There are so many factors to consider when forecasting. The processes required to forecast correctly are many but interconnected. For example you cannot manage cash flow if you don’t have a good forecasting system. In this article, I will be discussing the main steps to take in developing a budget/ forecast. Budgeting and forecasting work hand in hand. Once you have a budget in place, you can determine how much cash is needed to run the business.
Below are the steps to take before planning for cash:
Get an overall plan
Any serious business owners should sit down at least annually to decide what direction the business is going to take. At this time a budget should be put together. A budget is simply a formal written statement of the business owners plan for a specified time period, expressed in numbers. A budget signifies agreed upon objectives and goals of the business. Budgets promote efficiency.
Without a budget it is hard to forecast because you have no basis for which to draw on. Budgeting and forecasting work hand in hand.
Sales forecast
A budget is designed around the sales forecast. The sales forecast is the very first step one must take to develop a budget. Most business owners use past performance as a starting point in developing a sales forecast. This is why keeping track of marketing activities is vital. The better the data is, the better the forecast. A sales forecast must take into consideration the following:
a) Potential sales for the industry and general economic conditions:
b) Marketing plans
c) Technological development that can help improve productivity
Forecasting is highly dependent on your marketing system. A good marketing system will achieve the following:
a) Increase the predictability of sales: A good marketing system should be able to estimate what kind of outcomes to get from various marketing campaigns. Also a good marketing system packages and prices products in a way that increases the recurring nature of the sale.
b) Increases the reliability of data: A good marketing system tracks “relevant metrics”. Note the word relevant: You have to know what is important to the success of your business. Tracking the wrong metrics is worse than not tracking.
c) Increases the accuracy of the budgeting process: With good data and effective pricing and packaging, the accuracy of data in the budgeting/ forecasting process is increased.
Once the sales forecast is completed a sales budget is developed.
The Purchase Budget
Once the sales budget is done, the next step for a retailer (steps are different for manufactures and service businesses) will be to develop the purchase budget. The purchase budget shows the number of units to purchase to meet the forecasted sales. The purchase formula is as follows:
Budgeted sales unit + Desired ending inventory – Beginning inventory = Required purchase units
It is important to realistically estimate ending inventory based on the forecast. Excessive inventories is a problem especially if you sell perishable goods. There is additional cost to the business in keeping more inventory than needed. For example your cash is tied up in inventory and you can’t do other things you need in your business. On the other hand, too little inventory could mean lost sales.
Direct Labor Budget
Once the sales and purchase budget are done, the next step is to determine how much labor is required to make the forecast come to reality. At this level, we are only worried about labor that directly interacts with the product (all other labor is part of the business overhead). For example, you will need to pay someone (or do it yourself) to assemble the product if required, manage the logistics, manage the warehouse (assuming you sell a physical product), etc. The higher the volume, the more labor required. With a good budgeting system, you will be able to narrow down to how much labor is required to move one unit. The formula to determine your total direct labor budget is:
Units to be purchased * direct labor hours per unit * Direct labor cost per hour = Total direct labor cost.
In this phase, using activity based costing is so useful in determining how much labor is needed per unit.
Marketing Budget
Once you have created your sales, purchase and labor budget, you should create a marketing budget. A marketing budget is putting your marketing plan in numbers. This is directly related to your sales forecast. Here determine how much it will cost you to achieve those numbers.
Overhead Budget
Of course we all know that it is hard to run a business without some type of overhead. We want to minimize overhead as much as possible. Your overhead budget should distinguish between fixed and variable cost. At this point, you should have determined your optimal cost structure. Your optimal cost structure is the ratio of fixed to variable cost that maximizes your profitability. Your overhead is the catch all for all your expenses that don’t fall into the essentials such as purchasing, direct labor and marketing (remember, this is for a retailer). Your overhead will include things like rent, taxes, management salary, etc.
Budgeted Income Statement
Once you have the above budget in place, you are now ready to create your budgeted income statement. As a retailer you should use a multistep income statement as follows:
Revenue – Cost of goods sold (this comprises your purchases and direct labor budget. How you come up with the cost of goods sold is a topic for another post) = Gross Margin
Gross Margin – Marketing expenses – Overhead = Net Income
The Cash Budget
Finally, we come to the cash budget. Anybody who has been in business long enough knows that cash, revenue and expenses are not always simultaneous. This is why you need a good understanding of how cash flows through your business. Cash is the life blood of your business.
Your cash budget should comprise of the following sections:
1) The cash receipts section
2) The cash disbursement section
3) The financing section
Your cash budget should be divided into intervals that are important to the business. This depends on how quickly cash flows in and out of the business. For most businesses, forecasting monthly will be sufficient. If you use the monthly interval, and cash disbursements are expected to be less than cash receipts then some type of financing is required. A prudent retailer should aim to build long term relationship with some type of lender. I have clients that do vendor financing, some have line of credits and some just have high enough margins where they hardly ever have a cash short fall, so therefore need no financing. The cash budget should show expected financing and repayments plus interest. More details of how to do this will be discussed in a later post.
For the more ambitious retailer: The budgeted balance sheet and capital expenditure budget
For the retailer looking to increase the financial value of their business overtime either to pass it down or sell it, it is recommended to have a budgeted balance sheet and capital expenditure budget. That is all I am going to say about this for now.
Phew! No wonder people pay CFO’s to take care of this. Retailers who have sophisticated financial systems like the one described above sell at higher multiples. Hope to see you in my next post …
Excellence is continuously putting yourself out there even after repeated failures. Mediocrity is resting on your laurels.