Improve Your Sales Forecasting

The only award-winning business publication filled with exclusive no-nonsense how-to articles written to help you succeed, has been at it again.

The Business Owner has just released this valuable article series Profit Enhancement Strategies for purchase.

Click. Purchase. Profit.

================================================

Owning and running a business is a task. But accurate sales forecasts can make the job a heck of a lot easier. Particularly, they can help with four crucial business management tasks:

1. Earn a profit
2. Budget cash
3. Schedule production (or service delivery)
4. Manage inventory

First, if sales can be projected with some accuracy, earning a profit becomes easier. This is because if near-term revenue levels can be estimated with some degree of certainty, management can hold expenses to levels that allow an acceptable profit.

Second, there is no task more important than ensuring the business has the cash it needs to meet its obligations and remain solvent. Sales are the primary source of cash. Fluctuations in sales cause fluctuations in cash flow. If fluctuations can be anticipated, the owner-manager will be given the opportunity to:

1. Cover shortfalls in the most cost-effective and low-risk manner.
2. Put surpluses to use in the most appropriate and highest-yield manner.

Third, some of the business owner’s greatest challenges are setting production, inventory and staffing levels. Run out of product or fail to deliver as promised and revenue is lost. But overproduce, overpurchase or overstaff, and profit and cash flow take a hit. Accurate sales forecasts make each of these tasks easier.

History repeats itself

Yes, you can learn to make accurate sales forecasts. No, it won’t take a crazy amount of time. Yes, it can be well worth the effort.

We’re talking about 12-month forecasts. There are reasons you may want to, at times, make multiyear forecasts, but from an operational standpoint it’s the 12-month sales forecast that’s the most useful. And when the subject company is well established, it typically can be done with reasonable accuracy. This is because:

1. Recent sales patterns provide a solid base to build estimates of future sales on.
2. Many of the things that will cause future sales to deviate from the past are knowable.

Start with the past year’s monthly sales

Begin your 12-month sales forecast by simply dropping last year’s unit sales into a spreadsheet. Table 1 below shows last year’s monthly unit sales for Hicks Tools, Inc.

Next, consider the following as you begin to consider how the next 12 months might deviate from the prior:

• Your three- to five-year sales volumes and trends
• Your upcoming initiatives and programs
• Moves and development of your competitors, vendors and customers
• The broader economy

Your three- to five-year sales volumes and trends

Regarding your own recent sales, there are two primary things you want to review: product life cycle trends and seasonality. Doing so is simple once you’ve loaded the multiyear unit and dollar sales volumes into a spreadsheet. Space limitations here prevent us from showing all of the data for Hicks Tools, but you should “spread” the unit sales and dollars sales for each of your products and services for a minimum of five years. Once the data are loaded, generate graphs. It aids analysis and understanding.

Product Life Cycle Trends

The accompanying Graph 1 presents monthly unit sales for three of Hicks Tools products over the past four years. As one can see, Hicks Tools unit sales of these products declined quite markedly the past two years. You can also see there is a bit of seasonality, with sales spikes typically occurring around March, July and October. Finally, unit sales for Product 6 seem to be gradually trending downward while Product 5 is holding strong. These trends should be factored into the 2010 sales projections. Of course, the process should always involve an assessment of what is behind the trends and what impact they may have on future sales patterns. For example, is the unit decline of Product 6 due to lack of sales and marketing efforts; a generally downward pressure on revenue due to the poor economy; price increases that are encountering customer resistance; or maybe cannibalization from another product; competition; or product obsolescence?

Seasonality

Seasonality must also be considered when accurate sales forecasts are the goal. To do so, arrange the data as in Table 2. Most useful is to do this for each product and service, but space limitations prevent us from showing that detail here. Table 2 shows the seasonality analysis for Hicks sales in aggregate.

The methodology entails summing the contribution each month has made over the period and then dividing the monthly total by the total revenue for period. The result is the average annual percent of revenue contribution for each month. For example, Hicks Tools has booked $1.375 million in revenue during October over the past four years. Total revenue over the period was $14.3 million. By dividing $1.375 by $14.3, we find that October has contributed 9.6% of all revenue over the past four years. If a business had no seasonality, each month would contribute 8.333% of the annual total (100% divided by 12 = 8.333%).

Graphing the data makes the seasonality much easier to see. As one can see in Graph 2, monthly revenue fluctuates around the mean of 8.333%. The peaks in March, July and October are more easily seen on this graph as are the slower months — February, May, August and December. Mrs. Hicks accounts for this pattern in her sales forecasts.

If one wished to “seasonalize” an annual revenue estimate, doing so is simple with the data compiled as in Table 2. For example, if Hicks Tools estimated total 2010 revenue of $3.2 million, a monthly revenue estimate could easily be derived. Table 3 shows this calculation. But these numbers are only modestly useful because considerations have been given for things such as product-specific trends and initiatives. Also, this method yields neither a per-product sales estimate nor a per-product unit estimate (only consolidated monthly sales estimates with seasonality considerations based on the past four years of seasonality data) and thus provides little aid to the tasks of production planning and inventory levels planning. Still, it’s valuable to graph the monthly sales history and identify the seasonality patterns.

Your Upcoming Initiatives and Programs

Launching an updated product? Hiring a salesperson dedicated to a particular product or service? You’ll want to mold your projections accordingly. You’ll also want to consider moves you anticipate from your competitors or other outside influences.

The Economy

When projecting sales, you must give consideration to:

• Economic forecasts for the projected period
• Where the economy is in the current economic cycle
• Degree to which your sales and services are sensitive to the economy (i.e., elasticity of demand)

Addressing the above in reverse order, assessing the economic sensitivity of your products and services is the most important. It is also the easiest. Simply take a look at the pattern of your unit and dollar sales through several full economic cycles. Some products and services swing wildly. Others are relatively stable, even countercyclical. Your task is to peg whether your sales swing up or down 10 percentage points across the cycles or, say, 50%. If you are new to your industry or don’t have the historical data available, attend an industry conference and ask your peers. You also may need to assess each of your products or services independently.

Once you have a handle on how your products or services perform at different points in the economic cycle, the question is: Where are we currently? Determining this is not as difficult as it sounds. First, you don’t have to peg it exactly. Just get it close. Second, the federal government¹ officially announces the beginning and ending of expansionary and contractionary periods, referred to as peaks and troughs. The beginning of an expansionary period is called a trough (i.e., the bottom or end of a recession). The end of an expansionary period (and beginning of a recession) is called peak. The only question is, once a particular period has begun, when it will end. Of great use are historical data that:

• Expansionary periods tend to last about five years, give or take a year.
• Contractionary periods (i.e., recessions) tend to last about a year, give or take four months.

The National Bureau of Economic Research (www.nber.org) has officially announced that the current contractionary economic period we are in (i.e., recession) began December 2007. Judging from past recessions, this one should have ended around December 2008, give or take a few months. Now, of course, it’s spring 2010. Based on past recessions, we should be out of this one now and on to broad economic expansion. Interestingly, we may already be. The NBER announces these things in arrears, typically three or six months. But actionable information here is that the odds are we have already begun, or will soon begin, a broad economic expansion. Your sales projections and business plans should reflect this.

Bringing it all together

Hicks Tools, Inc. got hit pretty hard during the economic downturn of 2008/2009. Sales declined sharply during the period and Mrs. Hicks waited way too long to reduce staff and cut inventory. It was not the first time Hicks failed to anticipate swings in the general economic climate, so at the end of 2009 she endeavored to not let it happen again. To that end, she resolved to begin making regular 12-month sales projections. She reviewed her long-term unit sales trends and past changes in product pricing. She assessed both the seasonality and cyclicality of her operations. As we saw above, Hicks Tools has some seasonality. It is also cyclical. Sales declined some 41% from 2007 to 2009. To begin making meaningful sales projections, Mrs. Hicks listened to economists and reviewed regional and national economic forecasts. She noted when the current recession began and how long recessions typically last. After taking some time to assimilate it all, she developed her own opinion to base her sales projections on (at least in part): 2010 will show an uptick in activity, particularly in the latter part of the year.

Mrs. Hicks also has tweaked her product pricing some so that the ones priced just above a major price point were brought below. For example, she reduced Product 1 from $425 to $399 and Product 2 from $4,015 to $3,999. She thinks customers will continue to be particularly price sensitive on larger-ticket items. She also raised her price a bit on Product 5 as demand has remained strong; she thinks her customers have few quality substitutes; and there was room to raise and still keep the price under $3,000.

Mrs. Hicks factored a few other things into her projections as well, such as what appears to be a failure of one of her stronger competitors. She has been getting calls from some sales representative of BJ Supply looking for jobs. Overall, she’s forecasting 2010 total revenue of $3.4 million. Her sales forecasts, broken down by month and by product, will aid her in deciding how much inventory to purchase and carry, what staffing levels to maintain, and also prompt her to assess her ability to deal with the cash drain that a rapid rise in sales can cause.

A Continuous Process

Managing a business can be like driving a car at night with the lights off. Accurate sales projections turn the lights on. But they are brightest right after the analysis has been completed and new projections are made. It doesn’t make sense to let the light fade away until you are once again in darkness. Your seasonality analysis, economic cycle assessment and 12-month unit and sales forecasts should be updated every three months or as new significant information becomes available, whichever comes first. Compare actual to forecast and attempt to pinpoint errors and, over time, you’ll improve the accuracy of your sales forecasts.

Summary

Projecting unit and dollar sales is a bit of a task, but it can provide meaningful aid to the business owner who wishes to be more effective. The research required also can provide the owner-manager with the vision and confidence he or she needs to make some moves that could pay off handsomely.

Many business owners leave the sales projections up to their salespersons. This is a mistake. Sure, get their input, but accurate unit and dollar sales forecasts are developed from a thorough and reasoned assessment of the trends and forces that impact them. That type of analysis is more suited to you and your chief financial officer. And the only reason to go to the trouble of regularly making accurate sales forecasts is, of course, to make more money and have more fun.

^{1 The National Bureau of Economic Research (NBER)}