How to Forecast Sales


This article discusses the development of a small business sales plan and forecast. Included is an overview of the business planning process and the need to develop a sales forecast to support the achievement of planned financial results. Since business planning is a process, rather than just the preparation of a plan document, some of the benefits of using financial planning software to simulate results under alternative scenarios for decision-making purposes are described.

The business planning process begins with management team defining the company’s vision and long-term objectives. To achieve these objectives, operating managers collaborate with senior management, setting objectives and developing action plans for their respective areas of responsibility. Benefits of this collaborative process include improved communications and increased organizational commitment to successful plan implementation. The most critical part of any business plan is the sales forecast, which drives changes in revenues, costs, cash flows, assets and liabilities. Building the sales forecast and formulating product and service marketing strategies are prerequisites for an effective planning process. In this process, certain assumptions are made about conditions in the operating environment.

The planning process should consider economic, financial and competitive conditions and factor these into the sales forecasts and other financial projections.

A sales executive working on forecasting software

Translating the strategic objectives and assumptions into a sales forecast begins with an objective and realistic assessment of the size of the market served and the competitive position of the company’s products in each of these markets. This includes an analysis of the strengths and weaknesses of the company’s products and services relative to its competitors and the growth prospects for each product. Product or sales managers who have frequent contact with customers are in the best position to assess future sales potential and it is useful to have them develop a forecast for their area of responsibility. Trade associations and other industry sources often have information on the size of markets and market growth. The sales forecast should also include action plans for promotion and distribution. Strategies to support sales can include the company’s website, direct inside or outside sales people, trade show participation, advertising and marketing initiatives.

If the small business has more than one product, gross margins should be forecasted for each product or service provided. Total gross margin changes as the mix of products or services changes. Strategies to foster growth of higher margin sales relative to lower margin business will increase overall margin over time.

The most effective sales forecasting method depends on the type of business. Retailers often use sales per square foot or sales per square meter to set sales objectives, rather than aggregating individual product sales forecasts because of the large number of different products sold. An alternative approach would be to start with a gross margin dollar per square foot or per square meter objective. By dividing the gross margin dollars objective by the targeted gross margin percentage, the level of sales necessary to achieve the margin dollars objective is calculated. Strategies to increase gross margin dollars include increasing volume or increasing the gross profit margin percentage. For example, supermarket chains sell standard grocery items at low margins to attract traffic and heavily promote much higher margin products inside the store. These often include prepared foods, cosmetics, floral arrangements, seasonal items, restaurants and specialty food products.

To illustrate the relationship between unit costs, gross margins and sales volume, consider a small business providing consulting services. Unit costs consist of the direct cost of the consultant and indirect overhead costs of the firm. Assuming that 100% of the consultant’s time is billable at $200 per hour for a 2,000-hour year, total annual revenue generated by the consultant is $400,000. If the consultant’s total compensation is $50 per hour, the direct cost is $100,000 per year, generating a $300,000 gross profit for the firm, a 75 percent gross margin. Adding $50,000 overhead expenses per year to provide the consultant with office space, equipment, phones and other support, the total unit cost of the consultant is $150,000 and the unit pretax income is $250,000 or a 62.5 percent net margin. The firm should consider the impact of any changes in the gross margin objective, since a slightly lower billing rate could increase income if the volume of business increases margin more than lower rate reduces margin. A good financial forecasting software package provides capabilities to measure the bottom-line impact of these types of alternative scenarios.

In businesses where a small number of large customers account for a large portion of total sales, the customer can be asked about the expected level of future purchases and opportunities for increasing those purchases. Possibilities for increasing sales per account should be pursued, along with the addition of new accounts.

Some small businesses with operating histories start with growth in the past and project the same rate of growth in the future. This approach has a major pitfall. It implies that the future operating environment will be the same as it was in the past. This may be true at some times, but it is often not the case.

If the individual product or services sales projections for existing products in current markets do not achieve the overall objectives, there is said to be a planning gap. Strategies need to be developed to close this gap by adding new products or services, increasing margin, expanding the size of the market served to increase volume and other marketing initiatives.

Once annual objectives are established, seasonal adjustments can be made to convert annual projections into monthly or quarterly objectives. New businesses have no operating history and the seasonal pattern of sales may be an educated guess. Ongoing businesses with operating histories can look at the percentage of annual sales in each month in past years and apply these percentages to the months of the forecast to calculate monthly sales forecasts.

Generally, a forecast of overall inflation rates should not be used to adjust projected revenues or costs. A better method is to estimate the price realization potential of each of the company’s products or services and then multiply that price by sales volume. Similarly, raw materials, utilities, wages, benefits and other operating costs should be individually forecasted because some will increase faster than inflation and others will increase slower. Companies with operating histories can review past behavior in these costs as a starting point but should recognize that forecasts must reflect future expectations, not past experience.

Financial planning and forecasting software that provides the ability to do a sensitivity analysis of alternative revenue and cost scenarios can be of enormous benefit to the small business. Individual revenue and cost projections often vary widely from actual results. By having the ability to change any of the assumptions, the impact of any positive or negative variances from revenue and margin projections can be evaluated and mid-course corrections can be made. In addition, external users of the plan will be impressed with the ability and willingness of management to recognize, evaluate and respond to unexpected developments that could threaten the achievement of its objectives.

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