Forecasting

Although we don’t have a crystal ball, so forecasts are fundamentally informed guesses, businesses need to use them to make informed business decisions and develop business strategies.

The process of building a robust forecast will help you to better understand your business, its key drivers and interdependencies.  Analysing actual data compared to the forecast will provide earlier identification of problems with performance or the forecast, so that improvements can be made.

The result, is an invaluable business tool that supports business decision making and provides the financials equity investors need. 

Historical Data

The best starting point for forecasting is historic data.  Obviously, we cannot influence the past, but we can learn a lot from it.

• Up to date and accurate

Our actual data should be up to date, full and accurate.  Ideally it should be in software that can be used to provide reports that deliver the information in a useful way

• Relevant Variables

This data can be used to pull out relevant variables and interdependencies, things like:

• Direct costs (costs which vary in line with sales)
  • Things you buy to sell
  • People costs, how many people do you need to produce your output targets
  • Materials used to make or pack your products
  • Commissions and fees
  • Marketing costs (what was the cost of acquiring a new customer/client)
  • Sales metrics:
    • Client retention
    • Repeat sales
  • Gross Profit – what was it historically, and how can we improve it going forward

• Fixed costs
• Learning points – what have you tried that went well, or didn’t go so well, so that you can embed that learning into future strategy

Assumptions

As we don’t have a crystal ball, when we look at the variables for our forecasts, we will need to rely on assumptions.  It is really important that we state what these assumptions are, and that they look realistic.  We may even want to do scenario analysis, so what if sales growth was half the assumptions, or double..

Each variable should have an assumption or assumptions that go along with it.  These should be broken down into their smallest metric, so growth % per month, per product or service.

Analysing data and checking assumptions creates a really great incite into your business and what drives its numbers.

Which kind of Forecast?

Forecasts are about looking at the future, but we can detail these in many ways.  The most common forecast formats are:

• Profit and loss accounts
• Cash Flow
• Balance Sheet

You may also want to have detail pages behind these main pages, on things like:

• Sales by product
• Resource requirements
  • People
  • Stock
  • Factory hours

Forecasts are generally built monthly, but sometimes you will also see daily cash flow forecasts (when money is really tight), and quarterly, or annually for data that is projecting off into the future (say years 3, to 5)

Which kind of forecast you build will depend on who, or what it is going to be used for.  If you are looking for equity investment, or a loan, its always good to ask the recipient, what they are looking for, so that you can tailor your output to that.

Steps to building a forecast

1. Sales/Revenues

In your Business Plan you may have had a high level revenue aspiration for the next few years, but now we need to break this down.

• Show monthly

• Show as units, and price per unit – this gives the additional variable of increasing prices, and shows it separately

• Split by product or service (or product and service type)
  • Units per product/service per month
  • This allows different growth rates for each product/service type
  • Each product/service may have different cost interdependencies, so these can also be separated out

• Growth rates
  • By month and year
  • By product/service type
  • By scenario

2. Direct/Variable Costs

Based on your sales from above, what costs are directly related to these, you need to ensure that they all hang together in a logical way.  As you increase sales, these costs should go up at the same rate unless there is a big difference in margin across different products/services

What costs will you incur for each £1 of revenue you are forecasting.

Costs of materials

• These should be split by product/service, as above allowing   profitability analysis by product/service
• What is the impact of order quantities on these costs
• Larger order quantities will generally lead to cost savings, but you also need to consider stock holding and the impact on cash

Direct labour

• All labour should be analysed separately before allocating to either products/service as direct labour or allocated to indirect labour in the profit and loss account. 
• Start with current payroll and consider pay rises, new people, leavers.
• ensure you include all the associated costs of people including employers’ national insurance contributions and pensions, and bonuses etc
• People come with ancillary costs. 
• Things like laptops, desks and chairs, mobile phones etc
• Don’t forget recruitment costs and training for any new people
• These should be split by product/service wherever possible

Consider the cost of labour per hour

• When looking at the cost of labour per hour, we need to consider the full cost of employment, and the actual hours worked.
• Actual hours worked are lower than contracted hours due to:
  • Holidays – time taken off for holidays but paid in full
  • Non-productive time – this could be training, meetings, admin etc

Other costs that vary in line with sales

Utilities:

If you are utility heavy in the production of your goods, then the part of your utility bill that relates to production is variable.  Where possible, you should work out the cost per product, or service, or some other variable that is relevant to your business

Marketing:

• The purpose of marketing, is to generate sales, so, what sales are anticipated to be generated from each £1 of marketing spend.
• This spend may be campaign driven or monthly ongoing
• If possible we should try and split by product/service
• Was the marketing aimed at new customers, client retention, repeat sales, referrals etc

Warehousing space:

Whilst generally a fixed cost, if you have a period of high growth, you may need to look at new space, or more space.  If this is the case in your business, then you should look at the drivers of the cost and link to revenue.

3. Indirect costs

Some of these may remain the same regardless, but other will change, just not necessarily directly in line with Revenues.

Rent – are your offices, or other premises adequate, and at what point will this need to change.  Are they in the best location, and does this need to change.

Finance and interest – if you are looking at more traditional finance routes, you will need to include interest in the profit and loss forecast and also repayments in the cash flow.

Once a forecast has been completed, you will need to do a review.  Does it hang together, does it look right?  If not, go back around your assumptions and check whether amendments need making.

Cash flow forecasting

When converting the profit and loss elements of a forecast into a cash flow forecast, you need to consider a few non profit and loss items, and timing.

• Non-profit and loss transactions
  • Loans – Where you have a loan built in, you will need to include the repayment of the loan. 
  • Directors Loans – If you take a regular amount out of your business as a directors loan, that may be converted to a dividend at the end of the year. 
  • Payment of taxes
    • VAT – for most people, VAT will be based on a quarterly cycle paid one calendar month and 7 days after the end of the VAT quarter
    • PAYE and Pension contributions:

Wages are paid to employees net of deductions at a timing dictated by your employment contracts

Deductions made from staff salaries, plus employers’ national insurance and employers pension contributions are paid over after wages are paid.  Mostly, this is on or before the 19^th of the following month

• Corporation Tax – due 9 months and 1 day after the company year end
  • Buy back of equity (unless the plan is to sell the whole business in the medium term rather than buy back the equity)

• Other timing considerations
  • Payment terms – How long does it take each of your customers to pay?  This may be longer than your standard terms.

Better credit control procedures can improve this

• Stock purchases – If you use stock in your business, you will most likely buy in far greater quantities than you sell in, which leaded to holding stock.

Stock ties up cash and can cost in storage too, but order quantity impacts the price of what you buy, so this is a delicate balance

Often, to release goods, you have to pay, so you need to take account of:

• Whether the items are in stock at your supplier, or need to be schedules for manufacture
  • Shipping time
  • Customs, if importing
  • Conversion, once you receive the items

• Resources lags – your revenue numbers can be used to highlighting resource gaps:
  • People –  factor in recruiting and training, plus recruitment fees and any equipment they may need.
  • Premises – factor in the time taken to find suitable premises, then any legal fees, refurb costs, bond payments, or rent payable in advance etc
  • Marketing campaigns – You will need to decide on things like design and print, postage, people time for processing orders, a lag for any SEO to kick in etc

These numbers will highlight when your cash flow will be negative and for how long.  So, this will give you the answer to how much and for how long. 

Scenario analysis

It’s important to stress test any numbers, especially if you are going to use them to make a big decision.  To do this, you need to look at which of the assumptions you have made are:

• Most susceptible to outside forces
• Are the greatest risks

You should then ask “what if” and run a version of your data based on that, so things like:

• What if sales only grow at half the rate?
• What if the promotion only sells half the volume?
• What if we only get listed in half the outlets?
• What if occupancy is at a lower rate?
• What if we have to lower prices?
• What if we don’t solve the problem we are looking to solve?

Also, question, if you were to run this business without bringing in finance, what would that look like?  Or with less finance.