Techniques for successful forecasting By Gary Drake and Michael
Techniques for successful forecasting
By Gary Drake and Michael Kerrigan
Instructions: Carefully read the following article on forecasting and then do independent research that allows you to answer the following questions concerning this article and forecasting. Your point value on this exercise depends on the completeness of your answers in relationship to other students in your class. Be sure to include the question you are answering as part of your submission for each response.
1. You have been selected the CEO of an “average” company in the United States. You were hired because of your prior performance in forecasting at a similar company. You first task is to organize the forecasting process for this company. What will go into this process? Who will you involve? What resources will you use (data, people, outside experts, etc. to make this process work for your new company? Be explicit in your response.
2. Discuss the differences between Pro Forma budget analysis and capital budget analysis. In your forecasting for your new company which one will you use and why?
3. How would you keep your company’s forecast updated and current? What would be the length of time for your forecast, and what role will benchmarks play in determining the success or failure of your forecast? Explain.
4. Discuss in some detail your view of the impact of either inflation or deflation on a company’s forecast for sales in the next 5 years. Explain how you think an “average” company will be impacted by either, what they should do to prepare for this occurrence, and what you would do if you were this “average” company’s CEO.
5. Does your current or former employer use forecasting? What it successful in forecasting future sales and trends? Why was it either successful or not successful? What would you do in forecasting differently?
Techniques for successful forecasting
As a strategic planner, you are under intense pressure to generate positive performance results for shareholders and investors. At the same time, you are seeing globalization open markets and create intense competition. Advances in technology and business processes allow your company to rapidly bring new products and services to the worldwide market.
To succeed in this rapidly changing environment, your company can't rely on current growth levels and profit margins. You must regularly develop long-term strategic plans that consider factors such as:
- The viability of existing products and services;
- Opportunities around new products and services;
- The profit potential of internal investment options; and,
- The rate of return on strategic proposals.
Forecasting is the process of predicting how profitable a product or service will be over the long term — and it is a critical part of strategic planning.
A collaborative effort
Unfortunately, many companies get their forecasts from finance personnel who might rely too heavily on historical data. To develop an effective forecast, it's best to assemble a team of subject matter experts from many different disciplines. For example, the team can include:
- Sales personnel to create a long-term sales forecast for a product or service. Salespeople understand the demand for the product and the level of competition in the marketplace.
- Human resources personnel to determine staffing requirements.
- Procurement specialists to determine supplier costs.
- Technology personnel to determine hardware and software needs.
- Finance resources to develop best-case, worst-case, and most-likely scenarios.
This team approach can help you create a more accurate and useful plan.
Successful forecasting techniques
Forecasting techniques are evolving alongside technology. Identifying how you plan to use the forecast can help you decide on the most useful technique. Companies commonly use long-term sales forecasting, pro forma analysis, and capital budgeting analysis.
Long-term sales forecast (three to five years)
Companies typically develop a three-year to five-year sales forecast. This forecasting technique uses assumptions about macroeconomic and product-specific data to project future sales levels. A long-term sales forecast might include:
- A forecast of the economic environment in which the company will operate over the life of the plan.
- A thorough analysis of products and services, growth opportunities, impact of competition, any significant investment required and historical sales data to identify trends that might help support assumptions.
You use the results of this analysis to develop expected sales volumes and pricing levels.
- Determination of expenses that are required to support sales projections. Typically, you develop baseline expense projections by looking at past expenses as a percentage of total sales. You must also look at other factors, such as inflation, deflation, and increases in cost of materials and cost of labor.
Remember that significant growth projections most likely mean additional costs. These costs can have a major impact on profitability. As a result, you need to thoroughly scrutinize cost estimates.
- Calculation of projected profit levels. A company can also develop different scenarios to reflect changes in the relevant inputs.
Pro forma analysis
You can use the data generated from long-term forecasts to create a pro forma analysis, which projects balances and cash flows over a given period. This technique is useful for comparing several periods or evaluating the impact of different assumptions.
A pro forma analysis can also help you assess the attractiveness of a potential merger. It provides useful data to support the negotiation process.
Capital budgeting analysis
Capital budgeting analysis uses projected costs and returns to evaluate long-term strategic investments.
You can use this technique to help you determine whether to fund a proposed project. You begin a capital budget analysis by determining how much money comes in and goes out, and when. This can be a difficult exercise. It requires you to make assumptions about quality and quantity and to carefully review your assumptions.
After you project your cash outflows and inflows, you must select a method for analyzing the data. Companies commonly use one of the following three methods: Payback Period, Net Present Value, or Internal Rate of Return.
- Payback Period is the amount of time required to recover the initial cash investment. You determine this amount by adding up the cash inflows for a product or service and then determining when they will equal the total cash outflow of the project.
You typically approve projects that recover their investment within an acceptable amount of time.
- Net Present Value discounts the expected cash inflows to the present value by using an acceptable interest rate. Companies subtract the initial investment from the total to determine the project's net present value.
You typically approve projects with a positive net present value.
- Internal Rate of Return is the interest rate that gives you a net present value of zero. You usually need financial tools to determine this rate.
You typically approve projects that have an Internal Rate of Return that exceeds the assumed cost of capital.
An ongoing process
Strategic planning needs to be a dynamic process, not an annual activity. If your company is surviving in today's market, it constantly introduces new products and services or reinvents existing ones. As a result, you must constantly reevaluate assumptions and their impact on your long-term financial plans. Successful forecasting is a powerful tool. When used properly, it plays a key role in the strategic decision-making process.
About the authors Gary Drake is a managing associate and Michael Kerrigan is a principal with Beacon Consulting Group, Inc., in Boston, Massachusetts. Beacon specializes in providing operational and strategic consulting services to the investment management industry.
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