Managing a Business/MBA assignment questions
QUESTION: Sir ,can you please answer these question
1. International business is not a new activity-a product of the modern times. The 'imperative’ to international business may be a modern day feature; but organized international business took place even during historical times.–Substantiate this statement.
2"Every financial decision has an impact on the risk return Profile of a firm.”Therefore, the financing decision of Working capital of a firm also determines the risk return Profile of a firm with regard to its working capital. Do you agree with the statement? Support your answer with necessary examples
ANSWER: International business is not a new activity-a product of the modern times. The
‘imperative’ to international business may be a modern day feature; but
organized international business took place even during historical times.
–Substantiate this statement.
Today, business is acknowledged to be international and there is a general expectation that this will continue for the foreseeable future. International business may be defined simply as business transactions that take place across national borders. This broad definition includes the very small firm that exports (or imports) a small quantity to only one country, as well as the very large global firm with integrated operations and strategic alliances around the world. Within this broad array, distinctions are often made among different types of international firms, and these distinctions are helpful in understanding a firm's strategy, organization, and functional decisions (for example, its financial, administrative, marketing, human resource, or operations decisions). One distinction that can be helpful is the distinction between multi-domestic operations, with independent subsidiaries which act essentially as domestic firms, and global operations, with integrated subsidiaries which are closely related and interconnected. These may be thought of as the two ends of a continuum, with many possibilities in between. Firms are unlikely to be at one end of the continuum, though, as they often combine aspects of multi-domestic operations with aspects of global operations.
International business grew over the last half of the twentieth century partly because of liberalization of both trade and investment, and partly because doing business internationally had become easier. In terms of liberalization, the General Agreement on Tariffs and Trade (GATT) negotiation rounds resulted in trade liberalization, and this was continued with the formation of the World Trade Organization (WTO) in 1995. At the same time, worldwide capital movements were liberalized by most governments, particularly with the advent of electronic funds transfers. In addition, the introduction of a new European monetary unit, the euro, into circulation in January 2002 has impacted international business economically. The euro is the currency of the European Union, membership in March 2005 of 25 countries, and the euro replaced each country's previous currency. As of early 2005, the United States dollar continues to struggle against the euro and the impacts are being felt across industries worldwide.
In terms of ease of doing business internationally, two major forces are important:
technological developments which make global communication and transportation relatively quick and convenient; and
the disappearance of a substantial part of the communist world, opening many of the world's economies to private business.
Domestic and international enterprises, in both the public and private sectors, share the business objectives of functioning successfully to continue operations. Private enterprises seek to function profitably as well. Why, then, is international business different from domestic? The answer lies in the differences across borders. Nation-states generally have unique government systems, laws and regulations, currencies, taxes and duties, and so on, as well as different cultures and practices. An individual traveling from his home country to a foreign country needs to have the proper documents, to carry foreign currency, to be able to communicate in the foreign country, to be dressed appropriately, and so on. Doing business in a foreign country involves similar issues and is thus more complex than doing business at home. The following sections will explore some of these issues. Specifically, comparative advantage is introduced, the international business environment is explored, and forms of international entry are outlined.
THEORIES OF INTERNATIONAL
TRADE AND INVESTMENT
In order to understand international business, it is necessary to have a broad conceptual understanding of why trade and investment across national borders take place. Trade and investment can be examined in terms of the comparative advantage of nations.
Comparative advantage suggests that each nation is relatively good at producing certain products or services. This comparative advantage is based on the nation's abundant factors of production—land, labor, and capital—and a country will export those products/services that use its abundant factors of production intensively. Simply, consider only two factors of production, labor and capital, and two countries, X and Y. If country X has a relative abundance of labor and country Y a relative abundance of capital, country X should export products/services that use labor intensively, country Y should export products/services that use capital intensively.
This is a very simplistic explanation, of course. There are many more factors of production, of varying qualities, and there are many additional influences on trade such as government regulations. Nevertheless, it is a starting point for understanding what nations are likely to export or import. The concept of comparative advantage can also help explain investment flows. Generally, capital is the most mobile of the factors of production and can move relatively easily from one country to another. Other factors of production, such as land and labor, either do not move or are less mobile. The result is that where capital is available in one country it may be used to invest in other countries to take advantage of their abundant land or labor. Firms may develop expertise and firm specific advantages based initially on abundant resources at home, but as resource needs change, the stage of the product life cycle matures, and home markets become saturated, these firms find it advantageous to invest internationally.
International business is different from domestic business because the environment changes when a firm crosses international borders. Typically, a firm understands its domestic environment quite well, but is less familiar with the environment in other countries and must invest more time and resources into understanding the new environment. The following considers some of the important aspects of the environment that change internationally.
The economic environment can be very different from one nation to another. Countries are often divided into three main categories: the more developed or industrialized, the less developed or third world, and the newly industrializing or emerging economies. Within each category there are major variations, but overall the more developed countries are the rich countries, the less developed the poor ones, and the newly industrializing (those moving from poorer to richer). These distinctions are usually made on the basis of gross domestic product per capita (GDP/capita). Better education, infrastructure, technology, health care, and so on are also often associated with higher levels of economic development.
In addition to level of economic development, countries can be classified as free-market, centrally planned, or mixed. Free-market economies are those where government intervenes minimally in business activities, and market forces of supply and demand are allowed to determine production and prices. Centrally planned economies are those where the government determines production and prices based on forecasts of demand and desired levels of supply. Mixed economies are those where some activities are left to market forces and some, for national and individual welfare reasons, are government controlled. In the late twentieth century there has been a substantial move to free-market economies, but the People's Republic of China, the world's most populous country, along with a few others, remained largely centrally planned economies, and most countries maintain some government control of business activities.
Clearly the level of economic activity combined with education, infrastructure, and so on, as well as the degree of government control of the economy, affect virtually all facets of doing business, and a firm needs to understand this environment if it is to operate successfully internationally.
The political environment refers to the type of government, the government relationship with business, and the political risk in a country. Doing business internationally thus implies dealing with different types of governments, relationships, and levels of risk.
There are many different types of political systems, for example, multi-party democracies, one-party states, constitutional monarchies, dictatorships (military and nonmilitary). Also, governments change in different ways, for example, by regular elections, occasional elections, death, coups, war. Government-business relationships also differ from country to country. Business may be viewed positively as the engine of growth, it may be viewed negatively as the exploiter of the workers, or somewhere in between as providing both benefits and drawbacks. Specific government-business relationships can also vary from positive to negative depending on the type of business operations involved and the relationship between the people of the host country and the people of the home country. To be effective in a foreign location an international firm relies on the goodwill of the foreign government and needs to have a good understanding of all of these aspects of the political environment.
A particular concern of international firms is the degree of political risk in a foreign location. Political risk refers to the likelihood of government activity that has unwanted consequences for the firm. These consequences can be dramatic as in forced divestment, where a government requires the firm give up its assets, or more moderate, as in unwelcome regulations or interference in operations. In any case the risk occurs because of uncertainty about the likelihood of government activity occurring. Generally, risk is associated with instability and a country is thus seen as more risky if the government is likely to change unexpectedly, if there is social unrest, if there are riots, revolutions, war, terrorism, and so on. Firms naturally prefer countries that are stable and that present little political risk, but the returns need to be weighed against the risks, and firms often do business in countries where the risk is relatively high. In these situations, firms seek to manage the perceived risk through insurance, ownership and management choices, supply and market control, financing arrangements, and so on. In addition, the degree of political risk is not solely a function of the country, but depends on the company and its activities as well—a risky country for one company may be relatively safe for another.
The cultural environment is one of the critical components of the international business environment and one of the most difficult to understand. This is because the cultural environment is essentially unseen; it has been described as a shared, commonly held body of general beliefs and values that determine what is right for one group, according to Kluckhohn and Strodtbeck. National culture is described as the body of general beliefs and values that are shared by a nation. Beliefs and values are generally seen as formed by factors such as history, language, religion, geographic location, government, and education; thus firms begin a cultural analysis by seeking to understand these factors.
Firms want to understand what beliefs and values they may find in countries where they do business, and a number of models of cultural values have been proposed by scholars. The most well-known is that developed by Hofstede in1980. This model proposes four dimensions of cultural values including individualism, uncertainty avoidance, power distance and masculinity. Individualism is the degree to which a nation values and encourages individual action and decision making. Uncertainty avoidance is the degree to which a nation is willing to accept and deal with uncertainty. Power distance is the degree to which a national accepts and sanctions differences in power. And masculinity is the degree to which a nation accepts traditional male values or traditional female values. This model of cultural values has been used extensively because it provides data for a wide array of countries. Many academics and managers found this model helpful in exploring management approaches that would be appropriate in different cultures. For example, in a nation that is high on individualism one expects individual goals, individual tasks, and individual reward systems to be effective, whereas the reverse would be the case in a nation that is low on individualism. While this model is popular, there have been many attempts to develop more complex and inclusive models of culture.
The competitive environment can also change from country to country. This is partly because of the economic, political, and cultural environments; these environmental factors help determine the type and degree of competition that exists in a given country. Competition can come from a variety of sources. It can be public or private sector, come from large or small organizations, be domestic or global, and stem from traditional or new competitors. For the domestic firm the most likely sources of competition may be well understood. The same is not the case when one moves to compete in a new environment. For example, in the 1990s in the United States most business was privately owned and competition was among private sector companies, while in the People's Republic of China (PRC) businesses were owned by the state. Thus, a U.S. company in the PRC could find itself competing with organizations owned by state entities such as the PRC army. This could change the nature of competition dramatically.
The nature of competition can also change from place to place as the following illustrate: competition may be encouraged and accepted or discouraged in favor of cooperation; relations between buyers and sellers may be friendly or hostile; barriers to entry and exit may be low or high; regulations may permit or prohibit certain activities. To be effective internationally, firms need to understand these competitive issues and assess their impact.
An important aspect of the competitive environment is the level, and acceptance, of technological innovation in different countries. The last decades of the twentieth century saw major advances in technology, and this is continuing in the twenty-first century. Technology often is seen as giving firms a competitive advantage; hence, firms compete for access to the newest in technology, and international firms transfer technology to be globally competitive. It is easier than ever for even small businesses to have a global presence thanks to the internet, which greatly expands their exposure, their market, and their potential customer base. For economic, political, and cultural reasons, some countries are more accepting of technological innovations, others less accepting.
INTERNATIONAL ENTRY CHOICES
International firms may choose to do business in a variety of ways. Some of the most common include exports, licenses, contracts and turnkey operations, franchises, joint ventures, wholly owned subsidiaries, and strategic alliances.
Exporting is often the first international choice for firms, and many firms rely substantially on exports throughout their history. Exports are seen as relatively simple because the firm is relying on domestic production, can use a variety of intermediaries to assist in the process, and expects its foreign customers to deal with the marketing and sales issues. Many firms begin by exporting reactively; then become proactive when they realize the potential benefits of addressing a market that is much larger than the domestic one. Effective exporting requires attention to detail if the process is to be successful; for example, the exporter needs to decide if and when to use different intermediaries, select an appropriate transportation method, preparing export documentation, prepare the product, arrange acceptable payment terms, and so on. Most importantly, the exporter usually leaves marketing and sales to the foreign customers, and these may not receive the same attention as if the firm itself under-took these activities. Larger exporters often undertake their own marketing and establish sales subsidiaries in important foreign markets.
Licenses are granted from a licensor to a licensee for the rights to some intangible property (e.g. patents, processes, copyrights, trademarks) for agreed on compensation (a royalty payment). Many companies feel that production in a foreign country is desirable but they do not want to undertake this production themselves. In this situation the firm can grant a license to a foreign firm to undertake the production. The licensing agreement gives access to foreign markets through foreign production without the necessity of investing in the foreign location. This is particularly attractive for a company that does not have the financial or managerial capacity to invest and undertake foreign production. The major disadvantage to a licensing agreement is the dependence on the foreign producer for quality, efficiency, and promotion of the product—if the licensee is not effective this reflects on the licensor. In addition, the licensor risks losing some of its technology and creating a potential competitor. This means the licensor should choose a licensee carefully to be sure the licensee will perform at an acceptable level and is trustworthy. The agreement is important to both parties and should ensure that both parties benefit equitably.
Contracts are used frequently by firms that provide specialized services, such as management, technical knowledge, engineering, information technology, education, and so on, in a foreign location for a specified time period and fee. Contracts are attractive for firms that have talents not being fully utilized at home and in demand in foreign locations. They are relatively short-term, allowing for flexibility, and the fee is usually fixed so that revenues are known in advance. The major drawback is their short-term nature, which means that the contracting firm needs to develop new business constantly and negotiate new contracts. This negotiation is time consuming, costly, and requires skill at cross-cultural negotiations. Revenues are likely to be uneven and the firm must be able to weather periods when no new contracts materialize.
Turnkey contracts are a specific kind of contract where a firm constructs a facility, starts operations, trains local personnel, then transfers the facility (turns over the keys) to the foreign owner. These contracts are usually for very large infrastructure projects, such as dams, railways, and airports, and involve substantial financing; thus they are often financed by international financial institutions such as the World Bank. Companies that specialize in these projects can be very profitable, but they require specialized expertise. Further, the investment in obtaining these projects is very high, so only a relatively small number of large firms are involved in these projects, and often they involve a syndicate or collaboration of firms.
Similar to licensing agreements, franchises involve the sale of the right to operate a complete business operation. Well-known examples include independently owned fast-food restaurants like McDonald's and Pizza Hut. A successful franchise requires control over something that others are willing to pay for, such as a name, set of products, or a way of doing things, and the availability of willing and able franchisees. Finding franchisees and maintaining control over franchisable assets in foreign countries can be difficult; to be successful at international franchising firms need to ensure they can accomplish both of these.
Joint ventures involve shared ownership in a subsidiary company. A joint venture allows a firm to take an investment position in a foreign location without taking on the complete responsibility for the foreign investment. Joint ventures can take many forms. For example, there can be two partners or more, partners can share equally or have varying stakes, partners can come from the private sector or the public, partners can be silent or active, partners can be local or international. The decisions on what to share, how much to share, with whom to share, and how long to share are all important to the success of a joint venture. Joint ventures have been likened to marriages, with the suggestion that the choice of partner is critically important. Many joint ventures fail because partners have not agreed on their objectives and find it difficult to work out conflicts. Joint ventures provide an effective international entry when partners are complementary, but firms need to be thorough in their preparation for a joint venture.
Wholly-owned subsidiaries involve the establishment of businesses in foreign locations which are owned entirely by the investing firm. This entry choice puts the investor parent in full control of operations but also requires the ability to provide the needed capital and management, and to take on all of the risk. Where control is important and the firm is capable of the investment, it is often the preferred choice. Other firms feel the need for local input from local partners, or specialized input from international partners, and opt for joint ventures or strategic alliances, even where they are financially capable of 100 percent ownership.
Strategic alliances are arrangements among companies to cooperate for strategic purposes. Licenses and joint ventures are forms of strategic alliances, but are often differentiated from them. Strategic alliances can involve no joint ownership or specific license agreement, but rather two companies working together to develop a synergy. Joint advertising programs are a form of strategic alliance, as are joint research and development programs. Strategic alliances seem to make some firms vulnerable to loss of competitive advantage, especially where small firms ally with larger firms. In spite of this, many smaller firms find strategic alliances allow them to enter the international arena when they could not do so alone.
International business grew substantially in the second half of the twentieth century, and this growth is likely to continue. The international environment is complex and it is very important for firms to understand this environment and make effective choices in this complex environment. The previous discussion introduced the concept of comparative advantage, explored some of the important aspects of the international business environment, and outlined the major international entry choices available to firms. The topic of international business is itself complex, and this short discussion serves only to introduce a few ideas on international business issues.
"Every financial decision has an impact on the risk return Profile of a firm.”
Therefore, the financing decision of Working capital of a firm also determines
the risk return Profile of a firm with regard to its working capital. Do you agree
with the statement? Support your answer with necessary examples
- Working capital management
o Risk, Profitability and Liquidity
- Working capital policies
- Risk and return of current liabilities
Working Capital Management
Decisions relating to working capital and short term financing are referred to as working capital management.
These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The
goal of Working capital management is to ensure that the firm is able to continue its operations and that it
has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
By definition, Working capital management entails short term decisions - generally, relating to the next one
year period - which is "reversible". These decisions are therefore not taken on the same basis as Capital
Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or
• One measure of cash flow is provided by the cash conversion cycle - the net number of days from
the outlay of cash for raw material to receiving payment from the customer. As a management tool,
this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts
receivable and payable, and cash. Because this number effectively corresponds to the time that the
firm's cash is tied up in operations and unavailable for other activities, management generally aims
at a low net count.
• In this context, the most useful measure of profitability is Return on capital (ROC). The result is
shown as a percentage, determined by dividing relevant income for the 12 months by capital
employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is
enhanced when, and if, the return on capital, which results from working capital management,
exceeds the cost of capital, which results from capital investment decisions as above. ROC
measures are therefore useful as a management tool, in that they link short-term policy with long-
term decision making.
Management of Working Capital
Guided by the above criteria, management will use a combination of policies and techniques for the
management of working capital. These policies aim at managing the current assets (generally cash and cash
equivalent, inventories and debtors) and the short term financing, such that cash flows and returns are
• Cash Management. Identify the cash balance which allows for the business to meet day to day
expenses, but reduces cash holding costs.
• Inventory Management. Identify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials - and minimizes reordering costs - and
hence increases cash flow.
• Debtor's Management. Identify the appropriate credit policy, i.e. credit terms which will attract
customers, such that any impact on cash flows and the cash conversion cycle will be offset by
increased revenue and hence Return on Capital (or vice versa).
• Short Term Financing. Identify the appropriate source of financing, given the cash conversion
cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be
necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".
Financial Risk Management
Risk Management is the process of measuring risk and then developing and implementing strategies to
manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded
financial instruments (typically changes in commodity prices , internet rates, foreign exchange rates and
stock prices). Financial risk management will also play an important role in cash management.
This area is related to corporate finance in two ways. Firstly, firm exposure to business risk is a direct result
of previous Investment and Financing decisions. Secondly, both disciplines share the goal of creating, or
enhancing, firm value. All large corporations have risk management teams, and small firms practice
informal, if not formal, risk management.
Derivatives are the instruments most commonly used in financial risk management. Because unique
derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk
management methods usually involve derivatives that trade on well-established financial markets. These
standard derivative instruments include options, future contacts, forward contacts, and swaps.
Working Capital Policies
• Conservative - Use permanent capital for permanent assets and temporary assets.
• Moderate ¬ Match the maturity of the assets with the maturity of the financing.
• Aggressive ¬ Use short-term financing to finance permanent assets.
Let's view the characteristics of each policy.
1. CONSERVATIVE WORKING CAPITAL POLICY;
high level of investment in current assets
support any level of sales and production
high liquidity level
Avoid short-term financing to reduce risk, but decreases the potential for maximum value
creation because of the high cost of long-term debt and equity financing.
Borrowing long-term is considered less risky than borrowing short-term.
This approach involves the use of long-term debt and equity to finance all long-term fixed
assets and permanent assets, in addition to some part of temporary current assets.
The firm has a large amount of net working capital. It is a relatively low-risk position.
The safety of conservative approach has a cost.
Long-term financing is generally more expensive than short-term financing.
2. AGGRESSIVE WORKING CAPITAL POLICY;
Low level of investment
More short-term financing is used to finance current assets.
Support low level of production & sales
Borrowing short-term is considered more risky than borrowing long-term.
Firm risk increases, due to the risk of fluctuating interest rates, but the potential for higher
returns increases because of the generally low-cost financing.
This approach involves the use of short-term debt to finance at least the firm's temporary
assets, some or all of its permanent current assets, and possibly some of its long-term fixed
assets. (Heavy reliance on short term debt)
The firm has very little net working capital. It is more risky.
May be a negative net working capital. It is very risky
3. MODERATE WORKING CAPITAL POLICY
This approach tries to balance risk and return concerns.
Temporary current assets that are only going to be on the balance sheet for a short time
should be financed with short-term debt, current liabilities. And, permanent current assets
and long-term fixed assets that are going to be on the balance sheet for a long time should
be financed from long-term debt and equity sources.
The firm has a moderate amount of net working capital. It is a relatively amount of risk
balanced by a relatively moderate amount of expected return.
In the real world, each firm must decide on its balance of financing sources and its
approach to working capital management based on its particular industry and the firm's
risk and return strategy.
LIQUIDITY & PROFITABILITY:
• Lenders prefer a company having a large excess of current assets over current liabilities whereas the
owners prefer a high return.
• Current assets have the advantage of being liquid, but holding them is not very profitable.
• Cash account is paid no interest.
• Accounts receivable earns no return.
• Inventory earns no return until it is sold.
• Non-current assets can be profitable, but they are usually not very liquid.
• Firms are usually faced with creating trade-off in their working capital management policy.
• They seek a balance between liquidity and profitability that reflects their desire for profit and their
need for liquidity.
OPTIMAL LEVEL OF CURRENT ASSETS
A firm's optimal level of current assets is reached when the optimal level of cash, inventory, accounts
receivable, and other current assets is achieved.
Cash: firms try to keep just enough cash on hand to conduct day-to-day business, while investing extra
amounts in short-term marketable securities.
Inventory: firms seek the level that reduces lost sales due to lack of inventory, while at the same time
holding down bad debt and collection expenses through sound credit policies.
• PROJECTING THE ALL THREE POLICIES
• CONSERVATIVE = A
• MODERATE = B
• AGGRESSIVE = C
The chart tells us two things:
- Profitability varies inversely with liquidity; increased liquidity can be achieved at the expense of
- Profitability & risk have same direction; in order to have greater profitability, we need to take
- Conclusion: optimal level of each current asset will depend on the management's attitude
towards risk & return.
Risk and Return of Current Liabilities
The goal of the return management process is to maximize earnings in the context of an acceptable level of
Firm's working capital is financed from short-term borrowing, long-term borrowing, equity financing, or
some mixture of all three.
The choice of the firm's working capital financing depends on manager's desire for profit versus their
degree of risk aversion.
The balance between the risk and return of financing options depends on the firm, its financial managers,
and its financing approaches
---------- FOLLOW-UP ----------
QUESTION: Sir, can you please answer this question too,
If sales forecast is subject to error, then there is no purpose of budgeting. Do
you agree? Substantiate your views and also discuss how a flexible budget can
be used by management to control the costs.
If sales forecast is subject to error, then there is no purpose of budgeting. Do
you agree? Substantiate your views and also discuss how a flexible budget can
be used by management to control the costs.
Forecasting involves using several different methods of estimating to determine possible future outcomes for the business. Planning for these possible outcomes is the job of operations management. Additionally, operations management involves the managing of the processes required to manufacture and distribute products. Important aspects of operations management include creating, developing, producing and distributing products for the organization.
Advantages of Forecasting
An organization uses a variety of forecasting methods to assess possible outcomes for the company. The methods used by an individual organization will depend on the data available and the industry in which the organization operates. The primary advantage of forecasting is that it provides the business with valuable information that the business can use to make decisions about the future of the organization. In many cases forecasting uses qualitative data that depends on the judgment of experts.
Disadvantages of Forecasting
It is not possible to accurately forecast the future. Because of the qualitative nature of forecasting, a business can come up with different scenarios depending upon the interpretation of the data. For this reason, organizations should never rely 100 percent on any forecasting method. However, an organization can effectively use forecasting with other tools of analysis to give the organization the best possible information about the future. Making a decision on a bad forecast can result in financial ruin for the organization, so an organization should never base decisions solely on a forecast.
The Advantages of Sales Forecasting
Sales is the lifeblood of every company. The advantages of forecasting your company's sales lie mainly in giving you a firm idea of what to expect in the coming months. A standard sales forecast looks at conditions present in your business during previous months, and then applies assumptions regarding customer acquisition, the economy and your product and service offerings. Forecasting sales identifies weaknesses and strengths before you set your budget and marketing plans for the next year, allowing you to optimize your purchasing and expansion plans.
Knowing whether your revenues are likely to grow or shrink in coming months keeps you from spending at a time when you should be conserving cash to survive a recession. It also allows you to take advantage of special deals or expansion opportunities that come along, knowing you will have enough cash to support your business.
Buying too much or too little inventory can be a business disaster. By forecasting your sales, you will have a better idea of how much to buy and whether it will be advisable to add additional investment in marketing to take advantage of improving economic conditions. Sales forecasting and budgeting tend to be a mutually dependent balancing act. A good sales forecast anticipates changes in the economy and, therefore, changes in the buying habits of your customers. Knowing your customers' likely buying needs makes it easier to know how much inventory to purchase and how many sales reps to hire.
Having a good idea of future revenues and where they will be generated in your business allows you to plan the best way to take advantage of future changes in the economy. Uncertainty is a roadblock to besting your competition by expanding at just the right moment. Detailed and deep research into the economy, customer buying trends, new products and your company's past revenue production experience creates a reliable sales forecast that provides a strong basis for your future planning.
Having a tradition of forecasting sales on a quarterly, semi-annual or annual basis not only helps you plan your business, it also increases your corporate knowledge base. When changes in the economy arise, you can always go back to your previous forecasts for hints on what has and has not worked in the past. This can present a significant advantage over any of your competitors who use the "seat-of-the-pants" method of planning and operating their businesses.
An accurate sales forecast helps a company plan effective strategies and develop meaningful budgets. For example, a retail store might use a sales forecast to decide how much stock it must keep on hand to serve customers for a month. But sales forecasts aren't always accurate, which can lead to many disadvantages.
The obvious problem facing every company is that markets are unpredictable. Any sales forecast, however rigorous its analysis of conditions, can be flat-out wrong. For example, perhaps a company’s analysts failed to incorporate relevant data, such as upcoming legislative changes that change the business model. Or perhaps unexpected economic factors, such as a falling stock market, decrease consumer demand across the board, rendering previous forecasts useless. No matter what steps a company takes, there is always a risk that its sales forecast is incorrect.
The carry-over effects of a bad sales forecast can be devastating to a business. For example, suppose a tax-preparation company forecasts it will have a certain number of customers the month before taxes are due, basing its forecast on historical sales numbers. The company might prepare for the influx of customers by hiring temporary staff, buying extra computers and so forth, only to realize later that a less-expensive competitor poached many of its customers. The losses associated with the company’s over-preparation might doom the business, or at least put a large dent in its profits for the year. In other words, any strategy that depends too heavily on a sales forecast is risky.
Disadvantages of Qualitative Forecasts
Sales forecasts fall into two basic categories, each of which has distinct disadvantages. Qualitative sales forecasts rely on experts’ opinions to predict upcoming sales performance. For example, the “jury of executive opinion” approach involves asking a panel of experts from all of a company’s departments to synthesize their insights and expertise to generate a collective sales forecast. As capable as the experts might be, the disadvantage of this and other qualitative approaches is subjectivity: opinions, even well-informed ones, can be wrong, especially if they don’t take into account relevant economic data.
Disadvantages of Quanitative Forecasts
The second basic category of sales forecasts is quantitative. Forecasting techniques in this category use various statistical and data analysis methods to generate predictions. For example, a statistical demand analysis is a series of statistical procedures that analyze specific factors, such as price, income, promotion and population. This and other quantitative techniques can reveal patterns and identify trends -- but no quantitative method can account for every variable in a market. As a result, quantitative methods can fail just as easily as qualitative methods.
Every sales forecast method has its disadvantages. One way to compensate for the various problems is to perform many types of sales forecasts. If a company combines qualitative and quantitative approaches, for example, it might end up with a better prediction than either approach alone could have generated.
Sales forecasting is the prediction of future performance based on available information about past performance. Devoting resources to in-depth sales forecasting allows you to prepare for the upcoming needs of your business and increases the likelihood of success regardless of external circumstances. Businesses that use sales forecasting tend to perform better than those that don't.
Having a detailed business forecast gives you a basis for making fiscally responsible decisions about your cash flow. As a small-business owner, you must anticipate and budget your cash flow needs accurately. Sales forecasting can help you do this. By considering your past performance, you're better equipped to make informed decisions about the future. For example, if you have good reason to believe demand will far exceed your production capacity based on your forecasting research, you can plan to make cash available for production expansion, rather than trying to play catch up while other companies snap up your potential customer base.
Cost of Sales
Cost of sales refers to how much you are spending on products or components for each sale you make. This is really the core of sales forecasting. By predicting sales patterns, you can more accurately plan for what products or components you need. You definitely don't want to miss an opportunity by running out of materials during a busy season and having to scramble or pay extra to order what you need. On the other hand, you don't want to overstock and have products go bad or have to recoup your expenses over a long, drawn-out period. Sales forecasting allows you to make informed decisions about what you need, how much you need and when you need it.
Sales forecasting helps you manage your staffing needs, keep scheduling in order and maintain an open and respectful dialogue with your employees. By making predictions about how much business you will be doing at any given time, you’ll be better able to predict how much help you need. This allows you to be more organized and minimize time spent on scheduling. And it improves your relationship with your staff: You can allow for the scheduling needs of your employees and be able to give ample notice when you expect to cut or expand employee hours.
Effective, targeted advertising is essential to a small business. Detailed sales forecasting should help you develop the strategy and character of your advertising. A sales forecast will show you how much revenue you can expect and what kind of money is available for your advertising budget. It helps you track and predict the behavior of consumers, which is the basis for successful advertising. This information can help you break into new customer bases, address unmet consumer needs and abandon or scale down trends that are on the wane.
Strength & Weaknesses of Sales Forecasting
Companies focus on sales for good reason. Sales are how a business earns money to continue operations and justify its existence. Therefore, it becomes paramount for a business to forecast where it thinks sales are heading in the future. Sales forecasting provides a company with a framework for managing and tracking sales. On the other hand, forecasting sales is only as good as the available data.
The strength of sales forecasting is that it forces a company to think about how it intends to monitor and track sales beyond the current period. By thinking ahead, management can adjust the business strategy based on its prediction for sales growth. Sales forecasting based on prior sales results and management experience reduce the chances of the company being blindsided by a surge or drop in demand. For example, if management notices a seasonal pattern in sales, it can hire or reduce staff accordingly. Management can also track sales per item and use this information to focus stronger selling products and services.
Sales forecasting relies on historical data or prior results to predict future expectations. However, if there is limited data available because the company is new, this mitigates the effectiveness of putting together a sales forecast. Even so, past sales results are not always indicative of future sales results. In addition, sales forecasting uses some form of projection about future demand interpreted through consumer preferences, opinions and attitudes. This may be hard to gauge, since consumer demand is a moving target. In addition, the time series may have changed making the past sales data irrelevant for developing a sales forecast.
Measuring Actual Results Against Forecasts
When it comes to forecasting sales, nothing is guaranteed. However, it is still an important endeavor for a company to undertake. A starting point is using prior period sales results. A company needs to then compare actual results against its forecasts. If there is a wide disparity, management needs to adjust sales assumptions. The longer the historical sales information, the better equipped management is to make sound forecasts because having a longer time series allows the company to identify trends. The measuring stick for the effectiveness of a sales forecast is how close the actual results come in to management's predictions.
Macro and Micro Forecasting
Forecasting sales can be a complicated affair depending on how in-depth a company wants to go regarding its assumptions. Sales forecasting can include "macro" data, which concerns overall market demand and general economic factors such as level of employment, interest rates and consumer spending. On the other hand, "micro" data deals with the company's unit sales within the industry. The strength of doing a macro analysis and microanalysis is that it forces the company to look at internal and external factors that impact sales. However, developing comprehensive forecasts that include the general economy is time consuming and expensive. Many large organizations hire economists to create sophisticated sales forecasts for a product.
Top 10 Reasons Why Sales Forecasting Is Important
Sales forecasting is a key element in conducting your business. The realism that good forecasting provides can help you develop and improve your strategic plans by increasing your knowledge of the marketplace. The forecast that your sales force provides is the source of information that allows you to manage virtually all aspects of your business.
When your sales reps make their forecasts, they are also planning their future activities, providing each of them with a business plan for managing their territory. Assuming that each of them has a quota to fill, forecasting is the tool that helps them identify the customers to meet their objectives.
The sales forecast is your best tool to get a good estimate of the demand for the products you sell. Your sales team is the front line for your business and best positioned to gather information about anticipated demand.
Higher OTIF Delivery
With accurate sales forecasting, you can achieve a higher rate of on time in full, or OTIF, delivery. The information from sales forecasts guarantees that sufficient product will be manufactured or ordered to service customers on a timely basis, resulting in happier customers and fewer complaints.
The more accurate the sales forecast, the better prepared your company will be to manage its inventory, avoiding both overstock and stock-out situations. Stable inventory also means better management of your production.
Supply Chain Management
When you can predict demand and manage production more efficiently, you also have better control over your supply chain. This affords you the opportunities to manage resources and take full advantage of just-it-time ordering.
Anticipating sales gives you the information you need to predict revenue and profit. Having good forecasting information at your disposal also gives you the ability to explore possibilities to increase both revenue and net income.
Having a gasp on the projected production rates for your business makes it possible for you to have better control of your internal operations. By anticipating future sales you can make decisions about hiring – permanent or temporary – marketing and expansion.
Continuous improvement is a goal of many if not most businesses. By forecasting sales and continually revising the process to improve the accuracy, you can improve all aspects of your business performance.
With solid forecasting, the good levels of inventories that you maintain will prevent the need for panic sales to rid your business of excess merchandise. Sales may be managed on a thoughtful planned basis.
Sales forecasting gives marketing an advanced look at future sales and offers the opportunity to schedule promotions if it appears sales will be weak. In extreme cases, sales forecasts may lead to discontinuing slow-moving products.