In order to make decisions that will enable an organization to be successful, managers need to be able to predict the needs of the future so that the organization can act appropriately in order to gain or maintain a competitive edge. Forecasting is the science of estimating or predicting future trends. Forecasts are used to support managers in making decisions about many aspects of the organization including buying, selling, production, and hiring. Statistical techniques are available to help managers examine the impact of trends, business cycles, seasonal fluctuations, and irregular or random events on future needs. However, in isolation, these methods are not sufficient for developing good forecasts. Expert judgment needs to be used in combination with statistical techniques in order to optimize the effectiveness of each.
Since the beginning of written history, human beings have been interested in learning what the future holds. From our vantage point in the 21st century, we read with bemusement in history books about signs and omens and oracles, and wonder why people ever thought they could read the future in the entrails of a goat. Despite our relative sophistication, however, the desire to know the future persists, and we still long to know what is going to happen. We listen to the television meteorologist to find out whether or not to carry an umbrella. We read the business section of the newspaper to find out the cost of a barrel of oil to determine whether we should wait a few days to buy gas or get it today. We plan our vacations for sunny climes at times when we expect to be knee-deep in snow at home.
Importance of Trends to Business Operations
However, it is not only in our daily lives or in these relatively trivial examples that we need to know what will happen. In the business world, organizations need to know the trends of the marketplace in order to best position themselves to leverage this knowledge into profits. The production manager needs to know if there will be a continuing need for widgets and how much raw material is needed to meet the anticipated demand. The marketing manager needs to know whether changing demographics in the marketplace mean that a new marketing strategy will be needed. The shipping manager needs to know whether or not the price of oil will continue to rise and how this cost affects the outsourcing for the production of gizmos. The human resources manager needs to know whether or not the turnover in the organization will continue and new sources of qualified employees need to be found. To answer these and other questions about the future of the business and how best to respond to the changing needs of the environment and marketplace, businesses rely on forecasting. This is the science of estimating or predicting patterns and variations. Forecasts are used to support managers in making decisions about many aspects of the business including buying, selling, production, and hiring. It is part of the responsibility of management to determine the goals and direction of the organization for both the short and long terms. To do this, it is helpful to be able to predict the variations of economic activity that may affect the business and plan to either leverage these into successes or prepare the organization to survive until the next boom.
Causes of Variation in Economic Activity
There are a number of causes of variation in economic activity: trends, business cycles, and seasonal fluctuations as well as irregular and random fluctuations. Trends are persistent, underlying directions in which something is moving in either the short, intermediate, or long term. Many trends tend to be linear rather than cyclic, steadily growing (or shrinking) over a period of years. For example, in the US there is an increasing trend for outsourcing and offshoring of technical support and customer service in the high tech industry. On the other hand, trends in new industries tend to be curvilinear as the demand for the new product or service grows after its introduction then declines after the product or service becomes integrated into the economy.
Business cycles are continually recurring variations across the total economy. Such expansions or contractions of economic activity tend to occur across most sectors of the economy at the same time. For example, several years of a boom economy with expansion of economic activity (e.g., more jobs, higher sales) are frequently followed by slower growth or even contraction of economic activity. Business cycles tend not to occur only across one industry or business sector, but often occur across the economy in general.
Many industries also experience seasonal fluctuations -- changes in economic activity that occur in a fairly regular annual pattern. Seasonal fluctuations may be related to the seasons of the year, the calendar, or holidays. For example, office supply stores experience an upsurge in business in August as children receive their school supply lists for the coming year. Retail stores make a significant portion of their profits in the weeks between Thanksgiving and Christmas. Travel agencies experience a rise in clients in the winter who want to visit warmer climes and in the summer for families who need to go on vacation when their children are not in school.
In addition, there are irregular and random fluctuations in the economy that occur due to unpredictable factors. For example, natural disasters, political disturbance, strikes, and other external factors can cause fluctuations in the economy. In addition, there are unpredictable or random factors that can affect a business's profitability such as high absenteeism due to an epidemic. Although this category is by definition difficult if not impossible to predict, there are tools available that can help the manager recognize and predict the other kinds of variations. Identification of a these variations in economic activity allows managers to better plan to meet future needs and keep the business profitable.
Approaches to Forecasting in Business
There are a number of approaches to forecasting that are used in business. Subjective forecasting methods are used by many managers, particularly when a decision needs to be made quickly.
Subjective approaches to forecasting are qualitative rather than quantitative and based on the manager's experience and intuition about a situation rather than on the application of mathematics or an attempt to reduce the situation to quantifiable terms. Depending on the manager and his/her experience, however, subjective approaches to forecasting may or may not be effective. Further, because they are subjective, even when they are effective, subjective approaches are typically not reproducible. There is also no way to quantify the variables used in the forecasting process so that the process can be applied to future situations. The quality of a subjective forecasting approach is completely dependent on the skill and expertise of the manager using it.
A second category of approaches to business forecasting are structural and economic models. These approaches use mathematical and statistical techniques to support the development of a forecasting model. Structural models are sets of mathematical functions that are designed to represent the causal relationships within the organization's environment. For example, if an organization was interested in investing in a new venture, it would be helpful to know the future price of its current product in order to forecast its profits and the resultant availability of funds for the new venture. To do this, the manager or analyst might build a specification model of the factors affecting the supply and demand for the current product and the relationship between the factors. There are, however, a number of sources of error associated with this approach...
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