Planning for tomorrow is essential to your small business’s success. Having an approximation of the cash flow and growth you can expect over a given period allows you to estimate future earnings and working capital, and plan accordingly. This process is known as revenue forecasting, and it allows you to understand your margins, improve production schedules, manage credit and anticipate when you’ll be paid.
In the next few paragraphs, we’ll walk you through everything your business needs to know about how to forecast revenue. We’ll review the different revenue forecasting models you can use, the importance of estimating your expenses, why it’s good to have two sets of revenue projections, and how to check your key ratios.
What is Revenue Forecasting?
Revenue Forecasting is an estimation of the amount of money your business will generate during a particular period of time. Understanding the “right time” to make critical investments in your business starts with this forecast. Whether you plan to launch a new advertising campaign, increasing inventory before peak seasons or add to your team with a new hire, your goals need to coordinate with your revenue projections.
Revenue forecasting can be applied to your whole business, individual departments or specific initiatives (like an advertising campaign). For businesses with aggressive growth plans, learning how to project revenue can help your pitch to convince potential backers to invest in your business.
Comparing your latest financials to your forecast is a great way to gauge your business’s progress. Of course, no revenue forecast will be 100% accurate, but projecting your revenues greatly improves your ability to make the best possible decisions for your business.
Judgment Forecasting vs. Quantitative Forecasting
There are many approaches to projecting revenue, but two revenue forecasting methods are used most often by small business owners: judgment forecasting and quantitative forecasting.
Judgment forecasting is a prediction made by someone familiar with your business—typically either the business owner or another senior leader—relying on organizational knowledge and experience to provide an expectation of the year’s income and expenses.
Quantitative forecasting is more systematic and uses historical revenue data from your own business to follow tendencies and predict market progression. Recorded revenue data from other businesses in your industry can also be used to influence your quantitative forecast.
Accounting experts don’t indicate whether one revenue forecasting model is better than another. Many business owners even use a combination of each revenue forecasting method. By merging the two, your analysis benefits from the precise, historical data as well as the intuitive, “gut-feeling” advantage that comes from years of experience.
Once you’ve decided on your approach to revenue projections, it’s time to get to work.
1. Start With Your Expenses
Whether you’ve been in business for 15 years or 15 months, it’s often much easier to estimate expenses than predict revenues.
There are two main categories of expenses that will impact your business: fixed costs and variable costs:
Fixed costs are any bills or charges that remain the same regardless of how much your business is producing or how many clients you’re serving.
A few examples of fixed costs include:
- Property Taxes
- Interest expense
On the flip side, variable costs fluctuate with the ebbs and flows of the business.
A few examples of variable costs include:
- Cost of Goods Sold (COGS)
- Materials and Supplies
- Packaging materials
- Sales Commissions
- Direct Marketing
- Customer Care
- Credit Card Fees
As you’re reviewing your expenses and folding them into your forecast projections, here are a few guidelines to follow:
- When you’re preparing your marketing and advertising budget, double your original estimate; it’s common for these costs to exceed initial calculations.
- Record customer service interactions and direct sales as direct labor expenses. Keeping tabs on these expenses will be important as you scale.
- Much like marketing and advertising, legal, insurance and licensing fees can outpace your estimates. If you have no experience in these areas, you should probably overestimate them. Some entrepreneurs even suggest these estimates should be tripled.
2. What’s Changed in Your Business?
Odds are slim that your business is the same today as it was this time last year. When you’re forecasting revenues, consider the pieces of your business that have changed and could impact future earnings.
These changes include adding personnel, new product verticals, a more competitive pricing model, shifts in your competition and any other X-Factors (like new legislation) that could affect your business.
3. Calculate Anticipated Revenues
At this point in your projections, you should begin separating each source of income and segregating any variables for the business. This delineation will provide a clarified view of any positives and negatives in each revenue stream.
From each source of income, list the amount of revenue expected during the business’s review period (monthly, quarterly or as needed, etc) for your earnings and revenue. Arranging your data this way will reveal the total expected revenue for the desired time frame.
For example, Jennie’s Jellies expected $27,120 from farmer’s market sales and $91,630 from its grocery partners in the 2nd quarter. With these figures, Jennie’s Jellies would have a total expected revenue of $118,750. Approaching your projections directly gives you the most control and simplifies a potentially confusing process.
|Farmer’s Markets||Grocery Stores||Total Revenue|
4. Forecast Aggressively and Conservatively
As you approach the end of your revenue projections, you may be feeling one of two things: apprehension or excitement. No matter which side you’re on emotionally, we recommend that you create two revenue forecasts for your business—one aggressive and one conservative.
By creating two versions of your forecast, you’ll force yourself to think boldly to achieve your growth goals and rationally in the event that you need to scale back. Let’s see what each of these might look like for our friend’s at Jennie’s Jellies:
- A low price point for their standard jellies, higher price for choice, small-batch jellies
- Increasing promotional efforts from three to four marketing channels managed by a new marketing manager, as well as adding three commission-based salespeople
- One new jelly or complimentary product added by Q4, with three more products introduced within the next 18 months
- Low price point, no additional premium pricing
- No new marketing channels introduced
- Sales staff remains the same
- One new jelly introduced each year for the next 36 months
Clearly, the aggressive forecast is a fuller and more aspirational estimate. While there are no numbers tied to the bullets in these examples when executed properly, the aggressive forecast will incur more expenses, but greater opportunities for continued growth.
5. Double Check Your Key Ratios
Employing an aggressive forecast will provide more revenue opportunities while also driving greater expenses. You can balance your revenue and expenses by reviewing three specific ratios that that impact how much you can invest back in your business:
Your gross margin gives you the best view into your costs relative to your revenue, allowing you to make the most informed decisions for your business. To determine your gross margin, subtract your total cost of goods sold (COGS) from your total sales revenue and then divide that figure by your total sales revenue. The gross margin will be presented as a percentage.
Operating Profit Margin
This formula is a ratio of your business’s performance used to determine the percentage of profit you have produced from your transactions, before deducting taxes and interest charges. Also known as EBITDA, Operating Profit Margin is calculated by dividing your operating profit by your total revenue and is expressed as a percentage.
Overall Headcount per Client
If you aspire to manage more accounts in the next few years, understanding how much you spend on headcount per client is something you’ll need to factor into your revenue and payroll assumptions. The formula for this is simple; divide your current number of employees by the total number of clients you have. If you’re currently working alone with aspirations to increase your team, this ratio is especially important to you.
Final Thoughts on Revenue Forecasting
While establishing an accurate set of growth projections for your business takes time, revenue forecasting gives you the best chance to achieve your goals. Be honest about your expenses and how your business has evolved—and don’t be afraid to make bold projections as you map out your growth.
Even as you experience the evolution and progression of your business, the exercise of forecasting revenue will keep you in touch with your company. Concrete revenue projections will open your business to the possibility of leveraging financial products like business loans to help expedite and accomplish your goals for growth.
Your projections should be challenging, while manageable, forcing you to think ahead and take big steps. But most of all, they should force you to look at the future with a strategic eye and recognize the dangers and opportunities ahead.