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Friday, August 04, 2006

Forecast your future

You project your company's revenues, costs, and profits by making educated assumptions based on trends, events, and key economic indicators.

By Bay Cabrera

Forecasting is the process of planning and estimating something in the future. From the financial viewpoint, it is the practice of making educated assumptions about trends and events to calculate your company's future revenues, costs, profits, capital expenditures, financing and cash requirements, and financial condition.

Forecasting would not be possible without making assumptions. By identifying future events that could affect your company, and making reasonable assumptions about those factors, you can move the forecasting process forward. However, you need assumptions only for future trends and events that are most likely to have a significant effect on your company's business. If future occurrences deviate significantly from your assumptions, you will know what actions to take. Companies that have the best information generally make the most accurate assumptions, which can lead to a major competitive advantage.

Financial forecasting is complex because of unstable economic conditions, technological innovation, new products, improved services, stronger competition, and unforeseen events. To guide them in their forecasting, company owners and managers often rely on published key economic indicators and forecasts to identify external opportunities and threats effectively.

Computers are a big help in financial forecasting. They allow you to use financial spreadsheet programs to evaluate events before preparing your forecast for up to 10 years-and to project your projected income statement, cash flow statement, and balance sheet. The financial forecasting process may be divided into three main steps:

Projecting your company's revenues and expenses over the planning period

Estimating the levels of investment in current assets, and the capital assets required to support your projected revenues and expenses over the planning period

Determining the financing requirement throughout the planning period, and calculating your cash inflows and outflows

Preparing your projected income statement entails estimating your company's revenues and expenses over the planning period. You use your sales estimate (in units and in pesos) as basis for other calculations needed to prepare your projected income statement. The quantity of products you must buy or produce and your selling and administrative expenses depend on your sales estimate. As a result, the whole forecasting process begins with your estimate of your expected or possible sales volume.

Your sales forecast

You base your sales forecast on your pricing policy, the economic outlook and conditions within your industry, government policies, and your company's position in the economy. Your production capacity and the demand for your products or services are the main considerations in making your sales forecast.

The methods used in forecasting sales vary widely. In general, you base your forecast on an analysis of past sales and your estimate of prospects. You break down your past sales by product lines, locations, and salespeople to estimate future sales. Generally, your sales managers and salespeople will prepare estimates based on experience and expectations. Your top management people, who are better informed, will review these estimates and make adjustments where necessary.

Your inventory forecast

The sales forecast aside, you next calculate the number of units you must produce or buy to meet sales targets and satisfy your ending inventory requirements. You must consider your beginning and ending inventory units, but if your company uses the Just-In-Time or JIT system, the units sold equal the units produced or purchased. One formula for computing the number of units to be produced or purchased is: Units to be produced or purchased = Ending inventory units + Sales units - Beginning inventory units.

You calculate your cost of producing inventory by adding direct material cost, direct labor cost, and overhead cost. These are computed using the following formulas:

Direct material purchases = Desired ending inventory of direct materials + Expected usage - Beginning inventory of direct materials

Total direct materials purchase cost = [(Units to be produced x direct material per unit) + Desired ending inventory - Beginning inventory] x Cost per unit

Your labor cost forecast

You calculate your total cost of direct labor hours needed for the units to be produced as follows: Total direct labor cost = Units to be produced x Direct labor time per unit (hours) x Wage per hour (average of the salaries paid to workers)

Your overhead forecast

Overhead is the expected cost of all indirect manufacturing items, and may be grouped into fixed and variable costs. Some costs, such as utilities and supplies, are variable, and could be identified for each item per unit of activity. Others, such as indirect labor, must be estimated and spread on the units. Your calculate your overhead cost as follows: Total overhead = Sum of estimated direct cost x Variable overhead rate + Sum of the estimated fixed overhead, including depreciation

Your cost of sales

Cost of sales = Cost of goods purchased or sum of direct materials, direct labor and overhead + Beginning finished goods - Ending finished goods

Your selling expenses

You estimate your planned expenditures for selling and distribution by dividing them into variable and fixed components. Variable expenses are those that vary with sales, and these include sales commissions, freight and supplies. Fixed components (marketing staff salaries, office equipment depreciation, traveling and advertising expenses) remain constant. Your Total selling expenses = Planned sales in units x Variable selling expense per unit + Total fixed selling expenses

Your administrative expenses

Administrative expenses are your planned expenditures for the rest of the organization; these are not yet included in the preceding calculations. These expenses are also divided into fixed and variable components, but most are fixed expenses such as administration staff salaries, buildings and equipment depreciation, legal and auditing fees, insurance, utilities, supplies, and travel. Some components may be variable, such as part of management salaries that are pegged with sales or other performance criteria.

Your projected income statement

The projected income statement simply puts together the calculations we have discussed. Its general layout is presented above:

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