February 3rd, 2022
Proper Forecasting – A Crucial Element to Maximizing Profits
Every year I call my customers and ask them for a forecast. I get a varied response. Some say, “Your guess is as good as mine.” Others just repeat last year’s results. “Well last year we grew 10% so I am betting we will do that again.” It is evident from these conversations that very few have someone in charge of studying matters and putting together a well thought out forecast. Yet, calculating a forecast and updating it periodically throughout the year is a very important part of running a business.
There are three major benefits to maintaining an accurate forecast.
The first is Setting and Maintaining Proper Inventory Levels. Accountants love JIT (Just In Time inventory levels). The more inventory turns the higher the profitability. However, as any purchasing manager (who has not yet quit in the past two years) can tell you, such a system only works well when there is a steady and predictable supply of raw materials and components available. So many window and door companies who were well entrenched with the JIT model have been caught off guard more than a few times in the past several years. (See my previous blog entitled Is JIT Dead and Is a New Model Needed?) COVID has had its way with our demand curve and the subsequent upset in the supply chain. I have a few customers who have since taken a highly proactive approach and are sending me monthly forecasts in advance enabling the suppliers that I represent to plan production schedules and raw material inventories accordingly. This information is extremely useful when it comes to minimizing lead times and helping to ensure an uninterrupted supply of materials and components to the customers supplying such a forecast!
The second major benefit to forecasting is Improved Operations Planning and Budgeting. An accurate forecast is crucial for planning and budgeting equipment purchases as well as staffing to support the predicted level of growth. In this respect, the accuracy of such a forecast is critical as it can have a huge impact upon profitability. If you forecast a huge growth spurt and take a loan out to buy several million dollars of equipment, then your profit levels will nosedive if the projected sales levels do not come to fruition. Conversely, if you underestimate projected sales levels and do not hire and train the correct amount of people to man the floor, your profit levels will suffer dramatically when you find it necessary to pay large amounts of overtime pay to your production staff. In this scenario, you also risk employee burnout and the possibility of losing key employees who decide they do not want to work 60-plus hours per week. See Preventing Employee Burnout.
The third key area affected by proper forecasting is Accurate Pricing. The price of your product is set by three factors – Worth Perception, Standard Cost and of course Profit Margin. Worth Perception is determined by your customers’ perception of your product and the ability of your sales staff to prop up that perception. The Standard Cost is determined by the costs of materials and labor that you expect to incur and that you plan for in advance. Many companies calculate this “standard’ cost and use it to help set the price of each product they sell. But actual costs will vary from this Standard Cost based upon how things “actually” play out. So if you pay more for components because you underestimated how many you would need and had to pay additional costs to overnight materials then this would create what accountants call a “variance.” When it comes to cost, a negative variance is a good thing, but a positive variance is bad. Another example would be if you did not hire enough people to run production because your forecast underestimated the demand. Therefore, you had to pay a considerable amount of overtime pay to get your products out the door. In this case, your actual labor cost per unit will be inflated representing another positive cost “variance.” These variances all add up and if the net cost variance is on the plus side, then it makes your product underpriced based upon what it is “actually” costing you to make your products. The net effect is that: you either have to raise your price to keep your profit margin steady or lower your profit margin to keep your price the same. In the former scenario, you risk losing market share and in the latter scenario, your total gross profit declines. Either way, you earn less profit.
So, you can see from this discussion that putting together an accurate forecast or as close to one as possible has a very big impact on your company’s ability to turn a desired level of profit. The next obvious question is “with all that is going on in the window and door industry, how do I put together an accurate forecast? Well stay tuned as that is the topic for another day!