This article is part of our “Business Startup Guide”—a curated list of our articles that will get you up and running in no time!
First, allow me to deal with a very common problem: Business owners are often afraid to forecast sales.
But, you shouldn’t be. Don’t think there is some magic right answer that you don’t know. Don’t think that it’s a matter of training you don’t have. It doesn’t take spreadsheet modeling (much less econometric modeling) to estimate units and price per unit for future sales.
It isn’t about seeing into the future
Sales forecasting is much easier than you think, and much more useful than you imagine.
It’s not about guessing the future correctly. We’re human; we don’t do that well. Instead, it’s about assumptions, expectations, drivers, tracking, and management.
You review and revise your forecast regularly. Since sales are intimate with costs and expenses, the forecast helps you budget and manage. You measure the value of a sales forecast like you do anything in business, by its measurable business results.
I was a vice president of a market research firm for several years, doing expensive forecasts, and I saw many times that there’s nothing better than the educated guess of somebody who knows the business well. All those sophisticated techniques depend on data from the past—and the past, by itself, isn’t the best predictor of the future. You are.
That also means you should not back off from forecasting because you have a new product, or new business, without past data.
New product or not, your sales forecast won’t accurately predict the future. We know that from the start. What you want is to lay out the sales drivers and interdependencies, to connect the dots, so that as you review plan versus actual results every month, you can easily make course corrections.
If you think sales forecasting is hard, try running a business without a forecast. That’s much harder.
Your sales forecast is also the backbone of your business plan. People measure a business and its growth by sales, and your sales forecast sets the standard for expenses, profits, and growth. The sales forecast is almost always going to be the first set of numbers you’ll track for plan versus actual use, even if you do no other numbers.
If nothing else, just forecast your sales, track plan versus actual results, and make corrections—that’s already business planning.
It’s simple math
For a business plan, make your sales forecast a matter of the next 12 months and the two years after that.
Think of it as rows and columns as in the illustration here. Guess your unit, then price per unit, and multiply to get the sales that result.
This illustration is clipped for obvious reasons, but assume you have the rest of the months in your year one, plus your annual estimates for years two and three, flowing to the right.
You don’t sell units? In a pinch, you can just forecast the sales without the units, but consider time as units the way attorneys and accountants do, or trips like taxis and airlines do, or projects or engagements the way consultants do. That makes forecasting easier.
But how do you know what numbers to put into your sales forecast?
The math may be simple, yes, but this is predicting the future, and humans don’t do that well. Don’t try to guess the future accurately for months in advance.
Instead, aim for making clear assumptions and understanding what drives sales, such as web traffic and conversions, in one example, or the direct sales pipeline and leads, in another. Review results every month, and revise your forecast. Your educated guesses become more accurate over time.
Experience in the field is a huge advantage
In the example above, Garrett the bike store owner has ample experience with past sales. He doesn’t know accounting or technical forecasting, but he knows his bicycle store and the bicycle business. He’s aware of changes in the market, and his own store’s promotions, and other factors that business owners know. He’s comfortable making educated guesses.
If you don’t personally have the experience, try to find information and make guesses based on the experience of an employee, your mentor, or others you’ve spoken with in your field.
Use past results as a guide
Use results from the recent past if your business has them. Start a forecast by putting last year’s numbers into next year’s forecast, and then focus on what might be different this year from next.
Do you have new opportunities that will make sales grow? New marketing activities, promotions? Then increase the forecast. New competition, and new problems? Nobody wants to forecast decreasing sales, but if that’s likely, you need to deal with it by cutting costs or changing your focus.
Look for drivers
To forecast sales for a new restaurant, first draw a map of tables and chairs and then estimate how many meals per mealtime at capacity, and in the beginning. It’s not a random number; it’s a matter of how many people come in.
To forecast sales for a new mobile app, you might get data from the Apple and Android mobile app stores about average downloads for different apps. A good web search might also reveal some anecdotal evidence, blog posts, and news stories perhaps, about the ramp-up of existing apps that were successful.
Get those numbers and think about how your case might be different. Maybe you drive downloads with a website, so you can predict traffic on your website from past experience and then assume a percentage of web visitors who will download the app.
Estimate direct costs
Direct costs are also called cost of goods sold (COGS) and per-unit costs. Direct costs are important because they help calculate gross margin, which is used as a basis for comparison in financial benchmarks, and are an instant measure (sales less direct costs) of your underlying profitability.
For example, I know from benchmarks that an average sporting goods store makes a 34 percent gross margin. That means that they spend $66 on average to buy the goods they sell for $100.
Not all businesses have direct costs. Service businesses supposedly don’t have direct costs, so they have a gross margin of 100 percent. That may be true for some professionals like accountants and lawyers, but a lot of services do have direct costs. For example, taxis have gasoline and maintenance. So do airlines.
A normal sales forecast includes units, price per unit, sales, direct cost per unit, and direct costs. The math is simple, with the direct costs per unit related to total direct costs the same way price per unit relates to total sales.
Multiply the units projected for any time period by the unit direct costs, and that gives you total direct costs. And here too, assume this view is just a cut-out, it flows to the right. In this example, I projected the direct costs based on the assumption of 68 percent of sales.
Never forecast in a vacuum
Never think of your sales forecast in a vacuum. It flows from the strategic action plans with their assumptions, milestones, and metrics. Your marketing milestones affect your sales. Your business offering milestones affect your sales.
When you change milestones—and you will, because all business plans change—you should change your sales forecast to match.
Your sales are supposed to refer to when the ownership changes hands (for products) or when the service is performed (for services). It isn’t a sale when it’s ordered, or promised, or even when it’s contracted.
With proper accrual accounting, it is a sale even if it hasn’t been paid for. With so-called cash-based accounting, by the way, it isn’t a sale until it’s paid for. Accrual is better because it gives you a more accurate picture, unless you’re very small and do all your business, both buying and selling, with cash only.
I know that seems simple, but it’s surprising how many people decide to do something different. The penalty of doing things differently is that then you don’t match the standard, and the bankers, analysts, and investors can’t tell what you meant.
This goes for direct costs, too. The direct costs in your monthly Profit and Loss Statement are supposed to be just the costs associated with that month’s sales. Please notice how, in the examples above, the direct costs for the sample bicycle store are linked to the actual unit sales.
Live with your assumptions
Sales forecasting is not about accurately guessing the future. It’s about laying out your assumptions so you can manage changes effectively as sales and direct costs come out different from what you expected. Use this to adjust your sales forecast and improve your business by making course corrections to deal with what is working and what isn’t.
I believe that even if you do nothing else, by the time you use a sales forecast and review plan versus actual results every month, you are already managing with a business plan. You can’t review actual results without looking at what happened, why, and what to do next.
For more on small business financials, check out these resources:
- The Key Elements of the Financial Plan
- How to Build a Profit and Loss Statement (Income Statement)
- How to Forecast Cash Flow
- Building Your Balance Sheet
- The Difference Between Cash and Profits