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Financial forecasts for the final cost of activities are created to allow activity managers to make wise business decisions.  The approach used for forecasting should vary based upon the nature of the activities being forecasted.

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Forecasting Expenses

Financial forecasts for the final cost of activities are created to allow activity managers to make wise business decisions.  The approach used for forecasting should vary based upon the nature of the activities being forecasted.

When to Use Expense Forecasting

A budget is a forecast of expenses before the year or project starts.  As the year or project progresses, more information is available.  Actual spending occurs and it is seldom precisely what was in the budget.  With this information and better insight into current business conditions, the forecast can be improved.  I recommend starting annual forecasts after the first quarter and starting project forecasts after the first major milestone.  Forecasts are typically done monthly once the financial variance report for the previous month has been completed.

Instructions

Expense forecasts can be done for an organization, department, project, or specific account and activity.  They are done based upon an assessment of recent financial spending, the nature of the remaining work, and an assessment of upcoming business and industry events.  Forecasts are always based upon a set of planned activities or functions that must be supported.  There are three fundamental forecasting approaches.

  • Bottom-up forecast:  This is essentially starting over with the budgeting process.  A new set of tasks or activities that must be supported during the forecast time period is created.   An estimate for the spending required for each of those activities is generated.  These estimates are summed to create a forecast.
  • Trend forecast:   In this case the existing budget and spending are used as the starting point.  The variance between the budget and actual spending is determined.  The percentage of underrun or overrun is considered the trend for the organization or activity and that same percentage is applied to the total budget to create a forecast for the total spending.
  • Straight-line forecast: This is the simplest forecast since it does not require any budget or understanding of the remaining work.  The total amount of spending – for whatever reason - is extrapolated to continue at the same rate through the rest of the year or project. While the easiest forecast to generate, it can be very inaccurate unless the nature of the work is at the same level each time period (known as level-loaded).

 

Department Forecasts 

The most common approach used for forecasting functional departments is the trend approach.   Any business or industry effect that is causing an underrun or overrun is likely to continue.  If the departments work is “level-loaded,” the straight-line approach will also be fairly accurate.   

In many functional department budgets there are some activities that are level-loaded and some that are tied to an event, such as a plant shutdown or major tradeshow.  When the department budget is structured in this manner, a mixture of forecasting approaches may be required.  Use straight-line or trend analysis to forecast the level-loaded work.  The event related work should be forecasted with the trend analysis or bottom up approach.

 

Project Forecasts

Generally, the bottom-up approach is best for project activities.  Specific project activities are often of short duration and can involve unusual and one-time work.  The forecasts for these are changed in a bottom-up analysis based upon what has been learned on other project activities.

I normally forecast project work in “chunks.”  Either do it for one each phase or for each milestone.  If your business has a financial system that supports the earned value management methodology, that approach is far better than any other.  However, most companies do not have this capability.

Finance organizations will often use straight-line analysis for project activities because it is a simple approach and it is the approach that is most often used for other overhead expenses.  However this approach relies on two assumptions that are usually false with respect to project activities.  Those assumptions are: 1) project work is level-loaded – the reality is that most project work occurs in spikes and valleys.  2) project work is on-schedule – the reality is that project work is often ahead or behind schedule and that is the reason that money has been spent or not spent.    

 

Hints and Tips

  • Straight line analysis is a good quick approximation for any type of forecast, but don’t rely on it for the final forecast if the activities are not level-loaded.
  • If a major unplanned event occurs in your business or industry (natural disaster, merger, recall, etc.) do a new forecast with the new set of industry and business assumptions.
  • When a project is nearly finished or during the last month of the year, do a bottoms-up forecast of the known work that will be completed in order to forecast the final value of spending.
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  • 00:04 Hi, I'm Ray Sheen.
  • 00:05 As managers, we're often asked to manage our organizations so we hit key targets.
  • 00:10 And some of these are financial targets.
  • 00:12 So let's talk about how we can forecast expenses.
  • 00:16 Let's start by clarifying what goes into a forecast.
  • 00:20 A forecast is the expected future results of a set of financial transactions.
  • 00:25 Normally we do forecasts for our business department or project.
  • 00:29 When forecasting, we can do the forecast at a macro level for
  • 00:32 an entire department or project.
  • 00:34 Or you can do the forecast at the account level within the department or project.
  • 00:39 A forecast is an educated guess, it is based upon a set of assumptions.
  • 00:43 These include assumptions about industry conditions, business conditions.
  • 00:48 And assumptions about the activities and the performance of the individuals.
  • 00:51 Doing the work of the department or project.
  • 00:54 Most individuals in organizations use one of three common forecasting techniques.
  • 00:59 These are straight line analysis, trend analysis, or a new bottom up estimate.
  • 01:05 I'll review straight line analysis and
  • 01:07 basic trend analysis in the next few slides.
  • 01:10 A new bottom up estimate is just that, an estimate.
  • 01:13 There's another module in this program that addresses how to do estimates.
  • 01:16 So, we'll discuss it again now.
  • 01:19 So, lets talk about straight line forecasts.
  • 01:22 This is the easiest of all forecasting methods.
  • 01:25 This method is typically used on a functional department level.
  • 01:28 That would have aggregated a number of cost accounts.
  • 01:32 The fundamental assumption behind this technique,
  • 01:34 is that the spending will continue at the current rate.
  • 01:37 This technique does not require a budget to have been set.
  • 01:40 It only uses the actual spending.
  • 01:43 The forecast is calculated by taking the cumulative
  • 01:46 amount of spending as of a particular date.
  • 01:48 And extrapolating that spending through to the end of the year.
  • 01:51 In the example shown, the department has spent $2.5 million through the end of May.
  • 01:57 Extrapolating that through the end of the year,
  • 01:59 would forecast a total of $6 million.
  • 02:02 On the example a budget line is shown.
  • 02:04 However, as you can see the budget number is not used in the calculations.
  • 02:08 This technique is very quick and simple.
  • 02:11 However, it assumes the spending will be the same every month.
  • 02:14 No spikes or valleys in spending.
  • 02:17 Now let's look at the trend analysis forecasting approach.
  • 02:21 This technique is a little more complex.
  • 02:23 And it can be used either at a total department level or
  • 02:26 at an individual account level.
  • 02:28 For either department or project accounts.
  • 02:31 This also assumes that the effects causing an overrun or underrun will continue.
  • 02:35 But it allows for valleys and spikes in spending.
  • 02:39 This starts by determining the percentage of overrun or underrun.
  • 02:43 In the account or accounts being forecasted.
  • 02:46 The percentage is then applied to the total value for that account.
  • 02:50 So if a travel account has a 10% overrun after the first few trips.
  • 02:54 And the total budget for that account is $50,000.
  • 02:57 The trend analysis forecast is for that account to finish at 55,000.
  • 03:01 This is an easy set of calculations and
  • 03:04 a forecast that is likely to be more accurate than straight line.
  • 03:08 Let's look a little more closely at project forecasts and
  • 03:11 some of the challenges.
  • 03:13 The finance community likes to use the straight line method.
  • 03:16 Because it is both easy, and based upon actual data.
  • 03:18 And that is why they normally use it for department forecasts.
  • 03:22 This approach is not appropriate for projects.
  • 03:25 Project spending is not even from month to month, it has spikes and valleys.
  • 03:30 In addition, a project can be ahead or behind schedule.
  • 03:33 That means that it won't automatically finish on the last day of the fiscal year.
  • 03:37 The end date is unknown.
  • 03:39 Therefore, it is difficult if not impossible to know how long to extend
  • 03:43 the straight line.
  • 03:44 So let's discuss the options for doing project forecasts.
  • 03:48 The best method is earned value forecasting.
  • 03:50 It is essentially a trend analysis forecast on steroids.
  • 03:54 If your business has an earned value system, use it.
  • 03:57 However most organizations don't have an earned value system.
  • 04:01 There's an entire module devoted to this topic
  • 04:03 in the earned value portion of this class.
  • 04:06 If you don't have an earned value system.
  • 04:08 I suggest you use one of these two approaches.
  • 04:11 The first is to forecast the project one phase at a time.
  • 04:14 When using this approach, have the project team members provide a forecast.
  • 04:18 Of the work underway in the current phase.
  • 04:21 Usually with a bottom up approach.
  • 04:23 Then use the original budget for the succeeding phases.
  • 04:26 Applying any known changes in rates or estimates.
  • 04:29 That have occurred since the project was originally created.
  • 04:33 The other approach is to forecast project activity one deliverable at a time.
  • 04:38 This can apply to both internal efforts.
  • 04:40 Such as building hardware, software, testing, tooling or doing travel.
  • 04:44 I typically will use a trend analysis on this type of account.
  • 04:47 It will also work for
  • 04:49 sourced items such site work, construction, or purchasing systems.
  • 04:53 In this case, I usually rely on bottom up estimates from the supplier.
  • 04:59 Some managers are intimidated at the thought of creating forecasts.
  • 05:03 However, the math is easy,
  • 05:05 just pick your technique that fits the business conditions.

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