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The purpose and function of a forecast and types of forecasts

The purpose and function of a budget and types of budgets
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Hi everyone, the topic that we’re going to be discussing today, is types of forecasting. So we’re going to look at the main typical types of forecasting that are done within an organisation, doesn’t mean that these are the only ones, but they cover pretty much every type of forecasting, that you would do for your organisation. So let’s dive into the topic. So the types of forecasting we’re going to be looking at is the sales forecast. We have the cost of goods sold forecast, overhead expense forecast, or what you can also call as operating expense forecast (clears throat).
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And then lastly, we have the cash flow, which is extremely important, something that we’ve touched upon, when we were doing budgeting as well. Because cash flow tells us the position of liquidity, for an organisation. So if you can forecast your cash position, so standing here, if you can forecast, what cash flows do you expect or do you forecast for the upcoming months, or the upcoming year, you’re kind of prepared for any kind of liquidity crisis. And beforehand, you can start arranging for lines of credit, or you can go and approach a bank. But we’re going to discuss that in detail.
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But for now, we just have to remember that these are the main kinds of, or the main types of forecasts that we’re going to be looking at. And we’ll pick up each one of them individually, and then look at it. So the first one is a sales forecast. So the sales forecast is going to tell you how much of sales, do you expect to generate over the upcoming months.
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The thing with forecasting is that you can forecast, for a couple of months, or you can forecast for one year, or even more than one year, depends on what time horizon you’re choosing. So for our purposes, let’s choose a one year’s time horizon, and say we want to project our sales forecast, for the upcoming year.
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So for January, so this is where the year starts, first month, second month, third month, fourth month, fifth month, and six months. Okay? And then that’s going to continue till December. So sales forecast, we’re going to project the sales, that we forecast for each of the months. One thing that you always can start with is your historical performance. So suppose this is year 2021, we want to project for, or we want to forecast for, an easy approach to start your forecasting would be to look at the 2020 numbers, and compare what happened in each of these months, and then use that as your base to project forward. So suppose in last year, the sales was for 200 units,
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and the sales price was dollars five.
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So this is the unit sold, and this is the price per unit. This gives you an idea of how many units you can expect to sell in January, if everything remains the same, and then at what price can you sell given that then you will have to index it, for inflation and other factors. So historical performance is a good point, to start your forecast from, then you adjust them for industry outlook for markets. So what does the market look like? Is there a growing demand for my product?
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Are there more competitors entering into the market? You can tweak the numbers based on this information. So suppose next year you expect that the market is going to grow because the demand of your product is going to be higher. So then in that case, you can anticipate, that this year, it’s actually not going to be 200, but it’s going to increase to 300.
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Another scenario we can look at is that if you expect, that the industry is going to have more competitors coming in, and you’ve got new entrants coming into the market, then if you had 200 units sold in January last year,
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it’s highly unlikely that you’re going to be able to sell the same units this year, because now they’re more competitors in the market. So they’re actually going to eat away, some of your share as well, unless the demand is growing, and in that case, you will have to project with the growth in demand. Do you think this is sustainable with the new competitors coming in? Or do you think that it’s too optimistic? And then maybe you can lower it down a bit. Now, all of this, you just don’t do it yourself there are regression analysis, there are statistical packages, or softwares that you can use, to analyse it, and to project it.
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So you index it for market industry, historical performance, you also anticipate what your contracts are going to look like in the future. Again, something that is similar to demand and competitors. So if you have a new contract, or if you’ve got more pipeline work, or work in your pipeline, then you are going to, make your outlook a little bit more optimistic. Maybe instead of 200, you can add another 150 and say, “Okay, 350 units are going to be sold, because we just want another contract, or we have more work in our pipeline.” So this is just a formula that is used to calculate your sales revenue.
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So remember, just projecting revenue, is not enough, because revenue is a function of two things. And that’s why throughout this discussion, I’ve not limited myself to just saying sales revenue. I’ve continuously talked about units because sales revenue is a function of price per unit, and the quantity. Quantity we’ve already discussed in detail, depends on how much you sold last year, your industry, the market factors and what new work do you have in line.
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The other factor that you have to consider, is the price, and for price it depends on again, some of these factors, so if there are new, more competitors coming in, if your industry is changing somehow, so then you would have to see if the price is going to remain the same. Is it going to increase or is it going to decrease? The other factor, which is easy to invert is inflation. So, whatever price you sold at in January, 2020,
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you’re not going to be able to sell it at the same price. Given that typically most of the economies, are working under inflationary pressures. So this is going to go up. So suppose you’ve got an inflation of 3%, you’re going to index it for 3% and increase that.
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So that’s four things. The second component that we have to forecast, is the cost of goods sold. Now remember, the reason why we’re doing it is because sales, less cost of goods sold,
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gives us our gross profit. And then once we take out all the other expenses, and just clubbing them all together, not breaking them down, otherwise you’ve got lots of expenses here. So all the other expenses when you take it down, you have your net income, we should have put less here as well. So sales, less cost of goods sold, gives you gross profit, gross profit minus or less other expenses, gives you your net income. Therefore, once you’ve actually anticipated your sales, then you have to go and look at, that in order to sell those 200 units say for January, what is going to be the cost of these 200 units? Okay?
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So when we calculate the cost, a quick easy way to do cost of goods sold, and remember where we don’t have them as yet. So we’re not just taking units sold, and multiplying it by cost per unit, these are our projected numbers.
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So one way to do it, is to see how many units did you project to sale? So say 200. So I’m sticking with my hypothetical scenario, in which I said, “2020, January, I sold 200 units at $5.”
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And I’m keeping it constant and saying, “There is no change, I don’t expect anything to change.” So still going to be 200 units. So what do I expect for my cost of goods sold? I expect to sell 200 units, and each one of it, is going to cost me dollars suppose six. ‘Cause cost of production is going to go up. Now again, one thing that you have to look into it, is whether the price of the inputs are going up. So if you’re producing something, you would have raw materials in it, you would have labour in it, and then you would have overhead going into it.
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That’s going to be the total cost per unit, of whatever you’re planning to sell. So you have to anticipate changes in them, you have to project changes, in the labour wages you’re paying, in the raw material. So suppose your raw material is cotton, then you have to see what is the expected price of cotton going to be in the next 12 months? So a lot of this data is available. It’s just a matter of taking all those projections, that are available, and then using them for your projections in a way that you are also customising it, to your unique situations. And again, those unique situations we’ve reviewed them, they’re like your competitors, your market situation, your historical performance.
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So one way for us to put this projected cost of goods sold, is use the projected units that we’re going to be selling, and multiply it by the projected cost per unit, that we project and anticipate to incur, in order to produce these 200 units, that we want to sell. The second approach is use a historical percentage. So say last year, I sold 200 units, and I sold it at $5.
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So it means thousand dollars.
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And it was costing me $600.
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So maybe 200 times three, most likely this is what it is going to be. So typically, cost of goods sold for my company, is around 60%, or exactly 60% of sales.
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So in our last example, or on the last projection, we projected sales of 200 units at $5 each, which is 1000. So if historically you’ve been selling, whatever units you sell, you incur a cost for those goods, at 60% of sales, so you can use this as your projected sales. So you can use historical percentages, as your projected cost of goods sold. Again, if this situation would have been different, so suppose we anticipated we’re going to sell 300 units, and we project we’re going to be selling it at $6. So this is going to be 1800. And if we expect that this is going to be 6%,
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so then our expected cost of goods sold would be
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10, eight, zero, zero nope not zero, zero.
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Okay, so this is what is going to be,
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your cost of goods sold as a percentage, of your previous year of sales.
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Okay, so let’s move on now. And let’s look at the other type of forecasting, that we have to do. I’m not going to be touching cash flows right now, I’ve got a separate video for that. So overheads, just like we have been projecting, sales, cost of goods sold, all the overhead, or what we also call is operating expenses, can be forecasted the same way. So all you have to do is mark all the months, and then for each of these months, look at the historical number. So suppose for rent, utilities,
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these are going to be your typical operating expenses. So rent, utility, insurance.
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For each one of them, you’re going to see, what the historical costs that you incurred, or expense that you incurred. If something is changing, you adjust for that change, and you have your forecasted amount. So if last year, the rent that you paid was hundred per month, hundred dollars, and you haven’t rented a new premises or anything, it’s not going to change, it’s going to stay the same. If you have rented a new place, then you’re going to add it, and you’re going to come at your forecasted rate. So I hope this clarifies some of the concepts, that are around it, and I’ll see you in the next video.

This video will introduce you to types of forecasting in particular sales forecasting for an organisation. A sales forecast will display how much of sales an organisation expects to generate over the upcoming months.

After watching the video, share your thoughts in the comments on the key themes and questions that were raised.

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Financial Analysis for Business Performance: Planning, Budgeting, and Forecasting

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