Different types of forecasting techniques tested on the BEC section of the CPA exam
There are several different forecasting techniques that are tested on the BEC section of the CPA exam. These are techniques that businesses would use to project their revenues, cost of goods sold, and operating expenses for future periods. The methods covered in this article and video include the high low method, scenario analysis, and sensitivity analysis.
The examples used in the explanation below were adapted from a simulation in the Universal CPA Review platform. The YouTube video below walks you through the simulation and how to attack this type of simulation on the CPA exam. Sign up for a free trial here!
What is the high low method?
The high low method is a type of analysis that can be used to determine the mix of variable and fixed costs in a set of data. If a company has a data set that contains monthly units and total costs, the high low method would be used to identify the variable cost per unit and the company’s fixed costs. Let’s take a look at an example and then go through the steps to calculating the variable cost per unit and total fixed costs.
Data set of a manufacturing company:
Step 1) Calculate the difference between the high and low : Under the highlow method, we need to identify the months that had the lowest and highest units. Based on the data, March has the lowest units at 200 and November has the highest at 450 units. We need to take the difference in units and cost between these two months. As you can see, the difference is 250 units and a total cost of $50,000.
Step 2) To calculate the variable cost per unit, divide the difference in cost of $50,000 by the difference in units of 250, and you get variable cost per unit in $200. If fixed cost remains constant, then the driver in a change to total cost would purely the variable cost component.
Step 3) Now we can take total cost from the email for the low and high months. We’ll subtract total variable costs, which is calculated as the $200 variable cost per unit multiplied by total units. Once we subtract total variable costs, we are left with $75,000 of fixed costs in the low and high month. This is only on a monthly basis and the simulation is asking about the total for year 10, so we need to move to step 4 below.
Step 4) The last step is to convert the $75,000 of fixed costs per month to total budgeted year 10 costs by multiplying $75,000 x 12 months = $900,000.
What is the scenario analysis in forecasting?
Scenario analysis is when we consider the percentage impact on revenues or expenses, as well as the estimated probability of an event (new customer, partnership, new regulation, etc.) occurring. Business professionals with detailed information can analyze internal and external factors to determine the potential impact and probability of the event being realized. Let’s go through an example where a company had $500,000 of revenue in Year 9 and they are trying to project Year 10 revenues. Let’s say the following scenarios were used in the analysis:
Scenario A: We are finalizing a new partnership with a restaurant in Maui. If the partnership is finalized, I expect Year 10 revenue will increase 30%. However, there are some disagreements in the contract, so the probability of the partnership being finalized is 35%.
Scenario B: We caught wind that one of our key competitors may be acquired by a larger company in the space. If the acquisition is completed, I expect our revenue to decrease by 15% in Year 10. Based on what we currently know about the acquisition, I give it a 20% chance of being finalized.
Scenario C: The company is finalizing a new product line that will increase revenue by 40% in Year 10. It requires approval from the FDA. Since we are in advanced stages with the FDA, I estimate a 45% chance that we receive approval and can fully launch the product line in Year 10.
Step 1) We’ll start by calculating the weighted average expected percentage change for each scenario. The table below illustrates how we can calculate the weighted average percentage change for each scenario. We then need to add up those percentages. This means that on a combined basis, the weighted average expected change to revenue is 24% of growth (an increase to revenue vs the prior year).
Step 2) Now we can take actual Year 9 revenue of $500,000 and multiply by the expected growth rate of 24% (which is 1 + 24% = 124%). Multiply $500,000 by 124% and you get budgeted Year 10 revenue of $620,000.
What is the sensitivity analysis in forecasting?
Sensitivity analysis is used to apply possible increases or decreases to specific accounts and determine how those changes could impact a company’s revenue and overall profitability. Let’s say that a company had $500,000 of revenue in the prior year and based on internal and external factors, revenue could increase by as much as 10% or revenue could decline by as much as 10%.
Some additional assumptions to factor into your analysis includes:
1) Cost of goods sold as a percentage of revenue should remain consistent at 60%
2) Selling and marketing expenses as a percentage of revenue should remain consistent at 11% and 3%, respectively.
3) General and administrative expenses were $100,000 in Year 9. You can assume that general and administrative expenses will be $100,000 in Year 10.
4) Income tax expense was 25% of operating income in Year 9. You can assume that income tax expense will be 20% of operating income in Year 10. The decrease is due to some restructuring activities and changes in tax laws.
Solution:
If Year 9 revenue was $500,000, then a 10% decrease in revenue would be $450,000 and a 10% increase in revenue would be $550,000. We then would fill out the remaining expense lines by performing the following:
1) Cost of goods sold: Cost of goods sold was 60% of revenue in Year 9, so apply 60% to the two revenue figures.
2) Selling expense: Selling expense was 11% of Year 9 revenue, so apply 11% to the two revenue figures.
3) Marketing expenses was 3% of Year 9 revenue, so apply 3% to the two revenue figures.
4) G&A expense: G&A expense was $100,000 and will remain constant, so leave it at $100,000
5) Income tax expense: Email says to multiply operating profit by 20%. For +10%, it would be $43,000 x 20% = $8,600. For 10%, it would be $17,000 x 20% = $3,400
Once you have calculated each line item, you’ll be able to calculate the net income for +10% and 10%:
If you would like to review the Excel workbook used to create this simulation and follow the formulas, please click the link below to download the workbook!
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