Effective forecasting can be achieved by following a seven-step process. It involves a systematic analysis of the current and projected structure of the business, a break-even analysis, and various ways of determining reasonable growth patterns for your operation.

1. Identify all FIXED and VARIABLE costs

Any business will generate expenses over the course of a year. These expenses are either "fixed" or "variable." Fixed costs do not change with changes in the level of sales or operations; variable costs change relative to changes in sales or operations.

Make a list of all expenses you think you will encounter. For most businesses, a great deal of helpful information is available. If you are involved in a start-up or expansion, or even if you are in a stable, ongoing business situation and are trying to make your operation more efficient, there are various sources of help. Your accountant, because he is familiar with the cost structures of a variety of different businesses, will be able to help you make sure that you have identified all of the expense categories you can reasonably expect. In addition, various publications such as the Annual Statement Studies (Robert Morris Associates) show average operating expenses for a wide range of small businesses across the country. Trade associations and industry publications are still another source of such information.

2. Determine your BREAKEVEN sales level

Breakeven is that point where the business does not have a profit or a loss. Breakeven is the level of sales necessary to cover all of the fixed and variable costs. See Breakeven Analysis

3. Evaluate the ODDS of reaching breakeven

Once you know the level of sales you must reach before making a profit, how reasonable is this target? What are the odds of reaching this breakeven sales level? Convert the sales level into operational measures. If you are a restaurant selling soup, how many bowls of soup must you sell to reach breakeven? How does this measure relative to your capacity to cook and serve soup? How does it relate to your market? If you can’t say that your concept or operation makes sense at this point (as an expansion needing 110% of the market, for example), then reexamine your plans. The process of reexamination may make you aware of new solutions. In any case, recognizing limitations through this type of analysis is much cheaper than charging blindly into a disaster. If it isn’t going to work at all, acknowledge it at this point and save yourself the agony of failure.

4. Determine WHEN you will reach breakeven

Virtually all new businesses will start out at a loss, simply because it takes awhile to get started, for new customers to find out where your business is, and to learn that you are providing goods and services which will satisfy their wants and needs. It is essential to predict as accurately as possible how long it will take for your start-up operation to reach its breakeven point because the sum of the monthly operating deficits up to that point will help you to determine how much working capital you will require for your business. For an ongoing business, past sales experience is a good guide. Another way to achieve the needed result is by calculating how many new customers you can add per month, how many old customers you can retain, frequency of repeat sales, and the average dollar sale per customer.

5. Calculate your CONTINGENCY RESERVE

A contingency reserve is your backup working capital. Most businesses lose money when they start-up. Expansions usually behave similarly. By definition, these situations will lose money until they reach their breakeven level of sales. The amount of this loss can be calculated through your cash flow analysis and is the amount that you must have available to invest in the business as working capital. If it takes longer to reach the breakeven level than you first anticipated, the loss will continue and you will have to invest more capital. It is only common sense to have this additional working capital available as a cash or contingency reserve. The contingency reserve can be calculated by projecting two levels of growth: reasonable growth and pessimistic growth. The amount you should plan for is the negative cash flow difference between the two projections. Clearly, if you thought that there was a reasonable possibility of not having any sales, you should reconsider the project!

6. Translate the graphs into an INCOME FORECAST

The parts of the process for income forecasting have now been assembled. In STEP 1, you identified your FIXED and VARIABLE expenses. In STEPS 2 through 5, you experimented with different ways of constructing SALES FORECASTS. Using these understandings, now you can continue these steps so that you can inspect the changes that you expect in your business month by month. This will show you the actual profit or loss that you can expect from your venture, and becomes your projected or pro forma income statement.

7. Translate the income forecasts into a CASH FLOW

The PROJECTED CASH FLOW is the basis of your cash budget. It shows the TIMING of cash flows and enables you to ensure that you will have adequate cash reserves as well as working capital. For a new venture, or for a rapidly growing venture, it is likely that cash will flow out more rapidly than it comes in. The difference between the cash inflows and the cash outflows must come from somewhere. Cash flow forecasting enables you to predict both the size and timing of this kind of temporary operating deficit. By adding to this figure a cushion for unexpected emergencies (Step 5), you can figure how much cash reserve you will need to remain solvent. See the Cash Flow article (6.c).

FORECASTING is based on carefully reasoned assumptions, quantified in a systemic way to make your projections about what will happen in the future as accurate as possible. By taking a systematic approach to forecasting, you gain a deeper knowledge and understanding of your business. The final product of your forecasting effort becomes your projected cash flow, the basis of the cash budget, which in turn is a primary tool for controlling your business.

The purpose of the forecasting process is twofold. It affords an excellent opportunity to review the past and it provides the best guide for analyzing and managing the type of future your business can have. Anticipating problems and avoiding them, rather than waiting until they arrive and then trying to deal with them on a reactive basis, is the essence of good business planning. Good business planning is a primary key to business success.