...conventional expectations, results not support the contention that forecasts made by the managers of small firms are optimistic. Although systematic overestimation was not found, managers did tend to make forecasts that were generally too extreme, and tended to overextrapolate previous growth. These results are consistent with propositions that overconfidence biases and representative heuristics influence the revenue forecasts made in small firms.

Introduction

Although there is a substantial literature investigating factors that cause or encourage the growth of a firm, there is a dearth of research investigating owner/managers' expectations and forecasts of their firms' growth and the degree of rationality or accuracy in those forecasts. Even more fundamental questions relating to whether owner/managers are rational or overly optimistic have also received limited attention in the literature. The study of forecasting within small firms is important because forecasts and expectations have a vital influence on many commercial decisions and the subsequent growth, profitability, and survival of the firm. This paper provides evidence addressing the above questions, and by accessing a large sample frame, the study avoids the problems of small sample size or narrow sample focus that is present in other research. In addition, this study's use of mandatory and proprietary forecasts minimizes the influence of nonresponse bias and other biases often associated with public forecasts research.

Generally, research that has investigated the forecasting outcomes of firms has focused upon respondents from very large, publicly traded firms (Winklhofer, Diamantopoulos, and Witt 1996). The limited research that has investigated a broader population of firms is generally descriptive in nature, with a focus on emphasizing differences in forecasting processes between smaller and larger firms. For example, Smith et al. (1996) found that smaller firms tend to have a higher degree of subjectivity in the forecasting process, and that small firms used less complex, less quantitative and more qualitative forecasting techniques. Further, Peterson (1993) found that smaller firms use sales forecasts less frequently for planning, and are less likely to develop specific industry or customer forecasts. The less formalized forecasting approaches, lower levels of resources available, and less sophisticated processes for information gathering and analysis may lead to small business managers exhibiting less rational forecasting behavior than those in larger firms (Lang, Calantone, and Gudmundson 1997). Although Ashworth, Johnson, and Conway's (1998) finding of systematic over-estimation of expected employment in 121 U.K. small firms is an exception, there is little direct testing, and consequently understanding, of intra-organizational forecast accuracy and rationality outside large publicly traded firms.

The study of forecasting within small firms is of interest in a number of domains within and outside organizations. From an intrafirm perspective, forecasts and expectations have a vital influence upon many commercial decisions and the subsequent growth, profitability, and survival of the firm. The forecasting process and planning enable future-oriented decision-making, where strategic and operational goals or expectations can be developed (Hogarth and Makridakis 1981). For example, sales forecasts are pivotal in relation to acquisition and replenishment activities, scheduling and capacity issues, and capital investment and financing decisions. Potential consequences of inaccurate forecasts include higher inventory costs, poor customer services, and inefficient utilization of production resources (Diamantopoulos and Winklhofer 1999). Given the consequences of poor forecasting, it is not surprising that there should be a desire to understand the intraorganizational forecasting process and outcomes.

Also, investigations of psychological behaviors in small firm owners indicate that owners strongly exhibit optimism, overconfidence, and representativeness in their beliefs and decision-making (Busenitz and Barney 1997; Cooper, Dunkleberg, and Woo 1988). These attributes of small firm owners can be expected to influence the nature of their forecasting activities and managers in small firms may be inclined to make forecasts that are optimistic, extreme, and rely too heavily upon salient information.

There is also a need to understand forecasting behaviors and outcomes because of implications beyond the firm. In particular, investigations of forecasting accuracy effectively constitute an investigation of the rational expectations hypothesis of orthodox economics (Levine 1993). Such notions of rationality have been fundamental to the modeling and characterization of business decision processes. Understanding forecasting rationality is crucial given the linkages between forecasts by managers inside firms and subsequent planned and actual output, eventual investment and the entry or exit of goods and services within industries. Consequently, there are important economic theory and macroeconomic policy outcomes to be derived from understanding the forecasting process of firms.

This paper reports a series of examinations addressing the rationality and accuracy of forecasts by managers of small firms. These are: (1) the degree of bias in forecasts; (2) the degree of variation in forecasted growth compared with actual growth; (3) the degree of temporal and information set dependence in forecasts; and (4) comparison of individuals' forecast accuracy to the predictive accuracy of mechanical models. Similar types of examinations have been applied in other settings (Willis 2001; Ali, Klein, and Rosenfield 1992; De Bondt and Thaler 1990; Copeland and Marioni 1972). The contribution of this paper is the findings from these examinations in relation to a very important yet under-investigated population.

The paper proceeds along the following lines. The next section reviews the literature that examines why forecasts made by managers of small firms would not be rational and the empirical evidence that has investigated these issues from both a publicly held firm and a privately held firm perspective. We conclude the section by specifying a number of propositions concerning the forecasting activity of small firm managers. The subsequent section provides a research discussion that outlines the nature of the data used and also reviews and defines the techniques used to measure forecast accuracy and detect the presence of bias and inefficiencies. Results are then presented before a discussion of the findings including a consideration of the research limitations, the avenues for further research, and concluding comments.

Research Background and Proposition Development

There are several psychologically based explanations as to why managers of small firms would not make rational forecasts. These include optimism, overconfidence, and representativeness. Investigations of psychological behaviors by small firm owner/managers indicate that they strongly exhibit these attributes in their beliefs and decision-making.

Although there is little direct testing and consequently understanding of intraorganizational forecast accuracy and rationality outside large publicly traded firms, investigations of psychological behaviors in small firm owner/managers indicate that they strongly exhibit optimism, overconfidence, and representativeness in their beliefs and decision-making. In particular, Cooper, Dunkleberg, and Woo (1988) found individuals who had recently become business owners were highly optimistic concerning their chances of success, and that their perceived chances of success were significantly greater than that of other similar businesses. Consistent with differences between managers of small and large firms, Busenitz and Barney (1997), examining overconfidence and representativeness, found that entrepreneurs tended to exhibit biases and heuristics more extensively in their strategic decision-making. Therefore, both psychological theories and empirical evidence suggest that managers in small firms may be inclined to make forecasts that are optimistic, extreme, and rely too heavily upon salient information.

There is substantial evidence that most individuals are overly optimistic, in that they overestimate the probability of favorable outcomes. Individuals not only perceive that favorable events are more likely to happen, but also perceive that favorable events are more likely to happen to them rather than their peers (Weinstein 1980). These optimistic tendencies should lead to optimistic forecasting by individuals in a firm setting. The limited empirical research drawn from the literature supports the expectation that managers in small firms are generally optimistic (Ashworth, Johnson, and Conway 1998). This leads to our first proposition:

P1: Forecasts of small firm managers will tend to be optimistic.

Overconfidence describes a tendency whereby individuals overestimate their own ability. Overconfidence is reflected by individuals generally overestimating their ability to do well, achieve a stated goal, or influence an outcome (Larwood and Whittaker 1977; Langer 1975). For example, individuals when making forecasts generally overestimate the precision or certainty of their predicted forecasts, in that they believe the probability of event being outside their predicted bounds to be...

NOTE: All illustrations and photos have been removed from this article.



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