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Business Budget Series 2
Sales forecasting is the process of estimating future sales. It is a key part of budgeting and is essential for making informed decisions.
A number of different methods can be used to forecast sales. The most appropriate method will vary depending on the products, services and markets involved. In this article we discuss the best forecasting methods for small business and how you should use them.
Sales forecasting: demystifying the crystal ball
Why do businesses need to forecast sales?
Sales forecasts are the basis of business planning. Estimating and understanding future sales enables better decision making about:
Direct costs (features/options)
Indirect costs(costs of running the business)
Investment (what to invest in)
Funding (appropriate funding for the business)
Profit (how much should be retained for future investment)
Making decisions is easy, but every decision has consequences. Accurate sales forecasts increase the chance of good consequences for the business.
Sales forecasting methods
In business school we’re taught that forecasting falls into one of two categories:
Top Down, where targets are dictated from the head of the business and roll downwards.
Bottom Up, where opinions are gathered from all levels within the business and rolled up to form targets.
This is old-school thinking! We live in an age of data, where the best decisions are based on information.
In the words of former Hewlett Packard CEO Carly Fiorina:
The goal is to turn data into information, and information into insight Carly Fiorina
Next we’re going to explain the most useful forecasting methods but also explain how they’re best used – so you can determine the most useful for your business.
Customer Analysis
Vilfredo Pareto was an economist who observed in 1896 that 80% of Italy’s land was owned by 20% of the people. Later economists proved that this also applied to other economic and business sectors. You might recognise this by another name – the 80/20 rule.
The 80/20 rule holds true for customers – on average 80% of sales revenue will come from 20% of your customers. This top 20% are sales drivers for your business, which means their historical spend can be used to forecast future sales.
Calculate your top 20% clients using sales data from a similar historic period to forecast the next year. Most businesses find an average of the past 1-3 years data is best.
Increase or decrease the forecast for factors that will impact their spend with you in the coming year, such as:
Their financial performance
Their success & competition across various industries and sectors
Economic & other impacts on them
Your relationship with them
The result is a sales forecast built by customers or customer groups.
This analysis is most useful when: the business has been operating for a number of years and sales have been steady or have been growing/declining with a steady trend (the trend should be incorporated in the forecast).
Market Analysis
While customer analysis is very useful, it only captures your existing customers.
Your forecast will benefit from also including impacts on the broader market/s you sell into.
Gather data from reputable sources to answer questions like:
Is the market expected to grow / contract / remain stable?
What will drive your customer purchasing decisions over the next 12 months?
Are there opportunities to influence these decisions and lock in sales?
If market factors mean less sales are likely, what alternatives are available to either
repurpose those goods/services for other markets or alternately modify and sell back into the existing market?
This analysis is most useful when: you have a strong concentration of clients, or are expecting to grow more, in a particular industry. It’s also useful when good quality market data is available – solid data gives us useful information which in turn leads to insightful analysis (thanks again, Carly Fiorina!). Look for sources such as:
Australian Bureau of Statistics or similar
Industry bodies / Chambers of Commerce
Commercial market or economic research organisations
Product Analysis
Welcome back to our old friend Vilfredo Pareto! You’ll be happy to know that the 80/20 rule also holds true for products and services. The top 20% are sales drivers for your business, so you can use them to forecast future sales. Remember to use a relevant historical period as the base and assess factors such as:
Lifecycle of each product/service
Customer feedback
Supply chain constraints
Pricing
The result is a sales forecast built by products or product groups.
This analysis is most useful when: the business has been operating for a number of years and sales have been steady or growing/declining with a steady trend (the trend should be incorporated in the forecast).
Aspirational Analysis (with a touch of Realism)
The objective of aspirational forecasting is to consider what might happen in a perfect world, wherein all customers want to purchase in the anticipated sales period at the price you are willing to sell them at. These should be modified with real-world impacts, which drives operational planning for how to achieve that outcome.
For example, let’s say your business is a fabric retailer. The 2018 Christmas decoration trend is sequins. Every woman/man/child wants everything that’s sequined, including your fabrics. In an aspirational world, everyone wants to buy your fabrics at their respective maximum prices. In this we would build the sales forecast based on:
Maximum sales price x stock purchases (ie selling all stock at RRP)
Reduce by an estimate of unsold stock (based on prior season history if you have it)
Reduce by estimated discount % (based on prior season history if you have it)
The resulting sales forecast is modified for real-world effects and realistic sales targets to work towards.
This analysis is most useful when: stock purchases need to be made in fixed amounts, or in businesses with strict investment requirements to meet – eg cash burn rates for startups.
The best type of sales forecasting for your business
If you’re thinking that more than one type of analysis would be right for your business – you’re correct!
Most businesses will combine some or all of the above analyses based on:
Trading history (is there enough to use for historical trends?)
Industry/sector exposure
Customer mix
Product mix
Types of goods/services produced
Take time to evaluate the state of your business and the information available to help determine which analyses to use.
What Next?
This article is part of a series designed to help Small to Medium enterprises understand and implement budgets within their business. If you’re looking for more tailored advice for your business, contact us.
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