PROFIT FORECASTING

Forecasting, particularly on a short-term basis (one year to three years), is essential to planning for business success. This process, estimating future business performance based on the actual results from prior periods, enables the business owner/manager to modify the operation of the business on a timely basis. This allows the business to avoid losses or major financial problems should some future results from operations not conform with reasonable e pectations. Forecasts - or !ro Forma "ncome #tatements and $ash Flow #tatements as they are usually called - also provide the most persuasive management tools to apply for loans or attract investor money. %s a business e pands, there will inevitably be a need for more money than can be internally generated from profits. !rofit forecast is the amount of profit a company e pects to ma&e at the end of the period. The monthly profit and loss forecast will consist of the following' o o o o o o o #ales $ost of sales (ross !rofit )verheads Total )verheads *iscellaneous income +et !rofit

FACTORS AFFECTING PROFIT FORECASTING

!reparation of Forecasts (!ro Forma #tatements) re,uires assembling a wide array of pertinent, verifiable facts affecting your business and its past performance. These include' -ata from prior financial statements, particularly' .. !revious sales levels and trends /. !ast gross percentages

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0. %verage past general, administrative, and selling e penses necessary to generate your former sales volumes 1. Trends in the company2s need to borrow (supplier, trade credit, and ban& credit) to support various levels of inventory and trends in accounts receivable re,uired to achieve previous sales volumes 3ni,ue company data, particularly' .. !lant capacity /. $ompetition 0. Financial constraints

1. !ersonnel availability

"ndustry-wide factors, including'

.. )verall state of the economy

/. 4conomic status of your industry within the economy

1. 4lasticity of demand for the product or service your business provides ( -emand is said to be 5elastic5 if it decreases as prices increase, a demonstration that consumers can do without or with less of the goods or service. "f demand for something is relatively steady as prices increase, it is 5inelastic.5) 6. %vailability of raw materials )nce these factors are identified, they may be used in !ro Formas, which estimate the level of sales, e pense, and profitability that seem possible in a future period of operations.

0. !opulation growth

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STAGES IN MAKING PRO FORMA INCOME STATEMENT:

The important stages are as follows'
1. communicating details of profit forecasting policy and guidelines

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4.

6. 7.

8.

Communicating Details of the P ofit Fo ecasting Polic!

*any decisions affecting the profit forecasting process will have been ta&en previously as part of the long-term planning process. The longrange plan is therefore the starting point for the preparation of pro forma income statement. Thus top management must communicate the policy effects of the long-term plan to those responsible for preparing the current year9s pro forma income statement. !olicy effects might include planned changes in sales mi , or the e pansion or contraction of certain activities.

Dete mining the Facto s that Rest icts Pe fo mance

"n every organi:ation there is some factors that restrict performance for a given period. "n the majority of organi:ations this factor is sales demand. ;owever, it is possible for production capacity to restrict performance when sales demand is in e cess of available capacity. !rior to the preparation of the budgets, it is necessary for top management to determine the factor that restricts performance, since
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to those people responsible for the preparation of pro forma income statement7 determining the factor that restricts output7 preparation of the sales budget7 initial preparation of various budgets of pro forma income statement7 negotiation of budgets with superiors7 coordination and review of budgets of pro forma income statement7 final acceptance of pro forma income statement7 ongoing review of budgets.

this factor determines the point at which the annual profit forecasting process begins.

P e"a ation of the Sales #u$get

The volume of sales and the sales mi determine the level of a company9s operations, when sales demand is the factor that restricts output. For this reason, the sales budget is the most important plan in the annual profit forecasting process. This profit forecast is also the most difficult plan to produce, because total sales revenue depends on the actions of customers. "n addition, sales demand may be influenced by the state of the economy or the actions of competitors.

Negotiation of #u$gets of P o fo ma Income Statement

To implement a participative approach to profit forecasting, the pro forma statement should be originated at the lowest level of management. The managers at this level should submit their budget to their superiors for approval. The superior should then incorporate this budget with other budgets for which he or she is responsible and then submit this budget for approval to his or her superior. The manager who is the superior then becomes the budgetee at the ne t higher level.

The budgeted or pro forma income statement is prepared after the operating budgets have been completed. The managers who are responsible for meeting the budgeted performance should prepare the budget for those areas for which they are responsible. The preparations of the budget should be a bottom-up process. This means that the budget should originate at the lowest levels of management and be refined and coordinated at higher levels. The justification for this approach is that it enables managers to participate in the preparation of their budgets and increases the probability that they will accept the budget and strive to achieve the budget targets.

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Initial P e"a ation of #u$gets of P o fo ma Income Statement

Coo $ination an$ Re%ie& of #u$gets of P o fo ma Income Statement

%s the individual budgets move up the organi:ational hierarchy in the negotiation process, they must be e amined in relation to each other. This e amination may indicate that some budgets are out of balance with other budgets and need modifying so that are beyond a manager9s &nowledge or control.

Final Acce"tance of the P o Fo ma Statement

<hen all the budgets are in harmony with each other, they are summari:ed into main pro forma statement. %fter this pro forma statement has been approved, the budgets are then passed down through the organi:ation to the appropriate responsibility centers. The approval of pro forma statement is the authority for the manager of each responsibility center to carry out the plans in each budget.

P o fo ma Income Statement Re%ie&

#ENEFITS OF PROFIT FORECASTING

!rofit forecasting serves a number of useful purposes. They include' .. planning annual operations7 /. coordinating the activities of the various parts of the organi:ation and ensuring that the parts are in harmony with each other7 0. communicating plans to the various responsibility centre managers7

The profit forecasting should not stop when the operating budgets of pro forma income statement have been agreed, periodically, the actual results should be compared with the budgeted results. These comparisons should normally be made on a monthly basis7 so that it has the ma imum motivational impact. This will enable management to identify the items that are not proceeding according to plan and to investigate the reasons for differences

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1. motivating managers to strive to achieve the organi:ational goals7 6. controlling activities7 =. evaluating the performance of managers.

Planning
The profit forecasting process ensures that managers do plan for future operations, and that they consider how conditions in the ne t year might change and what steps they should ta&e now to respond to these changed conditions. This process encourages managers to anticipate problems before they arise, and hasty decisions that are made on the spur of the moment, based on e pediency rather than reasoned judgment will be minimi:ed.

Coo $ination

The profit forecasting serves as a vehicle through which the actions of the different parts of an organi:ation can be brought together and reconciled into a common plan. <ithout any guidance, managers may each ma&e their own decisions, believing that they are wor&ing in the best interests of the organi:ation.

Communication

Through the profit forecasting, top management communicates its e pectations to lower level management, so that all members of the organi:ation may understand these e pectations and can coordinate their activities to attain them.

Moti%ation
The profit forecasting can be a useful device for influencing managerial behavior and motivating managers to perform in line with the organi:ational objectives. !rofit forecasting provides a standard that under certain circumstances, a manager may be motivated to strive to achieve.

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Cont ol
% profit forecasting assists managers in managing and controlling the activities for which they are responsible. >y comparing the actual results with the budgeted amounts for different categories of e penses, managers can ascertain which costs do not conform to the original plan and thus re,uire their attention.

'IMITATIONS OF PROFIT FORECASTING

De(moti%ation
(enerally profit forecasting increases motivation but it could also be a reason of de-motivation of employees if they feel that the budgeted figures are way too high to achieve.

#u$geta ! Slac)

>udgetary slac& or padding the budgets can occur as managers will intentionally blow up their budget figures for fear of top management9s reprimanding them.

#a$ Decision Ma)ing

Doesn*t Reflect Com"le+ities

+o matter how well prepared a budget might be, it will never be able to reflect truly the reality/comple ities faced by the company.

Regula l! ,"$ating
There is a need to revise/update the budget which at the time was based on a certain set of circumstances/best information.

3nrealistic budgets can lead managers to ma&e decisions that might be detrimental to the company. % good e ample of over-ambitious sales budget will lead to disastrous impact li&e giving steep discount to increase volume, etc.

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