Forecasting: Methods and Types of Forecasting

What is forecasting?

According to etymology sources, the word “forecasting” dates back to the 14th century and means to plan in advance (before events are cast in stone).

It is used widely in management accounting and the running companies – budgets (in effect planning income and expenses), cash flow forecasts, revenue forecasts, and market share forecasts – to name but a few. But what about forecasting in the context of personal finance?

As a new year approaches, you might be thinking about:

• Forecasting how much income you will be able to generate in the new year, from what sources and the timing of that income
• Forecasting the impact on your finances of big predictable expenses (such as renewal of house, car or pet insurance) or being able to afford one-off discretionary spending such as a holiday or a new laptop
• Forecasting the level or regular expenses such as rent or mortgage, utilities, food, public transport, travel card
• Forecasting what percentage of your income you might be able to save on a recurring monthly basis and forecasting what return you might be able to get on those savings

Let’s look at what each one of those involves in turn.

Forecasting your income

If you are in a full-time job forecasting your income for the next year is pretty straightforward. If your monthly take-home pay after taxes and other deductions is, say, £1,500, then working out an estimate (or forecast) of your annual income is simply £1,500 x 12 months = £18,000.

But there may be other factors that are worth taking into consideration.

Perhaps a salary review takes effect immediately each year as part of your annual appraisal in April. Over the last 3 years, let’s say you had your salary increase by £100 a month when the review happened in April each year. It is not unreasonable to expect then that you would have the same increase this year. You may or may not end up having that increase (or any increase at all), but when you make the forecast, you go on the best available information. So the new updated forecast would be three months (January to March) at the old salary rate of £1,500 and the remaining nine months (April to December) at an increased rate of £1,600. This will give an updated income forecast of £1,500 x 3 + £1,600 x 9 = £18,900 (that’s an increase of 5% overall – £900 more than the previous forecast and the actual pay last year of £18,000).

It might be that you also expect a 10% bonus in January. That’s 10% x £18,000 = £1,800 as a bonus. The updated income forecast then is the combined sum of your regular income and one-off bonus payment: £18,900 + £1,800 = £20,700.

Forecasting takes account of the timing of income, expected increases or decreases in income and their timing, unusual one-off events, as well as any other plans you might have that change your income-generating capacity – for example, starting a new job or a second job, or introducing other income streams such as from subletting a room in your house, earning interest on the cash you hold on deposit or dividends you might earn on any shares you might have.

When you make a forecast, you cannot be absolutely certain what you forecast will happen. For example, you may have some savings (say £10,000) in a deposit account. For some time now, the interest rates in the UK have been meagre, and perhaps you were able to earn 0.1% interest on that deposit amount (1% x £10,000 = £10, which is a minimal return). It would have been reasonable to include that expected interest income in your forecast. However, in December 2021, the Bank of England increased interest rates to 0.25%. As soon as new information becomes available, your forecast changes too – the expected interest income on the £10,000 savings is now 0.25% x £10,000 = £25. You will be wise to update your income forecast accordingly.

Forecasting your expenditure

Expense forecast is usually more complex than forecasting your income because there are so many more categories of expenditure in one’s finances – from regular and predictable ones such as perhaps the gym membership you have signed on for a year under a fixed contract to the entirely unpredictable – like needing a new root canal treatment which you could not have anticipated.

The approach taken in forecasting expenditure is similar to that illustrated above in relation to income: it is usual to start with the actual expenditure of last year as a baseline and think of the various factors that may impact an increase or decrease in the level of that expenditure as well as its timing and adjusting the forecast accordingly. For example, someone with a mortgage would start forecasting their annual mortgage costs based on what they were last year. This works very well if one has a fixed-rate mortgage. If the mortgage is on a variable rate, it would have been impacted by the interest rate change in December 2021 mentioned above, so an adjustment in the mortgage payments forecast is appropriate. If one’s mortgage deal expires in 2022 and there will be a change from one mortgage product to another, then the forecast will not be as easy. However, one will still estimate what monthly mortgage payments might be under a new mortgage loan and include those in the forecast.

Forecasts change

Even though forecasting is never perfect (but rather – a best-informed guess), it is worth attempting that in personal finance. It can reveal some useful information that you can choose to act on – for example, if you discover that your forecasted expenses exceed your income forecast, you may get a prompt to look for a new job or to plan for ways to cut down expenditure so that you can live within your means. Without a forecast, you will undoubtedly discover the deficit after the event – when it is too late to do something about it. Forecasting, being a plan before the event, allows you to adjust a plan and, in so doing – manage your personal financial affairs better.