Building Financial Forecasts That Work

Every year, executive teams around the world gather together to prognosticate company sales, create operating budgets, and allocate resources. And every year, many of these documents prove to have little bearing on reality; they’re simply shelved until it’s time to produce a new one. But it doesn’t have to be that way.

By taking a strategic approach, rigorously testing assumptions, and keeping abreast of market shifts on a micro and macro level, you can establish a financial forecasting process that supports your goals for business growth. Here are some strategies to consider:

  • Shorten lead times. Financial forecasts are necessary in large part to ensure that you have the inventory and capacity to fulfill sales as they arise. The longer it takes to create that inventory or build that capacity—in other words, the longer your lead time—the less accurate your predictions are likely to be, says Tom Dykstra, a principal at Cayenne Consulting based in Florida. “So the best way to improve your forecast is to decrease your lead times,” he notes.

In a perfect world, he explains, you wouldn’t need to maintain an inventory or, if you’re in a service industry, have extra capacity to handle orders. And you wouldn’t need to forecast anything. Though unattainable, this frictionless ideal is worth approaching as closely as possible, whether through just-in-time manufacturing, downstream intelligence, or information technology.

  • Collaborate and calibrate. Financial forecasting is often tied into creating sales quotas, but these are separate functions that should not be confused with one another, says Dykstra and other experts. “Sales quotas represent stretch goals that would be overly optimistic if rolled into forecasts,” he explains.

Rather, senior executives collaborate to develop financial forecasts based on previous performance as well as expected outcomes. The sales department, for instance, is likely to have one number, marketing another, and operations yet one more. Only by examining, challenging, and ultimately calibrating these disparate figures can the team develop accurate forecasts. These discussions can also lead to a greater understanding of the relationships between numbers, for example, production capacity, raw material availability, and demand.

  • Keep an eye on the end customer. “Technology has made tremendous advances in our ability to anticipate demand,” Dykstra says. “If you’re a Wal-Mart supplier, you may be receiving data directly from their point-of-sale system, so you know the size of their order before it’s been placed.”

While it’s unlikely you have this degree of integration with your customers, it still behooves you to gain as much insight as possible from them—and their customers—to anticipate demand levels. “If you get information about what’s happening at the end-customer level, you can calculate when and how hard demand is going to hit you simply by adding together lead times along the supply chain,” Dykstra says.

  • Know your error. “The most important thing to know is your range of error,” Dykstra concludes. That means tracking actual figures against projections on a regular basis. “You can’t know the direction of your error, but the better your forecast, the more likely you’ll find yourself right in the middle of the dispersion,” he adds.

From there, you can choose what level of service to provide to customers. For instance, if your demand projections have a margin of error of 10 percent and you strive to maintain 80 percent of capacity, you will be able to deliver immediately on average about 90 percent of the time.

Perhaps the most important thing to understand about financial forecasts, however, is that you should never consider them set in stone. Rather, they should be refined on a regular basis depending on current circumstances, and constantly evaluated for accuracy. Once you’ve achieved that level of discipline, you’ll be operating lean and mean.


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