What Is Undercast?
Undercast is a type of forecasting error that occurs when estimates turn out to be below realized values. These estimates could apply to sales, an expense line item, net income, cash flow, or any other financial account.
- Undercast refers to a forecasting error when estimated numbers turn out to be lower than realized numbers.
- The estimates that are valued can include sales, expenses, income, cash flows, or any other financial account or metric.
- Undercast estimates can occur because of a conservative management team or a volatile or unpredictable market.
- Dishonest undercast estimates can occur because management purposefully lowered estimates to ensure that the actual performance would outperform the lower numbers.
- Continuous undercasting indicates that a company is ineffectively deploying its resources based on poor estimates.
Companies try to predict their financial performance for the upcoming year. They typically use forecasting models based on a variety of inputs, including the economic environment, past performance, and any changes in legislation that could impact the business.
Forecasts and budgets help a company determine how to best allocate resources, confirm areas in the company that are working efficiently, and highlight areas that need correction in the business process. When a company in the private sector, government agency, or nonprofit organization prepares its budget for the upcoming year, it relies on its best and most up-to-date information to estimate what the operational numbers will look like for the next 12 months.
Typically, the two main areas that a business aims to estimate are its revenues and its expenses. This will indicate what it expects its profits to be for the upcoming year. Managers of businesses pull together all relevant information and make assumptions. Sometimes these assumptions are subject to greater degrees of uncertainty, which may ultimately cause an undercast or overcast.
When a company's actual results fall short of what was expected, they have undercast that specific account. An undercast situation is akin to budgetary slack, and if undercasting occurs frequently, the causes should be investigated.
Undercasting could be a reflection of a cautious or conservative management team, particularly if its market or the general economy is in a state of flux. Continuous undercasting is a problem for a company as it means it does not strongly understand the business environment or its operational processes and is ineffectively deploying its resources based on poor estimates.
It should also be determined if undercast estimates are a result of compensation motives. For example, if the bonuses paid to managers are linked to how well they outperform the budget estimates, they may purposely undercast the budget, thereby ensuring that the actual results are better than the estimates.
Examples of Undercast
A steel manufacturer forecasts $3 billion in sales for the year. However, due to the imposition of tariffs to protect the domestic industry from foreign imports, which increases domestic sales, the company realized $3.5 billion in sales. The undercast amount of $500 million was due to an unforeseen change in legislation that helped the business.
As another example, the management team of a technology firm estimates that profits will be $50 million. However, they also know that their bonuses will be tied to beating the estimated profit number. Therefore, in reporting its profit estimates, the management team reports $35 million, ensuring that the actual profits will beat the reported estimate. This $15 million undercast was done on purpose, in a dishonest way, so that management could secure their bonus that is tied to performance.