Too often forecasts are mini-rehashes of the budget, which itself is usually based on the previous year’s performance. Done this way, forecasts tend to ignore business reality, such as competitive or wage pressures from an overheated economy. A better way to forecast is to focus on the metrics that drive your business.

Better Information, Not More Information
A bad forecast is the bane of any manufacturer’s existence. It can quickly send a company into a downward cash spiral. For example, underestimate demand and your production line will be understaffed. Employees work costly overtime to take up the slack. Raw materials on the shop floor are scarce, which forces buyers, who are trying to rush product to market, to pay premium prices. This puts a stranglehold on cash flow.  Having more information hasn’t improved the results. Instead, deluging managers with massive amounts of data makes it hard to discern important metrics from nonessential ones.

A solution is to use driver-based forecasting. This process uses the top 10 to 15 business drivers, such as market share, competitive pricing, and cycle time, to develop a full forecast based on the movements of those drivers. This type of forecasting better reflects the costs and revenue consequences of manufacturing more or fewer products. Forecasting done this way also becomes less an analysis of financial trends and more a strategic tool.

What to Measure?
With so many potential metrics, how do you choose the 10 to 15 that drive the business? Look at the factors — internal and external — that drive revenue, costs, and profit. Then ask two key questions:

1. Is the driver material? (Answer yes if the driver has a substantial impact on overall costs.)
2. Is the driver volatile? (Answer yes if the driver varies from period to period.) Drivers that are both material and volatile are the ones to measure and report to management.

Numbers and metrics are good tools, but they don’t work in isolation. Underneath that metric may be more revealing numbers. For example, a goal may be to reduce costs 10 percent across the board. A key metric might be annual spending in research and development. At first glance the numbers say R&D spending went up 10 percent over the last three years — a number that on its face seems inordinately high. But you need to ask the next logical question. What did the higher costs produce? If the answer is three new products that have become top revenue producers, the increased spending issue is moot.

Best Practices in Forecasting

• Set up the forecast process so it gives you an early warning of potential risks and opportunities instead of just reports against budgeted performance targets.
• Revise forecasts only when there’s an exception to the plan and the projected results differ from the plan by a predetermined range.
• Forecast only a handful of line items at any given time.
• Instead of emphasizing the financial result of a forecast, concentrate on the variables you can control. For example, if the forecast uncovers a quality problem, ask what can be done about it and consider the options.
• Integrate the forecasting system with budgeted and actual results.
• Eliminate complications by having all business units adopt unified structures and systems.
• Insist that modeling tools use multiple what-if scenarios.
• Make sure users at all levels can retrieve and submit data electronically.

Source: Adapted from The Hackett Group