I am surprised at how few small business owners do any kind of financial forecasting given how valuable a tool it is. I am given many reasons as to why this is, but most often it is: “I’ve tried, but my industry is too uncertain and my forecasts are always wrong, so there is no value in it and I have better things to do with my time”.
My answer to this is simple - almost every forecast in business will be wrong, but that is no reason not to do any forecasting. In fact, incorrect forecasts are the best kind!
Let’s look at two business owners, and you tell me which one benefits more from the exercise of doing some basic forecasts:
Jessica sits down and prepares a forecast for next quarter. She forecasts that sale will increase to $120,000, and expenses will increase to $80,000 due to an increse in her rent but a small saving from one staff member cutting back to 4 days per week. At the end of the quarter she reviews her forecasts and, no surprise to Jessica, her forecasts are almost exactly correct.
At the same time Steve was also doing his forecasts. He also forecast $120,000 of revenue for his business, and $80,000 in costs. At the end of the quarter he found his revenue was $20,000 below forecast, and his expenses were $5,000 above. He looked into why, and found a whole lot of issues: he forgot that this quarter was notoriously quiet for his industry; he had another debt go bad; he had a staff member take long service leave; and, he had to retrench another staff member which involved a sizeable payout.
Jessica was almost exactly correct, while Steve was very wrong. If forecasting is only worth doing when you are likely to be right, Jessica would keep at it while Steve would give up. Yet I hope that it is clear to everyone that Steve benefitted substantially more than Jessica did from this exercise.
Jessica learned almost nothing, but reconfirmed what she already knew – that her industry is relatively predictable and she is good at forecasting.
Steve, on the other hand, learned:
- his industry has peaks and troughs during the year that he should know are coming, if not the exact size of them, and he should take this into account when planning for his business (production levels, spending, staffing etc.);
- while he can’t know which debts will turn bad, he has a history of bad debts and he should factor in some allowance for bad debts each quarter. Sometimes his guess will be too high, and sometimes too low, but over time it will roughly average out – and its better to plan for some bad debts and be get a postive surprise if there are none than plan for no bad debts and have to find a way to deal with them if they do occur;
- he can’t predict when staff will take leave too far into the future, but he can ask his staff to give ample notice and factor this into short term forecasts, and put some allowance for it in the long term forecasts.
- occassionally he will have to let staff go, and he should allow something for this in the forecasts otherwise staff turnover will always be a negative surprise.
Steve, although he was quite wrong with his forecasts for the quarter, learned a lot more than Jessica. When he prepares his forecasts for next quarter he will do a much better job, and better again the quarter after that and so on. Even though Steve is operating in a volatile industry, even forecasts that end up being very wrong are teaching him a lot about his business.
Finally, some tips if you want to improve your forecasting:
- Forget about getting every single forecast right and accept that they will all be wrong. The goal is to get them right on average over time. The process of continually improving your forecasts will teach you enormous amounts about your business and impove the way you manage it.
- Detailed forecasts are better than high level forecasts, even though you will be getting more individual numbers wrong. For example, instead of forecasting sales revenue try forecasting sales volume by customer or division, and pricing by customer or division. Instead of getting one number (sales revenue) wrong you will get dozens of numbers wrong… but the resulting forcast of sales revenue (ie. the end goal) will be less wrong by having gone through the exercise. Plus, when your actual results come in you can see which component you got most wrong and work on correcting that part of your business first.
- Make sure that you dedicate time to analysing why your actual results were different to your forecasts. As we saw above, this is how you get most benefit from your forecasts, learn about your business, and improve your forecasting over time.
- if you cannot bear the idea of being wrong in every number you forecast, try doing best/worst case scenarios instead of single point forecasts (with the likely case falling in between). You will get all the benefits of preparing the forecast, but not be disheartened when your numbers are wrong (unless they come in way outside your best/worst case range – so start with a very wide range so this is less likely to happen!). In many ways forecasting this way is better than single point forecasts because it also makes you think about the volatility and risk in your forecasts, not just the most likely outcome. Understanding that is a great thing.
