2.2 FINANCIAL PLANNING

SALES FORECASTING

Sales forecasting is a crucial part of business planning.

The sales forecast forms the basis for most other common parts of business planning:

• Human resource plan: how many people we need linked with expected output

• Production / capacity plans

• Cash flow forecasts

• Profit forecasts and budgets

• Part of regular competitor analysis and helps to focus market research

KEY FACTORS AFFECTING THE ACCURACY AND RELIABILITY OF SALES FORECASTS

Sales forecasting requires a subjective judgement about an uncertain future. So it is inevitable that actual sales will differ from those forecast.

Key factors that create this variability include:

• Consumer trends
  • Demand in many markets changes as consumer tastes & fashions change
  • Affects both overall market demand & the market shares of existing competitors

• Economic variables
  • Demand often sensitive to changes in variables such as exchange rates, interest rates, taxation etc.
  • Overall strength of the economy (GDP growth) also important

• Competitor actions
  • Hard to predict, but often significant reason why sales forecasts prove over-optimistic

CIRCUMSTANCES WHERE SALES FORECASTS ARE LIKELY TO BE INACCURATE

The situations where actual sales are most likely to be significantly different from the sales forecast include:

• Business is new – a startup (notoriously difficult to forecast sales)

• Market subject to significant disruption from technological change

• Demand is highly sensitive to changes in price and income (elasticity)

• Product is a fashion item

• Significant changes in market share (e.g. new market entrants)

• Management have demonstrated poor sales forecasting ability in the past!

SALES VOLUME AND SALES REVENUE

• Sales volume and sales revenue

• Sales volume is the amount of sales expressed as a number of units sold

• e.g. 20 tonnes of wool

• Sales revenue is the amount of sales expressed as the total sum of money spent by consumers

• e.g. £3 million expenditure on clothing

SALES VOLUME AND SALES REVENUE

• Sales volume can be calculated as:

• Sales revenue / selling price

• A company has sales revenue of £50 000
• Selling price is £2.50
• Sales volume = £50 000/£2.50 = 20 000 units

• Sales revenue can be calculated as:

• Selling price x quantity sold

• A company sells 20 000 units
• Selling price is £2.50
• Sales revenue = £2.50 x 20 000 = £50 000

REVENUE

• Revenue is the money coming in from the sale of goods and services

• Revenue = Selling price x quantity sold

• If a business sold 20 000 units at a selling price of £15

• Revenue = £15 x 20 000 units = £300 000

• Revenue increases with the amount of units sold and therefore starts at 0 and slopes upwards when shown on a graph

FIXED AND VARIABLE COSTS

• Fixed costs stay the same regardless of output e.g. rent and manager’s salaries
• Fixed costs also include interest on bank loans

• A business borrows £30 000
• The annual rate of interest is 7.5%
• £30 000 x 0. 075 = £2250
• The business has a fixed interest payment of £2250 per annum

• Fixed costs are shown as a straight horizontal line when shown on a graph

VARIABLE COSTS

• Variable costs change in relation to the number of items produced e.g. raw materials
• Variable costs per unit or average variable costs (AVC) are multiplied by the number of units to calculate total variable costs (TVC)

• AVC x Q =TVC

• Variable costs start at zero and slope upwards when shown on a graph

TOTAL COSTS

• Total costs are fixed costs plus total variable costs

• TC = FC + TVC

• Total costs start at the fixed cost point on the y axis and slope upwards parallel to the variable cost line

BREAK-EVEN ANALYSIS

• Break-even is the point at which a business is not making a profit or a loss i.e. it is just breaking even

• At this point total costs must be the same as total revenue

• TR = TC

• Break-even output is the number of items that a business must sell to reach this point

• Before reaching break-even a business is operating at a loss

• After reaching break-even each additional unit sold will contribute towards profit

TOTAL CONTRIBUTION AND CONTRIBUTION PER UNIT

• What does the word contribution mean?

• In business each time a product is sold or service provided what does the money generated contribute towards?

TOTAL CONTRIBUTION AND CONTRIBUTION PER UNIT

• Contribution per unit is the difference between selling price per unit and variable cost per unit i.e. how much is left to contribute

• Firstly to fixed costs and secondly to profit

• Contribution = selling price – variable cost

• If I sell t-shirts at £11.50 and each one costs me £4.00 to make then from each item sold I have a contribution of £7.50 (SP £11.50 – VC £4.00)

• Total contribution is the difference between total sales revenue and total variable costs

• If I sell 100 t-shirts total sales revenue is (100 x £11.50) £1150 and total variable cost is (100 x £4.00) £400

• Therefore total contribution is £1150 - £400 = £750

CALCULATION OF BREAK-EVEN OUTPUT

• Contribution per unit can be used to calculate break-even

• Contribution = selling price – variable costs

• Fixed cost / contribution = break-even point

• The fixed costs to manufacture the t-shirts is £15 000

• Contribution = £11.50 - £4.00 = £7.50

• Fixed cost / contribution = break-even point

• £15 000 / £7.50 = 2000

• The business would have to sell 2000 t-shirts to break even

CALCULATION OF BREAK-EVEN OUTPUT

• Break-even is where neither a profit or a loss is being made (TC = TR)

MARGIN OF SAFETY

• Margin of safety is how much actual output is above the break-even level of output

• Calculated as:

• Actual output level – break-even level of output

• T-shirts break-even = 2000 t-shirts

• Assume output = 3000 t-shirts

• Margin of safety = 1000 t-shirts

BREAK-EVEN CHARTS

• An alternative to calculating break-even via contribution is to plot the lines on a break-even chart

• This makes it easy to see where the break-even point is

• i.e. where total costs = total revenue

• Break-even point should be read off the horizontal axis and therefore expressed as a number of units e.g. 2000 t-shirts

USING BREAK-EVEN CHARTS

• Break-even charts can also be used to read off the loss or profit that would be experienced at different levels of sales

CHANGING VARIABLES

• Businesses should treat break-even with a degree of caution

• It is based on the assumption that costs and revenues will be static, in reality this is not true

• Variables can change for the better or worse

• What variables might change?
  • Fixed costs
    • Landlord puts rent up
    • Bank changes interest rates
    • Management want pay increase
  • Variable costs
    • Raw materials change in price
    • Minimum wage is increased
    • Utility companies change price
  • Selling price
    • New competition enters the market
    • Positive word of mouth puts demand up

STRENGTHS AND WEAKNESSES OF BREAK-EVEN

STRENGTHS

• Allows businesses to calculate the minimum number of sales needed before starting to make a profit and therefore for see if a venture is viable

• Can calculate the level of profit or loss at different levels

• Can predict the outcome of changing variables

• Aids decision making

WEAKNESSES

• Is based on predicted costs and revenues

• Even fixed costs can vary in reality, especially in the long run

• Ignores changes in variable costs or selling price as items are bought or sold in larger quantities

BUDGETS

• Budgets are forecasts or plans for the future finances of a business

• These can be for the business as a whole or set for specific functions e.g. a marketing budget

• Budgets can be:

THE PURPOSE OF SETTING BUDGETS

• Provides a quantifiable target, that can be communicated to interested parties, against which actual outcomes can be measured

• e.g.

• Are sales targets being achieved?
• Are managers keeping expenditure under control?
• Is the businesses operating efficiently to achieve profit targets?

• Helps with planning and forecasting to inform decision making

• e.g.

• What are this year’s priorities?
• Where were budgets met or missed in previous years?
• Where can cuts be made or extra funds channelled?

• Motivates budget holders due to increased responsibility

BUDGETS

• Income budgets

BUDGETS

• Expenditure budgets

BUDGETS

• Profit budgets

SAMPLE BUDGET

                                  JANUARY          FEBRUARY          MARCH                

INCOME BUDGET        4000                    6000                     6000

EXPENDITURE            2500                     3500                    3500

BUDGET

PROFIT BUDGET          2500                    2500                    2500

TYPES OF BUDGETS

• Historical figures

• Zero based

THE CALCULATION AND INTERPRETATION OF VARIANCES

• An advantage of budgets was that they allow for monitoring of performance

• This is achieved by comparing the budget to the actual

• Any difference is known as a variance

PROFIT BUDGET

VARIANCE PROFIT ACTUAL

EXPENDITURE BUDGET £25000

VARIANCE £2000 EXPENDITURE ACTUAL £27000

THE CALCULATION AND INTERPRETATION OF VARIANCES

• Variance is therefore the difference between the actual income, expenditure or profit and the figure that had been budgeted

• Variance Analysis is the process of calculating and interpreting these variances

                             BUDGET      ACTUAL      VARIANCE

INCOME                 £60 000        £62 000        £2 000 fav

EXPENDITURE       £32 000        £32 000        £800 ad

PROFIT                  £28 000T      £29 200        £1 200 fav

VARIANCES CAN BE ADVERSE OR FAVOURABLE 

Adverse

• An adverse variance is one that is bad for the business

• Expenditure higher than budget

• Income lower than budget

• Profit lower than budget

Favourable

• A favourable variance is one that is good for the business

• Expenditure lower than budget

• Income higher than budget

• Profit higher than budget

INTERPRETING VARIANCES: Once a variance has been identified it is important to:

• 1) Identify the cause of the variance
• 2) Consider the effect of the variance
• 3) If appropriate look for a solution

DIFFICULTIES OF BUDGETING

• Dependent upon predictions and forecasts

• Costs are subject to change

• Actions of competitors are unknown

• Managers may lack experience

• May be subject to bias

• Takes time and effort which itself has an associated opportunity cost

POSSIBLE CAUSES OF VARIANCES

• Action of competitors
  • Lower prices
  • Introduce a new product
  • Close a store
• Action of suppliers
  • Change prices
  • Offer a discount
• Changes in the economy
  • Change in interest rates
  • Increase to minimum wage
• Internal inefficiency
  • Poor management of a budget
  • Demotivated sales team
• Internal decision making
  • Change suppliers
  • Special promotions