We live in an age of extreme unpredictability. The Covid-19 pandemic was just the tip of the iceberg, demonstrating just how unpredictable the future can be. Several years later, many businesses and organizations are still dealing with the fallout. Add in other external pressures that can impact your business, such as runaway inflation, natural disasters, etc., and it might seem extremely difficult to do any planning.
And yet, if your business expects to keep the lights on over the next quarter, much less the next 12 months, it’s essential to play fortune teller and look into a crystal ball to try to envision the future. While revenue forecasting might seem like something equally mysterious—and potentially doubtful—as fortune telling, in reality it is an essential tool that can help your business achieve its financial goals.
It's true that some see revenue forecasting as an academic exercise, something that’s taught in business school but not entirely relevant in the real world. However, there are a number of scenarios where revenue forecasting is not only essential, but mandatory to have, such as when your business is:
Even if your business isn’t planning to be in any of the above situations, the truth is that it needs to have an idea of where it’s going. Rather than looking at forecasting as a form of prediction, though, we should view it as an integral part of a business road map. Without a forecast, you’re basically operating in the dark.
In fact, failing to do revenue forecasting can be extremely hazardous for a business, maybe even negligent. A quarterly forecast can tell you if you will be able to make payroll or invest in new equipment. An annual forecast can tell you if and how you’ll be able to grow in the coming year. A forecast can help you set financial milestones that can be correlated to other business objectives, such as sales quotas or client acquisitions.
As with anything in business, there are a wide variety of factors to include and consider when developing a revenue forecast. Let’s take a closer look at how to develop a forecast, what role it can play in your own business planning, and what pitfalls to look out for and avoid.
Past performance is not indicative of future results.
Anyone who’s ever done any investing has probably heard this phrase. As it suggests, something that may have worked well in the past does not guarantee it will work today. There are a number of factors that dictate how well an investment does, and a similar disclaimer can be made about revenue forecasting.
That said, revenue forecasting takes a far more analytic and detailed approach by not only looking at past performance, but also taking into account current circumstances and other potential influences to build an informed view of future revenue. It is a peak into the near future based on recurring revenue, known production capabilities, and a host of other elements. There are also a variety of ways to develop an accurate forecast, which we discuss in detail below.
It’s important to note the difference between a revenue forecast and a revenue projection. The key difference is timing:
Before we look at different revenue forecasting models, it’s important to gain a better understanding of why you should create one for your business.
As mentioned above, there are a few situations where an outside party might want to see a revenue forecast. But those aren’t its sole purpose. Revenue forecasting can help you ensure your business stays healthy and efficient, as well as financially stable. Here are four ways conducting revenue forecasting can have a positive impact on your business.
1) Improved Cash Flow Management: At its very basic, revenue forecasting can help you keep a close eye on cash flow. It can help you identify months where cash flow might be more challenging, such as when a large capital investment is needed. By being able to recognize when cash flow might hit some obstacles, it will be easier to plan for or avoid any rough spots.
2) Reduced Production Bottlenecks: Revenue forecasting isn’t just about predicting how much money is coming into the business. It’s also about predicting when sales will close and the amount of work it will take to fulfill those orders. That potentially means hiring staff, procuring raw materials, or even buying additional equipment.
If you’re not attempting to calculate future sales, you might find yourself in a difficult situation where you’re not able to keep up with demand because you haven’t made the proper investments internally.
Not only can revenue forecasting help you identify potential spikes in demand, but it can also help you understand how and when to smartly invest in your business—and how much you can spend on those investments (see cash flow above).
3) Better Sales Analysis: Revenue forecasting and sales forecasting clearly go hand in hand. As a business owner or manager, you need to know what sales are coming down the pike in order to know what future revenues will looking like. But revenue forecasting can also help you improve how you analyze your sales. For example, you might use revenue forecasting to better identify which types of sales are more profitable. This can help you ensure your sales team stays focused on key business drivers or avoids sales that aren’t as profitable.
4) Smarter Credit Management: Being able to predict your cash flow can help you ensure you do a better job of managing business credit. By forecasting when you might be short or need a cash infusion, you can be much smarter about when to get credit and how much it will cost you. Without a revenue forecast, you will likely find yourself in a cash crunch more often than not, which in turn limits your choices and ability to make good decisions about your business.
Now that we’ve discussed the benefits, let’s take a closer look at four different models for developing revenue forecasts so that you can choose the one that best fits your business needs.
As is the case in almost everything in business, there’s more than one way to do things. For revenue forecasting, there are essentially four different models, each with their own pros and cons.
As the name suggests, this revenue forecasting model looks at past revenue data to predict future revenue. This model is particularly helpful for organizations that have recurring revenue models, such as service firms that operate on retainers.
To make this model work, it’s essential to compare similar periods, e.g. Q1 from previous year versus Q1 for coming year, etc. The basic assumption, of course, is that what happened in the previous timeframe will repeat in the upcoming timeframe of the same length.
Of course, it’s also important to include factors that could affect revenue, such as potential new clients, attrition of older clients, etc.
a) Pros:
• Data is easily available and highly reliable.
• Fairly fast and easy to make projections.
b) Cons:
• Does not always include any analysis of external factors.
• Ineffective for manufacturers or other businesses that don’t use a recurring revenue business model.
• Does not take into consideration capacity to meet growth expectations.
This model looks strictly at revenue that’s under contract but hasn’t been paid yet. It is not based on past revenue performance of a given period, but rather what’s slated to come in. While this model works for a variety of business types, it is commonly used for Software as a Service (SaaS) companies, as it enables them to gauge revenue based on the number of current subscriptions. Additionally, firms can add in projects for one-time sales, ongoing support services provided to customers, and investments.
Because forecasts are generally done for a 12-month period, total revenue is calculated and then distributed over each month in the period. Projections might also include expected growth in contracts/subscriptions.
a) Pros:
• Fairly easy to calculate.
• Can help with resource planning by identifying high-demand periods.
b) Cons:
• Can be difficult to track and report backlogged revenue.
• Revenue is not always evenly distributed.
• Potentially large margin of error, depending on how revenue is calculated.
Unlike the other models mentioned here, the bottom-up (a.k.a. resource-driven) forecasting model looks at planned work or sales—either from existing or expected projects—and matches resources to those projects.
Work or sales are then translated into what’s called a “time-phased revenue” based on their value. Revenue is projected by multiplying the amount of work/sales and the average value. It’s also possible to take other factors into consideration, such as refunds, exchanges, error rates, customer churn rate, etc.
a) Pros:
• Often more accurate because it considers both contracted and potential revenue.
• Takes into consideration labor and resource capacity.
• Identifies resource shortfalls well in advance, allowing firms more time to fill those resources.
b) Cons:
• Typically requires specialized software.
• Requires constant monitoring and updating.
In this model, the business tracks and measures pipeline activity, i.e. potential sales, with the main assumption that only a certain percentage of forecasted sales will be realized. The most difficult part of this forecasting model is reliably predicting a) the size of future deals and b) their likelihood to become revenue.
a) Pros:
• Pipeline data is readily accessible and easy to understand.
• Close rates can be based on previous sales performance, potentially making the forecast more accurate.
b) Cons:
• It’s easy to overestimate or be overly optimistic about deals closing.
• Doesn’t address any work that is already in progress, but hasn’t been paid for yet.
• Doesn’t provide any insights into when revenue will actually be earned.
Regardless of what revenue forecasting model you choose for your business, it’s essential to remember that there is no one-size-fits-all model. You need to find what works best for your business, particularly in terms of accuracy.
Additionally, a revenue forecast is only as good as the underlying data that drives it. That means you need to find a way to check for accuracy and reliability when developing your forecasts. Try to remove any opportunities for human error; a simple keying error could entirely throw your forecast off and make you over-confident in its projections.
While on the surface forecasting might seem as simple as looking at what was done in the past and what’s coming down the pike at any given moment, it’s not quite that easy. There are a variety of challenges that can erode your forecast’s accuracy, giving you a false sense of security in the process. And what good would a forecast be if it isn’t accurate?
Here are some of the most common impediments to producing an accurate revenue forecast.
1) Inaccurate Data: Garbage in, garbage out, as the old saying goes. If the data you’re relying on isn’t accurate, then your forecast won’t be accurate either. There are a number of reasons why your data might not be useable, such as having conflicting data sources or even a lack of data collection methodology. Even defining what needs to be collected in the first place often goes overlooked. Indeed, some sales people look at data input itself as something that prevents them from focusing on their core responsibilities, which can lead to poor data quality.
2) Poor Technology Integration: Every business today runs on technology. But when a firm uses a variety of software suites without integrating them, they run the risk of causing data integrity issues as discussed above. What’s more, they might miss essential data because it is siloed in a technology suite that’s not widely used.
3) Taking Too Narrow a View: One of the methods for forecasting is looking at historical data. But that rarely paints the full picture. Revenue forecasting often requires taking a holistic approach that accounts for past, present, and future conditions.
4) Taking Too Broad a View: Conversely, businesses can also take too broad of a view in their forecast. That is, they might only look at the global picture, but not necessarily break down their forecast by business unit, product line, market segment, region, etc. Failing to make a forecast detailed enough can also potentially set up a business for some disappointing results, such as expecting a market segment to grow faster than what’s realistic.
5) Ignoring Market Trends: Changes in market conditions can have a huge impact on forecast accuracy (or lack thereof). Too often, managers might look at a market trend and think it won’t affect their business. Or they’ll just ignore trends altogether. But whether they like it or not, business doesn’t happen in a vacuum. Not taking the time to fully understand what’s happening in the rest of the market and gauging its impact is a recipe not only for an inaccurate forecast, or even a potential disaster.
To be sure, addressing these challenges isn’t always going to be easy. Implementing a system to regularly churn out accurate revenue forecasts takes work aligning both software suites and business units. And while it might seem tedious or not worth the effort, following a clear and proven methodology for developing and fine tuning your forecast will pay dividends further down the road.
Now that we’ve discussed the common models and challenges in revenue forecasting, let’s take a look at what’s actually involved in developing a revenue forecast. In our experience, there are nine essential steps to follow to create an accurate and reliable forecast.
Typically, companies will forecast for a maximum of 12 months (remember, anything beyond that is more a projection and will likely have less certainty). But you can also develop a shorter-term forecast of one or two quarters. In fact, you might want to develop both simultaneously. Shorter term forecasts will likely be most accurate and can be updated fairly quickly, while the 12-month forecasts can help you focus on strategy.
As we know, business doesn’t exist in a bubble, and there are a variety of factors that can erode the accuracy of your forecast. By building these external factors into your forecast now, you can better ensure not only the forecast’s accuracy but your business’ overall health.
External factors, of course, are anything beyond your control that can affect revenue, either positively or negatively. Examples include (but aren’t limited to):
Of course, recent years have shown us that the future is unpredictable. Big events that send shockwaves throughout the world like the Covid-19 pandemic aren’t predictable. While you might not be able to directly account for them in your revenue forecast, they certainly should be cause to update it.
If you’re doing revenue forecasting, you clearly need some sort of software to help you. At the minimum, you will need a spreadsheet that contains all your data and formulas.
But there are also a number of tools out there that can also help. Depending on the complexity of your business and revenue sources, it’s likely worthwhile to invest in a software suite that can do the heavy lifting for you.
When looking into software, consider packages that use automation and integrate with your existing systems. This will make data collection far easier and more accurate. Additionally, you will want a software that uses the forecasting model you’ve chosen.
Some forecasting tools are packaged with other types of software, particularly CRMs. If you already have a CRM that doesn’t include forecasting, you may want to consider switching to a different platform.
Also be sure to find a tool that matches your type of business. For example, there are a number of forecasting tools on the market that help with inventory management, an essential component for businesses that sell products but not so much for service businesses.
At this stage, you will need to project how many products you’ll sell over the given time period. Start by looking at sales for each product line for each individual month. This can be based on the contracts you have, pass sales data, etc. (see the discussion on forecasting models above).
Many companies don’t earn revenues solely from the products or services they sell. They often gain revenue through maintenance, replacement parts, and other adjunct or auxiliary services. Be sure to include all other income sources to your revenue forecast.
This is where your forecast might get somewhat subjective. You need to realistically consider how you will grow your revenues. This can come from a number of areas, such as an increase in customers, sales volume, greater conversion rates, or even price increases you’re expecting to implement.
Here’s an example of how you might account for customer growth in your forecast:
|
|
January |
February |
March |
April |
|
Current Customers |
500 |
590 |
610 |
685 |
|
New Customers |
90 |
50 |
100 |
20 |
|
Customer Attrition |
0 |
30 |
25 |
15 |
|
Total Customers |
590 |
610 |
685 |
690 |
In this example, you would want to also calculate the average customer value by month, then multiply that out to project your revenues each month. For simplicity’s sake, we made the average monthly customer value the same for each month in the example below.
|
|
January |
February |
March |
April |
|
Number of Customers |
590 |
610 |
685 |
690 |
|
Avg. Monthly Revenue per Customer |
$50.00 |
$50.00 |
$50.00 |
$50.00 |
|
Projected Revenue |
$29,500 |
$30,500 |
$34,250 |
$34,500 |
It’s always important to understand the role expenses play in your revenue forecast. Consider both fixed and variable costs, including labor, packaging, raw materials, etc. Many of these costs are pegged to growth or reductions in sales, so be sure to account for both positive and negative changes to expenses as well.
This is a particularly important part of revenue forecasting for companies that sell products, though it can also be applied to business units. It’s important to have a good understanding of profitability for each product. This will ultimately help you understand the value each product (or business unit) contributes to overall revenue growth, ensuring you focus your energies on growing the most profitable parts of your business.
There are three type of margin you need to focus on:
Part of the point in creating a revenue forecast is to be able to prepare for different situations so that you’re not caught off guard in case something goes horribly wrong (like a global pandemic, for example).
That’s why it’s essential that once you have your basic forecast down, it’s a good idea to play with the numbers to see how different scenarios might affect your revenues.
For example, let’s say your sales team doesn’t hit its goals for an entire quarter. What impact does that have on revenue and profitability? Or what if you lose one large customer, but pick up three mid-sized customers? How does that affect operating costs and/or COGs?
There are probably countless numbers of scenarios, but it’s a good idea to focus on the ones that are most likely.
The more accurate your forecasting model is, the more prominent a role it will play in your decision making. But because a good part of revenue forecasting is somewhat subjective, it can be easy to make a few mistakes either when building your forecasting model or down the road when you’re using it.
Here are some of the more common mistakes to look out for when doing revenue forecasting.
1. Not keeping resources up-to-date: Even if you’re a product manufacturer with a lot of automation, you still need people to help produce your products. If you don’t have enough people to help fulfill orders in a timely manner, you’re going to see a major an impact on your revenue. Similarly, if you don’t have enough raw materials in your warehouse in time, then you won’t be able to produce your products and fulfill orders, and your revenue will likely take a hit.
The bottom line is that you need to stay on top of both human and material resource needs that you’ll need to meet projections.
2. Ignoring pricing: Regardless of whether you’re selling a product or a service, your pricing has a huge impact on your revenue forecast. As such, it’s a good idea to regularly review it to make sure you’re competitive, but also so that you can maximize revenues.
3. Failing to assess pipeline: Salespeople are notoriously optimistic. They have to be; their job demands it. However, their optimism can reduce your forecast’s accuracy. Don’t fall into that trap! Work with them to understand the factors that go into successfully closing a deal, then use that to asses each pipeline opportunity to get a more realistic picture of future revenues.
4. Not knowing the difference between revenue and cash flow: In almost every business, cash is always king. But having cash on hand doesn’t mean you have revenue coming in. All businesses require resources to make and/or sell their products or services. And those resources cost money. It’s extremely important for firms to understand that just because revenues are coming in doesn’t mean those funds are pure profit.
5. Ignoring variability: It can be easy to look at a short-term forecast and think that the entire year will yield the same level of results. That’s why it’s essential to remember that every business has ups and downs. Some of these are cyclical, where a business is inundated with sales at a certain time of year, only to have the pipeline dry up later on. Some of these variations can be highly irregular, though, like a sudden spike in demand caused by an external event (such as the sudden need for surgical masks during the early days of the pandemic).
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As we’ve mentioned throughout this post, your revenue forecast is only going to be as good as your data. The biggest challenge is having a clear picture of what’s coming in and what’s going out.
That’s where Credit Key can lend a hand. With Credit Key, you can accelerate your company’s growth by offering flexible credit terms. What’s more, regardless of order size, you typically get paid within 48 hours. So you almost always know what’s coming in, what’s going out, and how profitable you are.
Schedule a demo to learn how Credit Key can help you supercharge your revenue forecast—and results!