Forecasting Revenues
Forecasting revenues is important for all business owners in order to manage cash flow and respond to changing market conditions. Small business owners typically forecast revenue growth by identifying trends and seasonality from the prior three years, then averaging the revenue growth that was experienced, and using that percentage as a goal for the upcoming year. For example, if a business has experienced 3% growth each year for the past three years, one may aim to grow revenues by 3% once again for the next year. While this is perfectly acceptable, a small business owner should challenge the business to grow further and base this on the budget and stretch goals.
Stretch Goals from a Budget
In our resource “Proactive, Not Reactive, The Importance of a Budget,” the Giersch Group stressed the importance of creating a budget for the New Year. Revenue budgets can be driven as much by emotion as they are by economics. Business owners may choose a number that they would like to attain for the year in terms of revenue. This may or may not be based on the hard financial analysis of market projections and seasonality. It is important to ground revenue projections in market facts. This projection should not be some arbitrary number that sounds great, but is not attainable and is unfounded by research. A business owner saying the goal should be to double the revenue in a year can be acceptable, if it is backed up by the numbers.
A small business owner may be experiencing 12% growth each year, and currently sitting at $800,000 in annual revenue. This owner may set a goal of $1,000,000 for next year. This is more than double the growth that they have been experiencing, but the owner has used his judgment and pipeline to identify $700,000 worth of revenue already predictable for the coming year. Identifying the gap between goal and identified revenue is easy: It is $300,000 in this example. However, the second step in this process is to figure out how to fill this gap.
In order to fill this void, a manager needs to consider the effectiveness of sales channels and the purchasing behavior of customers, which are the two most important drivers of revenue growth. In some cases, the business owner is the sales team. It is essential to understand the sales teams’ (or owner’s) capacities and limits. Understanding your customers’ purchasing decisions is even more important. It is critical to understand the amount of time and effort needed to convert prospects to buyers when forecasting revenue. Projections should take into account:
- The total number of potential customers the business can realistically address.
- Variables in the sales teams’ productivity. These include the number of reps, their capacity to make calls, average length of time to close a sale and average close rates.
- Incentive structure and potential impact on sales.
- Any other sales channels that are in use.
- Seasonality of buyer behavior.
The portion of the budget that is driven by financial analysis must be as factual as possible. The forecasting should gather information about the industry and market, as well as competition and growth of all competitors. Through the gathering of strong facts and reliable information, it is possible to create realistic expectations and set attainable goals. Caution should be taken while procuring market information because third-party studies and estimates can be out of date or skewed. These statistics should be used as a reference and not as facts. Using several sources along with studies and interviews with prospects and customers from the market will provide relevant information about buying behaviors and aid in competitive analysis.
Projections of revenues are only as good as their assumptions, so being diligent with the research is imperative. The Giersch Group has written a resource titled, “Forecasting: The Importance of a Financial Model,” that covers the process of building a financial model that takes into account various assumptions that can affect the business’s budget. In making assumptions, managers and decision-makers need to be aware of two key pitfalls with assumptions. While making projections and planning for the future, it is important not to make implicit assumptions. A business stating that it will add ten new employees in the next year is assuming the business can actually sustain this growth. It is also critical to not assume that the likelihood of something happening or not happening is certain; using words like always and never. The budget-makers should distinguish between likelihood and certainty, and build risk analysis and probabilities into their projections. Using several scenarios and getting as much input from multiple stakeholders is also helpful when trying to identify assumptions and probable outcomes.
Role of Financials in Forecasting
Financial statements should paint a picture of how money is being used; where is it coming from and where is it going? Revenue is essentially the money coming in (Income), and on the Profit and Loss Statement in particular, should be broken out in order to identify what products or services make the most money. Most businesses have several ways that they make money and some are more profitable than others. For example, an IT company may offer managed services, break/fix and sell hardware. Managed services are a subscription service that does not cost much to maintain and produces high-profit margins. These services may be small in number, but can represent a high profit. They are also less variable in terms of pricing. While selling many of these may not represent much in the top line, the high margins directly contribute to net income.
Break/fix services represent a highly variable margin depending on how the business bills the service. This is a service that will require a tech to either diagnose an issue from a remote location, or may require a site visit. Site visits and scheduling can be troublesome and time-consuming, thus making margins and planning unpredictable. Many companies are moving away from providing break/fix because it can be inefficient and operates on a reactionary basis, which can take time away from opportunities that generate the most revenue. The revenue for this type of service can vary depending on the setup of the margins and the type of work performed. An employee may be reimbursed for travel or overtime, reducing the profit margin for the service. The employee may also be salaried. These types of services can produce medium revenue and have variable profit margins.
Lastly, the hardware sales may be an attractive statistic for the business. A business may sell a lot of hardware such as computers, hard drives, printers, and equipment, but for a low-profit margin. These types of products typically have a fixed margin due to the supply chain. In this example, if the IT business takes a 15% margin on all hardware sales, making many sales may not contribute much profit when compared to other offerings. In essence, a business may set and meet goals for sales of hardware, but not actually make much money. Hitting the $110,000 milestone may sound like a great achievement, but it did not make much profit for the company overall. It is important for business owners to understand what products and services are driving revenue and how they relate to gross profit.
Driving Profitable Revenue through a Marketing Plan
A marketing plan should be used to achieve the revenue growth that is desired. Many businesses struggle with the idea of a marketing plan. Business owners can get bogged down by generic goals and focus on what is important to them and their business, rather than what customers need and want. A marketing plan will create the need for research and analysis and in doing so, will uncover potential opportunities and threats. By performing market research and analysis, breaking down and refining financial statements, and identifying buyer behavior trends, small business owners can begin to formulate clear marketing plans.
A marketing plan should identify goals and provide a path in which to achieve those goals. These goals should be: specific, challenging, yet attainable, and, most of all measurable. A small business owner can use the aforementioned methods in order to perform market analysis and make assumptions. Using this data, it’s possible to formulate clear, measurable goals. In order to be measurable, all goals should be tied to the financials. It is not clear or measurable to simply state that the business should grow the customer base or revenue.
Using the IT company example, research may show that there is a market opportunity for managed services. It is estimated that the company could sell X amount of subscriptions. The goal should be tied to a monetary number. So, a goal would be to increase the number of managed services subscriptions to X amount in order to attain $500,000 in revenue for the year. The goal’s progress can then be tracked in terms of revenue for managed services throughout the year. The business owner would know that the margins are high and that reaching this goal would produce a large profit. This is clear, attainable and most importantly, measurable.
Conclusion
Forecasting for the coming year is critical to growing the revenue of a business. Research should be performed to understand the competition, the needs and wants of customers, the market as a whole, and what products and services are driving the revenue of the company. Identifying the most profitable products and services will aid owners in creating specific goals in order to grow revenue. Tying clear goals to financials makes it possible to track the progress of these goals and react to changing market conditions.
It is important to state that a budget is a commitment. A business owner is making a commitment to him or her-self, and to everyone in the company, that they will hit these numbers. A budget should be realistic, created through financial and market analysis, and used as a benchmark for comparison throughout the year. Adhering to the budget and making adjustments throughout the year will make it possible, and probable, that a company will hit or surpass its annual goals.
Articles for Further Reading
- The Fundamentals of Revenue Forecasting. This article summarizes the importance of creating high quality revenue budgets. http://www.pragmaticmarketing.com//resources/The-Fundamentals-of-Revenue-Forecasting?p=0
- Bridging the Gap: An Integrated Sales and Marketing Plan Provides Alignment Opportunity. This article provides a real world example of how a marketing plan with clear goals helped a large company increase revenue. http://www.salesandmarketing.com/article/bridging-gap-integrated-sales-and-marketing-plan-provides-alignment-opportunity
- Moving away from ‘Break-Fix.’ This article explains the advantages of managed services and the trends in the IT industry, moving away from traditional break/fix models. http://www.businesscomputingworld.co.uk/moving-away-from-break-fix/
For more information, please visit the Giersch Group at http://www.gierschgroup.com/ or contact us at prosper@gierschgroup.com
