast has an error of 2,000 toys, the company suffers financially. The company spent unnecessary money on the machines needed to produce more of these robotic toys. It also lost money on the wages of the extra employees.

When a Forecast Is Too Low

On the other hand, say RoboToys ends up getting 8,000 orders for the robot toy. Now, the company has to scramble to make the 3,000 additional toys that were ordered, if at all possible. The company may not be able to meet the demand. The company may need to cancel the orders it can't ship out in time.

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