Profit planning cannot be done without proper profit forecasting. Profit forecasting means projection of future earnings after considering all the factors affecting the size of business profits, such as firm’s pricing policies, costing policies, depreciation policy, and so on. A thorough study including a proper estimation of both economic as well as non-economic variables may be necessary for a firm to project its sales volume, costs and subsequently the profits in future.
Approaches to Profit Forecasting in Managerial Economics
According to Joel Dean, a famous economist, there are three approaches to profit forecasting, which are as follows:
- Spot Projection: Spot projection includes projecting the profit and loss statement of a business firm for a specified future period. Projecting of profit land loss statement means forecasting each important element separately. Forecasts are made about sales volume, prices and costs of producing the expected sales. The prediction of profits of a firm is subject to wide margins of error, from forecasting revenues to the inter-relation of the various components of the income statement.
- Break-Even Analysis: It helps in identifying functional relations of both revenues and costs to output rate, keeping in consideration the way in which output is related to the profits. It also helps in doing so by relating profits to output directly by the usual data used in break-even analysis.
- Environmental Analysis: It helps in relating the company’s profits to key variable, in the economic environment such as the general business activity and the general price level. These variables are not considered by a business firm.
All those factors that control profits move in regular and related patterns such as the rate of output, prices, wages, material costs and efficiency, which are all inter-related by their connections with the national markets and also by their interactions in business activity. Theories of business cycles are based on the hypothesis, which is shown by the national values of production, employment, wages and prices during any fluctuation in business activities. There is no clear pattern in detailed analysis. These patterns helps in increasing the possibility that the profits of a business firm, can be forecast directly by finding a relation to key variables. The need is to find a direct functional relation between profits of a business firm and activities at national level that shows statistical significance.
In practice, these three approaches need not be mutually exclusive. Theses approaches can also be used jointly for maximum information. In projecting the profit and loss statement, the functional relations can be used, arising out of the ratio of cost to output and to its other determinants. In the same way, by measuring the impact of outside economic forces upon the firms profit helps in facilitating good spot guesses. It can also enhance the accuracy of break-even analysis.