“All models are wrong; some are useful.” George E.P. Box
“When the facts change, I change my mind. What do you do?” Winston Churchill
Family businesses devote time and resources to creating forecasts and budgets to guide resource allocation and strategy decisions. Yet, as seen in 2020, the forecasts and budgets that many family businesses spent months creating quickly became worthless, and managers and directors faced the task of revising and updating those forecasts amid a uniquely uncertain environment.
The pandemic caused businesses to reassess all sorts of practices – should your family business re-think its forecasting models?
Granting that all models are wrong, what can family business leaders do to make their forecasts more useful? After all, anyone can put anything into an Excel spreadsheet. Useful forecasts are products of careful analysis.
Our English word “analysis” derives from the compound Greek word “ana-luein” which literally means to “loosen up” something. So a useful forecast is one that “loosens” the whole into its constituent parts for better understanding. In the remainder of this post, we provide some ideas of how to “loosen up” forecasting models to make them more useful.
Revenue
What are the component parts of revenue for your family business? The most obvious place to start for many of our clients is by breaking revenue into physical volume and unit pricing.
- What are the economic factors that drive demand for your family business? How has historical sales volume been correlated to some broader, objective, measure of economic activity? How did the pandemic influence that relationship?
- What trends do you expect in unit pricing over the forecast period? Is your family business typically a price leader or price responder in your industry? Do you propose lower pricing in order to secure more volume in the current environment? Or, are you considering increasing price to help offset the revenue impact of reduced volumes?
Some of our clients forecast revenue by constructing a sales funnel. By examining prospect activity, they develop sales forecasts that are rooted in objective measures of the business activities that lead to sales. For example, by examining historical conversion data, one can assign probabilities to revenue at various points along the sales funnel (X% of outstanding proposals turn into sales, and Y% of 2nd meetings turn into proposals, etc.).
In any event, the goal is to reduce the general (revenue) to the specific (price/volume, lead generations, etc.). By “loosening up” total revenue into its constituent parts, family business leaders can have more meaningful conversations at the appropriate level of detail to develop objective forecasts.
Expenses
There are multiple ways to “loosen up” expenses into various components.
- Fixed vs variable costs. While it is true that all expenses are variable in the long run, your family business is likely committed to incurring some expenses in the short-run (rent, depreciation, etc.). Classifying expenses as fixed or variable can help identify the “breakeven” level of sales volume and can provide important perspective for long-term strategic decisions in the current environment.
- Expenses by functional area. Sometimes it is more fruitful to segregate expenses into functional areas (manufacturing, selling, distribution, research and development, general and administrative, etc.). This perspective allows managers and directors to focus on what resources are necessary to fulfill the functions of the business, and may highlight opportunities to explore alternative models for executing certain functions.
- Expenses by nature. For many businesses, operating costs can be associated with either people or “stuff.” Or, somewhat more elegantly, costs can be divided into compensation and non-compensation expenses. On the compensation side of the ledger, one can then isolate headcount and compensation rate factors. This perspective can help managers and directors make strategic decisions regarding the relative use of labor and capital as means of production.
Regardless of the perspective adopted, managers should also consider whether to forecast using a percentage change relative to the prior period or a zero-base. Some advocate zero-base budgeting on an annual basis. That has always struck us as a bit extreme, but the potential value from a zero-base budgeting process is probably heightened in the current operating environment.
Useful forecast models do not focus exclusively on the trees. It is important to keep the forest in view by assessing the operating margins implied by a forecast to assess the overall reasonableness of the underlying assumptions.
Cash Flow
Cash flow is especially critical in difficult operating environments. A useful forecast model will make explicit the necessary assumptions regarding working capital management, capital expenditures, and financing obligations. Doing so will highlight just where managers and directors may be able to exercise discretion to help conserve cash and preserve liquidity during the downturn.
Conclusion
Does your family business generate useful forecasts? Usefulness is not the same thing as accuracy. A forecast can be very useful even if it turns out not to be accurate, just as a forecast that – by chance – turns out to be accurate may not be terribly useful. A useful forecast is one that Churchill would approve of: one that can adapt to changing facts. A useful forecast brings the key operating and strategic decisions that your family business needs to make out of the background and into the foreground, and helps frame those decisions appropriately.
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