Why is the typical approach to business planning and forecasting flawed?
Strategic planning generally aims to get to an estimate of future sales and profits, so how these items are estimated is critical. Typically, you would start with a forecast for demand, and by assessing how competition could affect prices, get a value-forecast for the market. Setting targets for increased market share would then give a forecast for sales volume and revenue. There are however problems associated with this typical approach to business planning and forecasting…
Applying this approach to low-fare airline Ryanair, for example, implies starting with a forecast for total air travel, targeting growth in market share to get the airline’s future passenger journeys, and then estimating the ticket prices it will be able to charge. Adding sales of ancillary items [ground transport, food etc] gives a forecast for total revenue [see Figure 1].
Figure 1: Market-based forecasts for Ryanair revenues
In practice, this process is not so simple. First, on which “market” is the forecast based – the total European market, or only that served by low-fare carriers? Where are the boundaries of that market? Does it include, for example, flights from Italy to Turkey or Israel, and if Ryanair starts to operate across those boundaries does the whole analysis have to be recreated to reflect this wider scope? Ryanair is relatively simple because it basically offers a single, clear service, but Amazon.com, for example, long ago diversified from selling books by adding music, software, games and so on. This kind of analysis would therefore have to be repeated for each product market, and the results added together.
Now you have a forecast for sales and revenue, you would set targets to cut the fraction of revenue spent on raw materials and operating costs (sales and marketing, distribution, product development, training, financial administration, etc.). From the revenue forecast and cost ratios, you can then project operating profit. You may want to go on to estimate any investment needed and the cost of capital, to arrive at your “economic profit” – the profit you will make after the cost of funding.
A forecast for Ryanair’s costs might assume, for example, that the company will be able to reduce airport costs as a fraction of revenue—perhaps due to scheduling more flights per week through each airport—but will need to sustain the percentage of revenue spent on staff, to ensure continuing service levels. Similar calculations can be made for costs of routes, aircraft, marketing and other items.
Problems with this typical forecasting approach
The logic of this process for forecasting revenues, costs and profit margins relies on some fundamental assumptions:
- that market growth is ‘out there’ and independent of what the company or its competitors do
- that competitive forces dominate the prices companies can charge, and the profit margins they can achieve … the focus on reducing cost fractions is a way of trying to make just a little higher profitability on each dollar or Euro of sales than the next guy.
Neither assumption stands up to scrutiny.
First, the airline market today is the size it is, and has grown at the rate it has, precisely because of the actions of Ryanair and others – opening new routes, offering lower fares than previously available, and so on. Other industries illustrate the same point – in IT, for example, the world is the way it is today because of what Microsoft, Dell, Google and a host of other companies have done, not because there was some independent force pushing demand for goods and services in certain directions and at certain speeds.
As regards prices, costs and margins, research now suggests, that the decisions of business executives have a larger influence on performance than do industry conditions. This implies it is possible to deliver strong performance [both profit margins and growth] in industries with tough competitive conditions—consider the airline industry where competitive forces are notoriously hostile, yet Ryanair, Southwest and a few other firms can be not just successful at a point in time, but sustain that performance over many years.
Resources will continue to drive revenues – and costs.
This will not take long to explain because briefing 5 showed the strong causal link from resources to profits. Ryanair’s performance up to 2006 demonstrated clearly that customers drive revenue, and other resources [staff, aircraft and so on] drive costs – and putting these two pieces together explains profits. Not only was that true throughout the company’s history, it will also continue to be true into the future [if the business continues the same activities].
Just continue that reasoning into the future. Ryanair’s fare revenues in years to come will be driven by growth in the number of customers using the airline, and changes in their journey frequency and fares. We still need to understand competitive pressures, which will affect both the frequency with which customers will choose to travel with this airline and the fares they are willing to pay. But customers’ willingness to choose this company is strongly affected by its own success in offering the routes and service they want, as well as by market conditions.
Figure 2: Customers will drive Ryanair future revenue
Adopting the same principle for the airline’s costly resources leads to the plausible projection for operating costs shown in Figure 3. If the company is to serve the number of customers above, then it will have to add airports to reach those customers, offer more routes to win their travel choice, add planes to carry them, and hire additional staff to serve them.
Figure 3: Resources will continue to drive Ryanair costs
As noted in a previous briefing, some other cost items must also be taken into account. In particular, it is costly not only to have resources but also to acquire them [opening a new route for example], and marketing may need to be spent to win customers. Nevertheless, starting with resources to estimate future revenues, costs and profits is a much more rigorous and practical approach than the broad-brush methods more commonly applied.
I hope you found this longer briefing to be worth the extra few moments of reading. In the next, we will show how exactly equivalent principles apply in non-business cases
Until next time…
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Not all heroes drive growth!
Although the general media and business case studies love to investigate and report on examples of outstanding business growth, there are other heroes out there whose achievements are usually ignored. Would you volunteer, for example, to run Kodak’s camera-film business when the world is switching to digital devices, or jump at the chance to run Blockbuster video stores as the performance and availability of video downloading rises?
But someone has to do those jobs. Nor can you escape this question by saying that these businesses should diversify or switch into something else, such as Kodak print-shops for producing hard copies of digital photos – someone still has the job of selling photo-film for traditional cameras. It seems that, during 2000 to 2005 at least, Kodak was not doing as well on this challenge as its arch-rival Fuji, whose sales of photo film declined at a much slower rate.
Don’t under-estimate the importance of this capability. As explained in an earlier briefing, business value reflects the stream of future cash-flows, so the ability to hold the rate of decline, say, to 10% a year when it would otherwise be 25% has considerable business value. So let’s recognise those unknown heroes.
Estimating future business performance is outlined in many sources; see for example:
Martin J and Petty J, Value Based Management, (2000), Harvard Business School Press: Cambridge MA, Chapter 4
Copeland T, Koller T and Murrin J, Valuation – Measuring and Managing the Value of Companies, (2000), 4th Edition, Wiley: Chichester, Chapter 8
This briefing topic is covered in more depth in Strategic Management Dynamics, pp 68-81
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