Forecasting may not be a top-of-the-list item on the minds of entrepreneurs and small-business owners. But failing to take a forward-looking, bird’s-eye view of a business could lead to critical mistakes and a lack of direction. A situation that could be avoided with a well-devised, objective forecast based on sound data.
Forecasting, when done right, is more than a simple prediction. A business forecast is based on a deep analysis of information about the company, the industry, and the economy. It becomes a critical resource that management can use to prepare for and get ahead of market changes. And it allows you to establish realistic plans for the future of your business instead of just winging it.
So, what does a forecast look like?
One could make forecasts for the market broadly or for specific metrics, such as revenue and inventory. The right method for you will depend on your businesses, but some common quantitative methods include:
- Regression analysis – a statistical model that predicts a variable based on its relationship to another variable
- Moving averages – this is where you take averages of previous periods to predict outcomes for upcoming periods
- Simulations – the use of probabilities based on historical data, often via computing software.
It is possible to make a bad forecast. By definition, forecasting is a way of looking into the future, and it likely won’t be an exact exercise with 100% accuracy. However, one can conduct forecasts with greater confidence if potential shortcomings are identified in advance and kept in check. Some common causes of poor forecasting include the following:
- Not taking it seriously
Companies that believe a budgeting exercise is sufficient could fall into this trap. Management or the finance team may only conduct forecasts occasionally or reactively. This could lead to inaccuracies and almost always defeats the point of forecasting in an effort to try to equip the business for the future. Forecasts that are taken lightly and not fully understood may not have the credibility needed in the planning stages that follow.
- Ignoring reality
Planning done around pipe dreams rather than real circumstances may lead to less-than-effective forecasts. Aspirational qualities are necessary for running a business, but forecasts should be based on facts and verifiable data. This will then serve as the basis for realistic changes and growth that management can digest.
- Using bad data
A forecast is only as sound as the data on which it is based. Accurate quantitative predictions cannot be made if the underlying data points are insufficient or based on faulty assumptions. A mistake in a calculation somewhere in the process could have an outsized effect on the output and have great consequences if left unchecked.
- Incorporating biases
Individuals have different ways of viewing the world and this is sometimes based on biases. An entrepreneur may be overly optimistic, or a management team may be too conservative. Some may be driven by confirmation bias and search for or interpret data in a way that confirms their pre-existing beliefs or conclusions. For this reason, guidelines and various levels of checks should be in place to ensure that analyses are conducted in an objective manner.
Creating a forecast is not an exact science, and there is no single right way to do it. Nevertheless, forecasting is a key aspect in managing a business for the future. When combined with detailed budgets and open communication among departments and leadership, a forecast can be an essential tool with which to navigate a business toward success. Here are some suggestions for improving your financial forecasting:
- Develop a process
Many companies have now adopted a quarterly rolling forecasting process instead of the traditional annual cycle. A rolling forecast requires the timely collection of business data and key inputs that will drive the forecast model. So, it is important that the company develops a robust process to drive collaboration between the business analytics function, the forecasting function, and key stakeholders so it can incorporate business insights and decisions into the forecast.
- Understand your business drivers
No good forecasting can exist without a firm grasp of the underlying business drivers, which translate into the key inputs feeding the forecast model. At a minimum, the forecasting team should have a good understanding of the key factors impacting revenue and variable costs of the business, such as the pricing, the volume drivers, and the various distribution channels for the products.
- Keep it simple
There are many methods for forecasting, and it might take some time for each company to determine the best approach for its business and industry. In general, there is no need to use overly complicated techniques in financial forecasting, when simple methods (such as moving average) might prove to be effective.
At The CEO’s Right Hand, we work with our clients to build realistic, data-based forecasts that they can use when making business decisions. Contact us today to learn what we can do for you.