In each of the components of the forecasting process, you might come face to face with pitfalls. Recognizing the potential problems and overcoming them are crucial steps to developing a sound forecast.
Information capture
Collecting the wrong information Some forecasts are based on the wrong information. For example, sales pipeline data from sales representatives is often the source of forecasting information. Because sales representatives are generally optimistic about their potential sales, this data can lead to an overly high forecast.
Not collecting the right information Many companies don’t think through what the true “leading indicators” are for their products. Management might miss large pieces of the forecasting puzzle if it doesn’t capture all relevant data. For example, a regional construction materials company might base its forecast on recent sales trends. Instead, the company should closely monitor new construction builds, demographics, and the number of new building permits.
Information aggregation
Storing information After the correct information is captured, financial analysts need to aggregate all of the collected information. If you use only some of the information in the forecast, the forecast will not be a good basis for decision-making. For example, if a company bases hiring decisions only on product sales data and doesn’t consider that the products are nearing the end of their product life cycle, the company might make the wrong decisions. This company’s monthly forecast should include aggregated data for both product sales and product life cycle.
Analysis
Making the analysis too simple Techniques such as trend analysis, seasonality analysis, and pipeline forecasting are good tools to use when building a forecast. However, if you rely on them exclusively, you might build weak forecasts that cannot support good decision-making.
Making the analysis too complex Analyzing too many variables can inundate management with too much information. If you give management forecasts for too many types of information, management might experience “analysis paralysis.” Forecast only the key top-line financial metrics. Generally, if you create a well-done revenue forecast, all the other pieces will fall into place.
Reporting
Neglecting management’s needs You must keep the primary end user of the forecast — management — in mind when you develop the forecast. Different management teams have different forecast requirements as far as style, detail, and timing. Financial analysts should be sensitive to management’s requirements and ensure that the forecasting approach is tailored to support management’s decision-making.
Analyze your forecasting process
By taking the following steps, you can identify the issues that plague your current forecasting process and avoid the common forecasting pitfalls.
- Map your current forecasting process Ask yourself: Where do I obtain the data from? In what form do I aggregate the data? Do I use separate reports? How often are reports developed? Who develops the reports? What techniques do the reports use?
- Analyze the effectiveness of prior forecasts Ask yourself: Has there been a major variance (either positive or negative) from one period to the next? What factors caused the variances? Are these variances now considered part of the analysis approach? If not, why not? Is there data that would assist with forecasting that’s not readily available? What is management’s opinion of forecasts? Does management use forecasts to support decision-making, or does management make decisions based on intuition?
- Define the gaps in your forecasting process Order the gaps according to significance.
- Develop an action plan For companies that have a sound forecasting approach, an action plan might involve only a few tweaks to the forecasting process, the data gathered, or the analytical techniques used. For other companies, an action plan might require a complete re-engineering of the forecasting process. You might need to use new tools for information capture, aggregation, analysis, and reporting.
A stronger forecasting process
By analyzing your forecasting process, you can avoid the pitfalls that plague many forecasting approaches and strengthen your forecasting process. You will develop better forecasts and be able provide your organization with the comprehensive forecasts it needs.