Forecasting: A Basic Process for Stabbing in the Dark
Over the last few days I’ve spent some time polishing up our financial forecasts for some interested 3rd parties. I’m a firm believer in the value of forecasting and planning from the very earliest stages of a venture. I do all kinds of estimating, budgeting, and forecasting for many reasons. Sometimes I need an accurate picture of where we are, sometimes I need a conservative picture of where we will likely be in the near term, sometimes I need and exciting picture of where we could be in the longer term. In any case, the aggregate of the analysis helps provide me with a comprehensive understanding of our business, past, present, and future. During the refresh process I decided it may be valuable to share some basic thoughts regarding forecasting for a small business. Although there are very sophisticated methods available to “Engineer MBA’s”, there are some real basics that I think would be beneficial to someone just starting out, and pointed in the right direction. After all, who really wants to get into linear regression?
In general, as you walk through the accounts in your profit and loss statement you will find that some accounts are what I will call “fixed and known”, at least in the near term. These accounts may include things like monthly lease payments, general liability premiums, or your annual California LLC fees. The rest of the accounts are things that are generally tied to a combination of historic reality and a forward looking strategic plan.
Start with the “Fixed and Known”
I suggest tackling the more obvious “fixed and known” accounts first. For example, if you’re in the highest LLC fee tier then the fee isn’t going to change until it’s finally ruled unconstitutional and goes away. Then you get a big refund check, assuming you’ve filed the right paperwork, and you can go buy a Range Rover. Anyway, knock those easy ones out first. Careful though, even some of these “easy” ones may need a little extra thought... If you’re sure your office space and lease terms will accommodate your planning horizon then plug in the number. However, if you plan to grow or move within the period, you’ll need to estimate the new “fixed and known” lease payment numbers starting at that point. If your office space use is very flexible you may even forecast based on headcount and a standard square footage per employee. In any case, with a little thought and consideration of your future plans you’ll be able to knock these out fairly quickly.
Forecasting the Unknowns
On to the tougher ones! The revenue forecast may be the most challenging and important forecast of all. Many times other accounts are driven by the revenue forecast. For example, if your margin is a steady 35%, your cost of goods sold will likely be forecast at 65% of revenue, assuming the absence of early payment discounts. The revenue forecast should incorporate your historic performance as well as future plans. You can look at simple sales dollars, customer acquisition, order generation, average ticket, market trends, growth rate when you did X vs. Y in the past, etc. Hypothetically speaking you may say that in 2006 you focused on “product offering breath and depth” initiative which generated 35% growth in order count. In 2009 you plan to focus on that initiative again, while also implementing an up-sell program to increase average order by 5%. You can use these numbers, with a 2008 actual, to build a 2009 forecast. Likewise, if your plan includes less sales growth focused initiatives in 2010 you may forecast less growth in that year.
Performance, Present Condition and Future Plans
This past performance, present condition, future plans thinking is the cycle you need to go through for each account. Using transaction fees as an example… A) In the past our volume was lower and our rates were higher. B) Recently we had our rates reviewed and lowered based on our increased volume. C) Next year we plan to implement a payment service that carries a lower average rate than the services we offer today. If you can estimate the percentage of transactions that will use the new service based on some past marker you can easily forecast the transaction fees through your planning horizon by applying the current rate to a portion of your revenue forecast and the new rate to the remainder of your revenue forecast. How about 3rd party vendors that don’t have fixed contracts… A) How many seats with which vendors have you used at past revenue levels? B) How many are you using at current revenue levels? C) Do you plan to fundamentally change seats/revenue dollar in the future? Maybe you exchange revenue levels with customer service rep count, which is based on a staffing plan pegged back to revenue. In either case, revenue is driving its way through to give relative reference for A, B, C, and the forecast.
In this way you’ll go through each account: A, B, C, forecast. Historic data, current actuals, and a strategic plan is all you need. And, well, a spreadsheet. Hope this provides some help and motivation to get started with your forecasting early!