PROFIT PLANNING

The most critical element of all in financial planning is the revenue, or sales, forecast. It is the basis of the cost and profit forecasts, and the key element in planning a firm's people, money, and material needs. At the same time, the revenue or sales forecast is the most difficult to make of all forecasts. Anyone who can project sales a year ahead and come in less than 10% off the mark is doing pretty well.

THE NATURE OF SALES FORECASTING

Sales are mostly a function of demand for the product, and demand is largely out of the control of the seller. Numerous factors influence a company's sales; most of them cannot be controlled, and many of them are not even known.

But the overall effect of these factors usually changes rather slowly over time. For that reason a naive projection of sales always merits consideration in the forecasting process. A naive forecast is one that simply extrapolates past figures and trends into the future.

However, most companies use a goals down-plans up approach to sales forecasting. Top management defines the ballpark by specifying what is in their opinion an achievable sales goal; it is then up to the sales staff to submit detailed plans on how that goal will be met.

Another form of forecasting is the sales goal form. This form or template helps top management set a sales goal. It starts with the latest 12 months' actual sales and a tentative goal for the coming year. The difference between the two will have several causes. Here are some causes for a change in sales volume and a typical annual impact of each cause.

• Inflation ” Up 2 to 12 percent

• Demand for the product ” Up or down 0 “10%

• State of the economy ” Up or down 0 “10%

• New products ” Up 0 “10%

The sales goal form also aids in the forecasting of gross profit, operating profit, net income, and earnings per share. In addition, it permits what-if analyses, showing the effect on net income of a change in the sales or cost inputs.

The Plans Up Form

This format is meant as an aid to individual salespeople who forecast the revenues in their own territories . The cumulative totals of these estimates must eventually be reconciled to the sales goal figures issued by top management.

Statistical Analysis

A few things in business lend themselves to statistical projections. Chief among them is revenues or sales forecasting. Statistics are tricky. They can describe with precision the behavior of two or more business components , but it is left to you to decide if the activities are related , unrelated, or coincident, and in the case of the former, which is the cause and which the effect. A statistical forecast of sales, on the other hand, is useful mainly as an anchor for the subjective guesses of salespeople and top management, or as a starting point in developing judicious estimates. While the end purpose of a sales forecast is a projection of profits, direct statistical analyses of past profits are normally useless, if not worse .

Compound Growth Rates

Sales patterns usually trace a gentle curve rather than a straight line. All products, and for that matter, all companies and the people who run them, move through life cycles that can often be represented by a lazy S curve. Its components are tryout, growth, maturity and decline ” see Figure 15.1. The compound growth rates over short segments of the life cycle can be useful in forecasting 12 months or so ahead. The rates will vary depending on how far back you go, and it is up to you to decide which rate is best to project. While you are working that out, remember that the sales trend is a curve that changes direction now and then. It is also up to you to figure out if such a change is about to occur.

Regression Analysis

Regression analysis is a mathematical procedure that figuratively plots past sales on a graph and then draws a line through the middle of the points; extending the line into the future gives the forecast. The results will vary depending on how much past data you use, and the whole process is meaningful only if the past plot points form a linear pattern. Even then, we must be mindful that unusual past events can skew the pattern, and that nothing in life really travels in a straight line.

Revenues and Costs

Once revenues have been forecast, the task of projecting costs is largely routine. Most costs, even those we consider fixed, relate to sales or revenues. When sales rise, costs will soon follow. When sales go down, however, costs tend to follow more slowly due to a natural human reluctance to do without something we once had and a natural hope that conditions will soon be better again.

The largest expense in most businesses is the cost of sales, sometimes called the cost of goods sold, and it can usually be determined with fair precision. The task of manufacturing a product is well defined, as are the materials and labor that lend it value.

Departmental Budgets

Beyond the estimates for the direct costs of manufacturing or buying products for resale lie the budgets for administrative expense, overhead, marketing, R&D, and so on. We speak of these as budgets rather than forecasts because we have some control over them.

The computer is a helpful tool in the process because such budgets are negotiated rather than merely extrapolated from revenues, planned rather than merely projected . There are often several versions prepared before the final plan is hammered out. A good deal of posturing and gamesmanship goes into the process, and a not untypical scenario finds the department manager padding his or her budget secure in the knowledge that top management will cut it, and top management cutting it because they know it is always padded a little.

How to Budget

The easiest way to budget is to increase last year's budget by some percentage that will allow a comfortable salary raise for everyone, plus a few more bodies to ease the workload, and some extra gadgets and trips to make it more fun. A more businesslike method is to adjust last year's budget to the expected level of next year's principal activities of the department. Every department has its tasks , and if the output or the activities can be quantified , this will furnish a standard for setting the new budget. The best lever for controlling department expense is the number of people employed. Employees not only cost salaries, fringe benefits, and taxes, but desks, computers, food service, and parking spaces, too.

Zero-Growth Budgeting

This is not to be confused with zero-based budgeting, which deservedly died a quiet death a few years back. Zero-growth budgeting is a term for a plan that seeks to hold expenses at the current level while revenues grow. If it works it will obviously mean more profit. Of the two ways to get rich in life, the more excusable is to increase your productivity ” work harder or faster or smarter so that the value of your output goes up.

To the department manager, zero-growth budgeting says, "Look, we expect sales to rise 10% this year but we would like to handle the increased business with the same budget as last year. What is more, we think the better people should get nice raises, but out of the same pot as last year. That means you have to handle the work more efficiently , and perhaps not replace people so fast when they leave."

The idea is to challenge people to work smarter but not threaten them with the annihilation that was implicit in the zero-based budgeting concept. Most productivity gains are made inch by inch, and if too much is asked of people, they tend to give up.