Section A.

Planning Budgeting, and Forecasting (30%) CMA Part I

A.2. Forecasting Techniques

Forecasting Techniques
Since planning and budgeting involve looking into the future, the company must make some
assumptions about the outlook for the environment in which its business operates. These
assumptions are called premises.
• When identifying premises, it is essential that management focus only on those
that will actually impact the potential Success of their business.
• By focusing on premises that are not a critical part of the organisation's success,
management is wasting valuable company time and resources.
• Some premises will affect the whole company, whereas some premises will not.
• Different departments will have different premises because of the unique tasks
they face.
o Example: The finance department concerned about the expected interest rate,
o but for the production department the interest rate will not impact in the fulfillment
of its objectives.
o the rate of growth (or rate of contraction) in the economy and the rate of inflation
(or deflation) expected during the budget period will probably impact planning and
budgeting for nearly every area of the organization.
• Once the premises have been identified and quantified, the forecasting can be
done.

There are two basic forecasting methods:

• Time series methods, which look only at the historical pattern of one variable
• Causal forecasting methods, which look for a cause-and-effect relationship
between two variables the dependent variable and the independent variable(s).

Time Series Analysis

Time series data reflects activity for one variable, (i.e. an organisation, plant, activity, or one
expense classification) over a sequence of past time periods in an attempt to find a pattern in it
that can be used in forecasting the future.
• Only one set of historical time series data is used in time series analysis and that
historical data is not compared to any other set of data.
• Time series analysis looks at patterns of the desired variable over time. These
patterns from the past are then used to forecast a future result.
A time series may have one or more of four patterns (also called components) ttiat influence its
behavior over time

1. Trend Pattern
Over a long period of time, the historical data may exhibit a trend.
• A Trend is a gradual shifting to a higher or lower level.
• If a long-term trend exists, there will probably still be short-term fluctuations
within that trend; however, the long-term trend will be apparent.
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A.2. Forecasting Techniques

• For example, sales from year to year may fluctuate but overall, they may be going
up.
• A trend pattern is anaylsed using simple regression analysis.
• A scattering of points that have no relationship to one another would represent no
trend at all.

3. 2. Cyclical Pattern
• Any recurring fluctuation that lasts longer than one year is attributable to the
cyclical component of the time series.
• The cyclical component is usually due to the cyclical nature of the economy.
• A long-term trend line can still be established even if the sequential data
fluctuates greatly from year to year due to cyclical factors.

4. Seasonal Pattern
• Jn trend and cyclical patterns, we track the annual historical movements of the
data over several years. However, to identify seasonality in the business, we observe a
time series fluctuation within the year.
• Example: a swim club's subscriptions would be highest during the warm summer
months.
• Variability in the time series due to seasonal influences is called the seasonal
component.

5. Irregular Pattern
• A random pattern, not repeating itself in any regular pattern.
• It is caused by short-term, nonrecurring factors,
• its impact on the time series cannot be predicted.

Time Series Analysis techniques: Smoothing, and Regression Trends

1- Smoothing (moving averages, weighted moving averages and exponential smoothing),

• smoothing methods attempt to '"smooth out" random fluctuations caused by the
irregular component of a time series.
• Smoothing methods work with a time series that has no significant trend, cyclical or
seasonal effects.
• If only random variations affect the values, smoothing methods can provide
highly accurate, short-range forecasts such as a forecast for the next tim period.

a. Simple moving averages:

• Moving averages use the average of the most recent data in the time series.
• Whenever a new value becomes available for the time series, it replaces the oldest value.
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A.2. Forecasting Techniques

• For example, when using a four-week moving average to forecast sales, to forecast sales
for week five, we would average the sales for weeks one through four. The forecast of sales for
week ten would use the average sales for weeks six through nine.
• This method assumes that each of the values used (in this case, the previous four weeks
of sales) are of equal value in predicting future results.
• While this may be the case, it may also be that the more recent values are more indicative
of future results than die results from longer ago periods. >> why we use the weighted average.

b-Weighted moving average:

• we use different weights foreach value and compute a weighted moving average, using
the most recent data in the time series.
• For example, we might give more recent historical values weights that are greater than
those given to the older values. If there are four months of data, to forecast the fifth month's
value using a weighted moving average,
• The accuracy of the weighted moving average will depend on the weights that are given
to the previous periods. If the weights are "correct', the resulting forecast will be accurate.

Example: JB Co. Wants to use a 4-month weighted moving average method to forecast sales for
the month of May. The weights JB has assigned to the four previous months are 40%, 30%,
20%, and 10%.Actual sales for JB Co. for the last 4 month are as follows:

Jan. 21,000 ;
Feb. 23,000
March 25,000
April 20,000

Solution:
Simple Moving Aver. Weighted Moving Aver.
Jan. 21,000 x 10% = 2100
Feb. 23,000 x 20% = 4600
Mar. 25,000 x 30% = 7500
Apr. 20,000 x 40% = 8000
Total 89,000 /4
May = 22,250 = 22,200

c- Exponential Smoothing:

• Exponential smoothing takes the forecast developed for the most recent period and
adjusts it up or down based on what actually occurred in that period.
• Both the previous month's forecasted and actual values are given a weight. The expected
and actual values from the previous month are multiplied by their weights and the two numbers
added together becomes the forecast for the next period.
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A.2. Forecasting Techniques

1- The actual value (times) a smoothing factor (.α) Plus

2- The forecasted value above (times) a smoothing factor complement (1- α),
Ft = (α) xt-1 +(1- α) Ft-1

Where F= Forecast for a period,

t= the time period,
α= the smoothing factor (0 < α<1),
x = the actual result for the period.

• One of the advantages of exponential smoothing is that it does not require a lot of
historical data. Therefore, it is an inexpensive method to use because datastorage requirements
are minimized.
• A disadvantage of exponential smoothing is that its forecast will lag behind as the trend
increases or decreases over time. And it does not account for dynamic changes that occur In
actual practice. Its forecasts will require constant updating in order to respond to new
information.

2- Regression Analysis (Trend projection)

When a time series is increasing or decreasing consistently, smoothing methods are not
appropriate for forecasting. Instead, a time series that has a long-term upward or downward
trend can be forecasted by means of trend projection. trend projection is done with simple
regression analysis.
• Simple linear regression analysis relies on two assumptions:
1- Variation in the dependent variable (x: what we are forecasting) are explained
by variations in one single independent variable (y)
2- The relation between the dependent and the independent variables is linear.
That will graph as a straight line.
3- This relationship is valid through a relevant range.

Y = a + b(x)
• Mixed Costs: Regression analysis in budgeting and cost accoiunting is almost a
necessity for computing the fixed and vaiable portions of mixed costs for flexible budgeting.
The formula as follwos:
Total Cost = Fixed Cost + (Variable Cost) (Activity level)
High-Low Method: The high-low method is used to generate a regression line by basing the
equation on only the highest and lowest of a series of observations.

Variable Cost = (Highest Activity- Lowest Activity) / (Highest Total Cost-Lowest Total Cost)
Fixed Cost = Total Cost at either level (highest or lowest) – Total variable cost computed.
 Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

See Gliem Example: P.51

• Before actually using regression analysis for a forecast, however, we should perform
correlation analysis to determine the strength of the linear relationship between the
value of X and the value of Y in order to determine whether trend projection would be
meaningful.
• Correlation analysis measures the relationship between two or more variables. This
measurement shows how closely connected the variables are and the extent to which a change
in one variable will result in a change in the other.
• The coefficient of correlation,(-1 < r < +1), can be used to determine whether trend
projection would be meaningful.
o A high correlation coefficient, (r close to +1 or – 1) would indicate that simple
linear regression analysis would be useful as away of making a projection using a
trend line.
o A low correlation coefficient, (r close to 0), would indicate that a forecast made
using simple regression analysis would not be very meaningful.
• The coefficient of determination (r2) is the square of the
coefficient of correlation and is the percentage of the total amount of change in the
dependent variable that can be explained by changes in the independent variable
o Example: If coefficient of correlation is r = 8, this is equivalent to stating that 64%
(82) of the variation of the dependent variables from the average can be explained
by changes in the independent variable.
• Multipe regression is used when there is more than one
independent variable.
Y = a + b1x1 + b2x2 + ...
Learning Curve Analysis

Learning curves describe the fact that the more experience people have with something, the
more efficient tfiey become in doing that task. Higher costs per unit early in production are part
of the start-up costs. It is commonly accepted that new products and production processes
experience a period of low productivity followed by increased productivity. However, the rate of
productivity improvement declines over time until it reaches a level where it remains, until
another change in production occurs.
Learning curve analysis is used in planning, budgeting and forecasting and also to determine
costs when bidding on a contract.
There are two learning-curve models: Cumulative Average Vs. Incremental Unit
The Cumulative Average-Time Learning Model evaluates the average time per unit required
to produce all of a given number of units produced to date. The Incremental Unit-Time
Learning Model evaluates the time needed to produce the last unit in a quantity of units.
The Cumulatiove average time learning model (The Traditional)
 Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

• Example: if a plant that manufactures automobiles is subject to an 80% learning curve,

and if the time required to build the first automobile is 10 hours, then the total time required to
manufacture the first 2 autos will be 80% of (10 hours x 2), or 16 hours, which equates to an
average of 8 hours for each of the two automobile built to date.
• Note that this model measures total time required, which includes the time for the first
unit, and uses that total time to determine average time per unit for the entire amount
produced. This is what "cumulative average* means.
• However, because learning did take place at the first unit produced and the learning
curve was 80%, the time required to produce the first auto was 10 hours, and the time required to
produce the second auto was 6 hours, for a total of 16 hours for both. The cumulative average
was 8 hours fore each auto.
The Incremental unit time learning model
• The Incremental Unit-Time Learning Model states that the time needed to produce the
last unit (incremental unit time) declines by a constant percentage each time the cumulative
quantity of units produced doubles.
• For example, for the automobile manufacturing plant, which is subject to an 80%
learning curve rate and requires 10 hours to build the first automobile.
o the time required to manufacture the second auto will be 80% of 10 hours, or
8 hours. Thus, the total time required to produce two autos is 10 hours + 8 hours, or 18 hours.
And the average time per unit will be 18 / 2, or 9 hours.
Under the same assumptions for both models, the Incremental Unit-Time Model will predict a
higher cumulative total time (and thus a higher average time per unit) to produce two or more
units than the Cumulative Average-Time Model,
The choice of which model to use should be based on which one more accurately predicts the
behavior of labor hour usage as production levels increase.
• To calculate the time required to produce die last unit, simply multiply the time required
for the first unit by the % of the learning curve for each time that the production doubles.
• Example; Let us assume that it requires 12 hours to produce the 1st unit, and there is an
80% learning curve.
o To determine the production time for the 2nd unit we simply multiply 12 by .8. In
order
o to determine the time required to produce the 4th unit we have 12 x .8 x .8.
o The time For the 8th unit will be calculated as 12 x ,8 x .8 x .8, and so on for the
16th, 32nd and incremental units.
o Note that these times that we have calculated are for only the 2nd, 4"', 8", 161" ...
units as this method calculates the time to produce the last unit each time that production
doubles.

Note: On an Exam, you may be asked for the time or the cost required for the final unit in a
production process where production levels are doubling. If you are not told whetherto use the
Incremental Unit-Time Learning Model or the Cumulative Average-Time Learning Model, try
working it out both ways to see if you can reach one of the answer choices provided by the
Exam. You will probably be able to calculate the time and cost of the final unit faster by using
 Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

the Incremental Unit-Time Learning Model instead of the Cumulative Average- Time
Learning Model, so try it that way first.

Benefits of Learning Curve Analysis

Many Decisions such as the following can be aided by learning curve analysis: Make or buy
decisions - the analysis of the cost to make will be affected,Life-Cycle costing -- In calculating
the cost of a contract, learning curve analysis can ensure that the cost estimates are accurate over
the life of the contract, leading to better bidding. Cost-Volume-Profit analysis - in determining a
breakeven point. If learning is not considered, the result may be overstatement of the number of
units required to break even.Development of standard costs - labor costs should be adjusted
regularly in recognition of the fact that learning causes standard costs to change over
time.Capital budgeting - costs can be projected more accurately over the life of the capital
investment when expected improvements in labor productivity due to learning are included. b)
Development ol production plans and labor requirements - production and labor budgets should
be adjusted to accommodate learning curves. Management control - recognizing that higher
costs will occur in theeariy phase of the product life cycle allows more effective evaluation of
managers.

Limitations of Learning Curve Analysis

Learning curve analysis is appropriate only for labor-intensive operations involving
repetitive tasks where repeated trials improve performance. If the production process is
designed to have fast set-Lip times using robotics and computer controls, there is little
repetitive labor and thus little opportunity for learning to take place.
The learning rate is assumed to be constant. In real life, the decline in labor time might
not be so constant. It might be that the learning rate would decline at the rate of 70% for the
first 75,000 units, followed by 80% for the next 50,000 units and 95% for the next 25,000
units.The reliability of a learning curve calculation can be jeopardized because an observed
change in productivity might actually be associated with factors other than
learning, such a change in the labor mix, or the product mix or other factors. In this
situation, a learning model developed using this historical data would produce inaccurate
estimates of labor time and cost.

Expected Value

• The expected value of a discrete random variable is the weighted average of all
the possible values of the random variable. The weights are the probabilities
for each of the values. The expected value is the mean value, also known as
the average.
• For decisions involving risk and uncertainty, we use expected value or expected
return to express the most likely result of our decision.
• the expected value cf an action is found by multiplying the probability of each potential
outcome by its payoff. Therefore, expected value, or expected return, is a weighted
average of the possible returns, with the weights being the probabilities of occurrence.
Expected Value in Estimating Future Cash Flows
• Estimating, or projecting, future cash flows is an important application of expected
 Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

value. It is used in capital budgeting analysis for evaluating potential projects.

• Every project has numerous possible future cash flows. A project has a range of
estimated cash flows that reflect different possibilities as foreseen by management. To
determine the various possible cash flows, management must;
o Determine what influences have affected the net cash flows of similar projects in
the past, such as economic conditions, labor conditions, or international
conditions, and then
o Make assumptions about each of those events. For instance, if a recession is
expected, management would assume that demand for the project's product will
be below normal.
• The probabilities for each year will all sum to 1. The financial manager will then
calculate the expected value for cash flow for each year of the project's life by
calculating the weighted average of all the possible cash flows.

Sensitivity Analysis

Reveals how sensivitve expected value calculations are to the caccuracy of the intitial estimates.
Sensitivity analysis is useful in determining whether expending additional resources to obtain
better forecasts is justified. If a change in the probabilities assigned to the various states of nature
results in large changes in the expected values, the decision maker is justified in expending more
effort to make better predicitions about the outcomes.
Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

Sample MCQs
Source: Online Assessment Tests
Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques
Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques
 Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

Sample MCQs
Source: CMA Support Package
1. Which of the following types of budget systems most strongly supports the objective of improving
communication and promoting coordination?

a. Bottom up, flexible budgets.

b. Bottom up, fixed budgets.

c. Top down, flexible budgets.

d. Top down, fixed budgets.

4. A forecasting technique that is a combination of the last forecast and the last observed value is
called

a. Delphi.
b. least squares.
c. regression.
d. exponential smoothing.

5. A large manufacturer’s forecast of total sales revenues for a year is least likely to be influenced by

a. the seasonal pattern of sales revenues throughout the year.

b. anticipated interest rates and unemployment rates.
c. expected shortages of key raw materials.
d. input from sales personnel.

7. The type of budget that is available on a continuous basis for a specified future period by adding a
month, quarter, or year in the future as the month, quarter, or year just ended is deleted, is called a

a. rolling budget.
b. kaizen budget.
c. activity-based budget.
d. flexible budget.

8. In the budgeting and planning process for a firm, which one of the following should be completed
first?

a. Sales budget. ; b. Financial budget. ; c. Cost management plan. ; d. Strategic plan.

9. Which one of the following is not an advantage of activity-based budgeting?

a. Better identification of resource needs.

b. Linking of costs to outputs.
c. Identification of budgetary slack.
 Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

d. Reduction of planning uncertainty.

11. Which one of the following is most important to a successful budgeting effort?

a. Experienced analysts.
b. Integrated budget software.
c. Reliable forecasts and trend analysis.
d. Top management support.

10. In preparing a corporate master budget, which one of the following is most likely to be prepared
last?

a. Sales budget.
b. Cash budget.
c. Production budget.
d. Cost of Goods Sold budget.

12. In an organization that plans by using comprehensive budgeting, the master budget refers to

a. a compilation of all the separate operational and financial budget schedules of the
organization.
b. the booklet containing budget guidelines, policies, and forms to use in the budgeting process.
c. the current budget updated for operations for part of the current year.
d. a budget of a not-for-profit organization after it is approved by the appropriate authoritative
body.
13. Steers Company has just completed its pro forma financial statements for the coming year.
Relevant information is summarized below.
Projected net income $100,000
Anticipated capital expenditures 50,000
Increase in working capital 25,000
Depreciation expense 15,000
From the information provided above, the increase in Steers’ cash account for the coming year will
be
a. $25,000.
b. $40,000.
c. $90,000.
d. $160,000.

17. The starting point for creating a master budget for a proprietary secretarial school would be

a. estimating salaries of the instructors.

b. forecasting enrollment.
c. preparing a capital expenditure budget.
d. preparing the student recruiting budget.

18. Trumbull Company budgeted sales on account of $120,000 for July, $211,000 for August, and
$198,000 for September. Collection experience indicates that 60% of the budgeted sales will be
collected the month after the sale, 36% the second month, and 4% will be uncollectible. The cash
from accounts receivable that should be budgeted for September would be
 Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

a. $169,800. ; b. $194,760. ; c. $197,880. ; d. $198,600.

16. Maximilian Computer Company uses a comprehensive budgeting system in planning its annual
operations. Which of the following best describes the information needed in order to determine the
budgeted cost of circuit boards to be purchased for use in building its laptop computer? Assume one
circuit board is used in each laptop.

a. Begin with budgeted laptop sales in units, add the desired ending inventory of circuit boards,
deduct the expected beginning inventory of circuit boards, and multiply the resulting amount by the
budgeted purchase cost per circuit board.
b. Begin with budgeted laptop sales in units, deduct the desired ending inventory of circuit boards,
add the expected beginning inventory of circuit boards, and multiply the resulting amount by the
purchase cost per circuit board.
c. Begin with budgeted laptop production in units, deduct the desired ending inventory of circuit
boards, add the expected beginning inventory of circuit boards, and multiply the resulting amount by
the purchase cost per circuit board.
d. Begin with budgeted laptop production in units, add the desired ending inventory of circuit boards,
deduct the expected beginning inventory of circuit boards, and multiply the resulting amount by the
budgeted purchase cost per circuit board.

14. Holland Company is in the process of projecting its cash position at the end of the second quarter.
Shown below is pertinent information from Holland’s records.
Cash balance at end of 1st quarter $ 36,000
Cash collections from customers for 2nd quarter 1,300,000
Accounts payable at end of 1st quarter 100,000
Accounts payable at end of 2nd quarter 75,000
All 2nd quarter costs and expenses (accrual basis) 1,200,000
Depreciation (accrued expense included above) 60,000
Purchases of equipment (for cash) 50,000
Gain on sale of asset (for cash) 5,000
Net book value of asset sold 35,000
Repayment of notes payable 66,000
From the data above, determine Holland’s projected cash balance at the end of the second quarter.
a. Zero.
b. $25,000.
c. $60,000.
d. $95,000.

15. Werner Company buys raw materials from several suppliers, and makes payments according to
the following schedule.
In the month of purchase 25%
In the month after purchase 60%
In the second month after purchase 15%
In preparing the master budget for the fourth quarter of the year, Werner assumed that total purchases
for the quarter would be spread evenly over the three months. In its pro forma balance sheet, Werner
anticipated a December 31 account payable balance of $207,000. What amount of purchase did
Werner anticipate for the fourth quarter of the year?

a. $496,800. ; b. $558,900. ; c. $621,000. ; d. $690,000.

 Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques

Essay Sample Question (TruJeans-12)

Source: Support Package
TruJeans, a new startup company, plans to produce blue jean pants, customized with the buyer's
first name stitched across the back pocket. The product will be marketed exclusively via an
internet website. For the coming year, sales have been projected at three different levels:
optimistic, neutral, and pessimistic. TruJeans does keep inventory on hand, but prefers to
minimize this investment.
The controller is preparing to assemble the budget for the coming year, and is unsure about a
number of issues, including the following.

� The level of sales to enter into the budget.

� How to allocate the significant fixed costs to individual units.
� Whether to use job order costing or process costing.

REQUIRED:
A. How can the controller use the expected value approach to set the sales level for the budget?
What additional information would be needed?
B. 1. Define sensitivity analysis and describe how the controller can use sensitivity analysis in
forecasting sales.
2. Identify and explain one benefit and one shortcoming of sensitivity analysis.
C. How could the use of variable (direct) costing mitigate the problem of how to allocate the
fixed costs to individual units?
D. Which cost system seems to make more sense for TruJeans, job order costing or process
costing? Explain your answer.

Answer:
A. The sales staff has not presented the controller with a unique expected level of sales, but
rather sales numbers under various scenarios. The controller could use the expected sales in
the budget, which is the summation of the anticipated sales under each scenario times the
probability of that scenario. The controller would need to estimate the probability of each
scenario in order to complete the task.
B. 1. The controller could change the level of sales at various levels to see impact on
variable costs, contribution margin and net income.
B.2. A benefit of sensitivity analysis is that one can input various values of an independent
variable and very quickly see the impact on the dependent variable. A shortcoming is that it
can be simplistic, as real-world business situations often involve a very complex interplay of
variables.
C. Under direct costing, fixed manufacturing costs are expensed rather than being added to
the inventoriable cost of each unit. Thus, it is not necessary to determine the allocation of
fixed costs to individual units.
D. At first glance, job order costing appears to make more sense, as each pair of jeans is
literally unique, given that the buyer’s name is stitched on the back pocket. However, in
reality, process costing should be used, because jeans will be produced continually, and for
cost purposes, will be same for each pair.
Section A. Planning Budgeting, and Forecasting (30%) CMA Part I
A.2. Forecasting Techniques