Creating a revenue forecast allows companies to plan for future projects, hiring, purchasing of a building, and more. It isn’t enough to slap together any ‘ol forecast. Companies that can forecast accurately will have a heads up on their competition.
In fact, research from Aberdeen Group can quantify just how much of an advantage these companies have. Aberdeen Group found that companies that generate accurate sales forecasts have a 10% greater chance at growing their revenue year-over-year and are 7.3% more likely to hit their quota.
There are many ways to forecast revenue; but, if the numbers are off, you may end up chasing an unrealistic goal. Good forecasting means accurate forecasting and that starts with the data you have and the technique used to forecast.
Before trying to create any forecast, decide which data should contribute to the forecast. Obviously, revenue drivers are important. Revenue drivers are activities that can be tied directly to revenue. If an activity associated with a revenue driver increases, it will produce more revenue. The opposite is true if the activity decreases – it will produce less revenue. Sales is a great example of a revenue driver.
There are activities that do not contribute directly to revenue but establish a baseline of revenue. These may be software development, people within HR, customer support, and other employees who generally keep the gears turning. Certainly, all of these people are important but their activities are difficult to measure in regard to contribution to revenue.
So, how does the above information help with forecasting? Now that you know what drives your revenue, you know what to analyze for potential fluctuations in that revenue. Talking to salespeople can give you some idea about how many deals will be closed this quarter and how many will remain in the pipeline with the potential for closing the next quarter.
Baseline revenue from monthly recurring subscriptions or average product purchases can be forecasted by looking at historical data. If baseline revenue has remained flat and nothing has changed to increase it, you have a good idea that baseline revenue will remain flat in the next quarter as well. Next is to calculate next quarter’s revenue from revenue drivers.
After discussing next quarter’s deals with your salespeople, you conclude that closed deals will result in increased sales vs. the previous quarter. Let’s look at an example, to understand.
- Baseline revenue Q1: $500,000
- Baseline revenue Q2: $525,000
- Baseline revenue Q3: $510,000
- Baseline revenue Q4 (estimated): $511,000
Because there is little variation, estimate baseline revenue simply uses as average of the previous three quarters. Now for revenue drivers:
- Revenue drivers Q1: $300,000
- Revenue drivers Q2: $340,000
- Revenue drivers Q3: $360,000
- Revenue drivers Q4 (estimated): $375,000
As mentioned above, salespeople expect the next quarter (Q4) to close $15,000 more than the previous quarter (Q3). Because sales have been on an upward trend, you can have confidence that the Q4 projection is accurate.
In total, Q4 revenue is expected to be $886,000.
If a company has fairly stable revenue and a consistent growth rate, it can use the simple straight-line forecasting method. This method takes the product of the last quarter’s revenue and growth rate to determine next quarter’s revenue. Here’s what it looks like:
- Q1 Revenue: $500,000 Q1 Growth rate: 2.1%
- Q2 Revenue: $515,000 Q2 Growth rate: 2.9%
- Q3 Revenue: $525,000 Q3 Growth rate: 1.9%
- Q4 Revenue: 2.3% x $525,000 = $12,075 + $525,000 = $537,075
- Q4 Growth rate: (2.1 + 2.9 + 1.9)/3 = 2.3%
Using an average of the previous three-quarters of growth rates, Q4 revenue is expected to be $537,075.
The straight-line method works well when growth is consistent. For companies with more volatile growth, this method won’t work.
Using the same forecasting method each quarter is also important for generating an accurate forecast. Continuously changing your forecasting method can get complex and doesn’t allow you to improve your technique.
Also, know that forecasts aren’t crystal balls. Sure – you can get some idea of what revenues will be for the next quarter, and maybe the next year. But, going out five and ten years is an exercise in futility. In general, the further out in time for your forecast, the more likely it is to be incorrect.
Focusing on good operational controls will help with generating consistent revenues, which, in turn, can help improve forecasting. These controls include being able to get accurate data from people on the front lines of the business, such as salespeople.
Big shocks will certainly throw off a forecast. If 25% of the company is laid off, that’s a very large fluctuation with which to deal. It will come through in revenues, but your forecasting may not be able to accurately predict it. The next few quarters will allow the company to reset and the forecast to come back in line.
As a final word, use enough data that forecasting makes sense. Trying to project the next quarter or two of revenue from the previous quarter or two won’t yield anything useful. Instead, have a few quarters of data lined up. There needs to be enough data with which the forecast can work.