When you begin planning for the next business year, one of the first steps you should take is to forecast your sales. Forecasting your sales is the process of guessing what your revenue will be in the upcoming year. Estimating your sales allows you to understand how much money you have available to spend, what your cash flow may look like, and how your company may do in the following year.
Best Practices for Forecasting
There are general things to keep in mind as you begin forecasting. Forecasts are only as good as the information you provide. Although it is tempting to make budget forecasts where your company appears better than it actually is, you should understand a forecast is a planning tool. You’ll use the information to make smarter decisions, so be reasonable. Forecasting models work differently across industries because of the nature of different businesses. You should also use multiple forecasting methods to improve the accuracy of your predictions. The three most common forecasting methods look at your historical sales, product breakdown, and customer demographics.
Percent of Sales Method
One way you can forecast is by using the percent of sales method. This technique begins with you taking a look at your sales from the past few years. Look for trends in your sales amounts based on your number of customers, your sales per customer, or total revenue earned. From this information, you can calculate the average change over the past few years and apply this rate to your total sales. If your sales have been growing 10% and last year’s sales were $35,000, your total sales for next year would be $38,500. If you are a fairly new company and do not have years of historical data, look at your growth from month to month. As long as your industry is not highly seasonal, you can still get a sense of your growth rate. Also, do not be afraid to forecast a decrease in sales. If your sales have been getting smaller, it is important for you to still forecast this so you can plan appropriately.
Product Line Volume
You can also forecast by taking a small sample size of your business and scaling up. Ask yourself how many items you sell on an average day. Multiply this by the number of working days in a week, month, or year to get a bigger sense of what you sell. Looking at the big picture can make it hard to pinpoint exactly what your activity really looks like, but by looking at your product line volume as a manageable piece, you can easily multiply your average day to get a larger forecast. Make sure to adjust for holidays, unexpected business closures, and other events that may change your normal operations.
Estimating Sales on Location or Geography
The third most common financial forecasting technique is based on your knowledge of your market. To estimate your sales based on your physical location, you must know the customer demographics of the area where you are selling. You can base your forecast on any number of demographics including age, gender, ethnicity, or education level. If 2% of all customers between the age of 30 and 40 will buy your product, you can multiple 2% by the number of customers within your physical market. By repeating this process for each age group, you can forecast your entire market and get an idea of what your sales will be for the next year.
Limitations of Forecasting Models
Each of these forecasting models has weaknesses. The percent of sales method doesnt take into account how your business has changed over time. Even if your sales have grown 10% the past three years, your past performance may not relate to your future performance. The product line volume variance has to be performed for each product you sell. Plus, an average day may be difficult to assess based on your industrys seasonality. Finally, the physical location method assumes your information is correct. You need the right numbers on your customers or the model will be off. The physical location is also very limited for forecasting online sales because your customer reach is hard to estimate.
Selecting a Forecasting Method
When preparing your sales forecast, you should consider which methods work best for your company and attempt to perform multiple forecasts using different models. This gives you a range of estimates that will be more helpful than one figure. If you have a range of sales forecasts that are all close to each other, you know that your data and information are valid. In some cases, it doesnt make sense to use some of the methods listed above. The percent of sales is most useful if your company has historical data on which you can rely. The product line volume method should only be used if your business operations are consistent. The physical location method relies heavily on the information you collect about your demographics. You want to look beyond these three variance models if any of them do not work for your situation. The entire point of forecasting is to make a plan for the future. Using these techniques, you will be armed with the information you need to make business decisions.