Tuesday, February 21, 2012

Small Business and Entrepreneurship - To Startup or Not To Startup Part IV - Sales Forecasts

"At my lemonade stand I used to give the first glass away free and charge five dollars for the second glass. The refill contained the antidote." -- Anonymous

In this part of our series on the decision of whether or not to start a new business we will look at sales forecasts. The two major parts of our financial projections, costs and sales, are very different entities to predict. Whereas predicting costs can be basically an exercise in brainstorming and collecting quotes, sales projections require a lot of thinking about what exactly is the nature of our business and what is our business model - how are we going to make money?

First off, what are sales projections? Well, they are educated (hopefully) guesses about how much money the company expects to generate over the next few years. They are usually wrong and the farther out the projected figure, the more likely it is to be wrong. They are often shaped something like a hockey stick (see Exhibit 1), and they tell a story. Sales forecasts can say something like "we don't expect to make any money for the first year while we do product development, but then we will start limited sales as we hire a small sales staff. Soon our marketing efforts will begin to pay off as customers realize the superiority of our product and viola! We get a larger sales staff, things take off and we never look back (see Exhibit 1)".

Before we begin to determine some numbers, let us think about the purpose of these projections. In this circumstance the figures are for ourselves. We are not trying to sell a project to ourselves, we are trying to decide whether or not to start a business. This is a potentially serious undertaking, and we want to have as clear an idea as possible of what to expect should we decide to go ahead. For that reason we want to use as much of a sound and realistic basis for our projections as we can.

So a good way to begin is to think about the nature of your product, how you expect to generate revenue, and what the major roadblocks to more significant revenue may be:
  • Will your sales be reliant upon the efforts of a direct sales force?
  • Is the size of the sales force a limiting factor in your ability to generate additional revenue?
  • Do you need the cumulative effect of marketing efforts (i.e., "getting the word out") before you see significant sales?
  • Are you limited by manufacturing capabilities - can you only produce X number of units per month?
Consider the following two sound examples of determining initial sales figures:

"I will begin with 3 sales people, and we will spend $50,000 on advertising. I expect my sales people and ads to reach 300,000 people and 5% of those will purchase my product meaning 15,000 units sold. I do not expect to have any difficulty meeting those production demands. With my product priced at $10.00 this gives me $150,000 in sales during the first year".

The second example is:
"My product will take 300 hours to produce and I expect to start with 4 technicians meaning I can produce at a maximum 2 products per month. I don't expect to have difficulty selling the product at $25,000 a piece so I expect initial sales of $50,000 per month".

What both of these examples have in common is that the basis for the sales figures is founded in logic. If all the assumptions (such as "5% will purchase my product", "my product takes 300 hours to produce", or "$25,000 is a good price for my product") are reasonable then the sales projections these methods yield can be just as reasonable.

Both of the above examples identify where the sales come from, and both identify limiting factors. However, it will not always be possible to generate a sales forecast using this "bottom-up" type of method. One common "top-down" method used instead utilizes market share to determine sales figures. This method is to identify the likely size of the market during your time period and identify what percentage of the market you think your product can control, relative to competing products. So if you enter a $150 million per year market and expect to control 0.5% (for the duration of the year) you would generate $750,000 in revenue.

The sales forecasts generated by this "top-down" method are just as reliable as the assumptions used to determine the size of the market and the percentage of market share expected to be captured. The problem is that it can be difficult to make a logic-based prediction of captured market share, and that when compared with "bottom-up"forecasting methods, the "top-down" methods do not take into account as much the nature of the product or business.

Whatever the method we have used to determine our initial sales forecast, it is now time to think about growth. If we've used a "bottom-up" type approach for our initial sales forecast, growth could be determined by adjusting the variables according to the future nature of the company. Looking at the "sales force" first example above, perhaps after a year and $150,000 in revenue you think it would be a good time to expand the sales force and increase your marketing budget. You could then adjust the figures and %s accordingly and calculate your sales figures for the next period.

When using a "top-down" market share approach to predicting sales two things to consider would be the growth in market share of your company (say we moved from 0.5% to 1%) and also the growth in the market itself (maybe the market itself by 10%). Adjusting both figures accordingly will yield your next period's sales forecast.

The bottom line in both forecasting costs and forecasting sales is that the numbers are going to be just as good as the logic and assumptions we used to create them. If we are trying to decide whether or not to start a business we do not want to mislead ourselves with poorly founded figures. The numbers are going to be wrong, it is doubtful that any financial projection ever compiled was 100% accurate; but it is important to get as close an idea as possible to what we can expect should we decide to start this business. Now that we have calculated our expected sales and costs we will take a look next week at compiling and analyzing the results.


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