Living in Uncertain Times - Part Two
Last week, I opened up the Daily Business News Headlines and was greeted by the following:
Oil prices mixed after uneven China data
Precious metals lift on Nymex
A$ lower on US-led strikes in Syria
US stocks sink after Eurozone data
As a business owner, what does this all mean?
Will fuel and transport costs increase or decrease as a result of changes in the oil price?
Will the gold price increase and generate more activity in the gold mining sector and how might this flow through to your particular business?
If the Australian dollar reduces, how will this affect the costs of any imported goods that you depend upon (or sell)?
How will the US share price movement flow through to Australian shares? Will this affect your own share portfolio or will it affect the confidence of your customers?
Perhaps the biggest question to ask, is what control do you have over any of these external factors? The answer to that question is nil.
A fairly typical approach is to continue to do exactly the same things that you have previously been doing and then review the financial results some time after the event – either at the end of the month, end of the quarter, or even the end of the financial year…….
There is an alternative.
The process starts with having a comprehensive line-by-line set of monthly financial projections, based on the best information at the time.
Starting from the very top, sales forecasts should be broken down into product line or category, number of units sold and the sales price.
If applicable, the Cost of Goods Sold and Gross Margin can similarly be forecasted for each individual product line.
Similarly, operating expenses can each be forecasted on a month-by-month basis, taking into account when the payment is actually made. Insurances and utility bills are examples of annual expenses that are often paid quarterly.
The primary difference between the above approach and more ‘traditional’ methods is the detailed breakdown of Sales/ Cost of Goods sold to a number of units and the unit sales/ cost price. The other difference is the detailed treatment of expenses on a monthly basis as opposed to an alternative approach that is often used which simply apportions an annual cost equally over 12-months.
The more detailed approach allows you to model monthly cash balances.
When you have a detailed set of monthly forecasts, you can make better-educated decisions.
As an example, if you are a transport company that is highly susceptible to rising fuel prices, it is easy to build-in a fuel cost increase into the projections and see the effect on net profit and the monthly cash balance. If the effect is material, strategic decisions can be made on pricing, or other cost savings. It is far better to predict a problem, than to find out about it when cash flow runs out.
Similarly, on a monthly basis actual sales can be compared to budget and the rolling forecast can be changed. As an example, if sales of a particular product line are performing better than forecast, future sales levels can be amended and a new set of rolling projections can be formulated. This amended projection will update the bank balance forecast. Again providing more certainty.
Obviously forecasting is not a science. You cannot accurately predict the future however, the more effort and detail that is included within the forecasts, the more accurate the result.
This gets me back to the question that I asked earlier, “….what control do you have over these external factors?”
The answer still remains that you have no control over external factors however, you have full control over what you do within your own business. The key to better decision-making is having access to better information.
Proteger Consulting are forecasting experts. We have the financial tools and experience with a diverse group of clients to provide unique insights into your budgeting process.