Chapter 4: Forecasting Results
Forecasting is the heart and soul of successful innovations. Such
guidance for innovations is critical when one begins a venture, when
it is vital to do the right thing by setting a viable price. It is
also critical later when it is equally important to do things right
when going after market share. A mentality shift is needed to cross
that divide, but the same forecasting technique applies either way.
There are many factors to consider. Demographic, technological,
economic, social and political trends are each favored by some. I
will not focus on these. Rather I will assume that the society we
are venturing in is stable and that our intent is to create capital,
not inflated stock values. And I will illustrate how to integrate
a forecast into a pro forma-a fancy word used for summaries of sales
and profits expected over some future time.
First, a word about capital. Capital comes in three forms: human,
material, and an exchange medium between the two-money. I include
intellectual capital in the human part of the equation. As an individual,
I have two ways I can labor, physically and mentally. I can create
things like mouse traps, books, ideas, music, and potato salads.
Each of these things has value to someone else as evidenced by their
willingness to adopt or pay for them. What the other person will
pay depends upon his/her need for the product(s) of my labor. If
I get paid to produce an item, not just a service, then capital has
been created and the central bank can print a like amount of new
money for circulation. This illustration is grossly oversimplified,
but this simplified concept is useful to me in dealing with the market
economy we live and compete in.
What follows is intended to be illustrative only and educational.
I strongly recommend that anyone venturing retain a professional
accountant to create the pro forma. A pro forma can have as many
forms as there are situations that need to be fit. I will illustrate
a simple example.
What the other person will pay for an item or a service needs thinking
about. What people will pay for an item or a service varies for many
legitimate reasons. For salable items, the lower the price, the more
items we can sell. This relationship is price elasticity. Effective
forecasting includes price elasticity as I will illustrate.
All products are subject to price elasticity. That is, if we charge
too much, sales will not cover costs, and if we charge too little
there is no profit. Only if the price is right can there be capital
formation. And that will only happen if our innovation is wanted
by others having the ability to pay us a fair price for our product.
Ed Zimmer (http://www.tenonline.org/) is right on here-it is all
in the market. The closer we can get to the pulse of our customers,
the better we can forecast the market potential.
In my experience, the most successful forecasting strategies are
those that calculate consumption by determining what each end-user
is likely to pay for one or more items and multiply that by the number
of consumers or users and their levels of consumption. For established
businesses that do their homework regularly and thoroughly, this
procedure can accurately forecast sales within a few percentage points.
I did just that for years forecasting the usage of titanium by the
aerospace industry. Ross Stander at Tensor Metrix uses an improved
version of the same basic technique to forecast consumption of electronic
grade metals world wide. Historical consumption records are necessary
to provide the starting point.
This technique is not infallible because it is not often possible
to predict when buyers will build or draw down their inventory positions
or when they err in their own forecasting. Nevertheless, the method
is basically sound. So how can we use consumption forecasting in
venturing an innovation? One basic method is to integrate our forecast
into a pro forma, a spreadsheet of cash in and out over a period
of time into the future with cash or income balances on the bottom
By calling our prospective customers and getting their current and
expected future purchase rates, we can estimate consumption. Not
all buyers will cooperate on first contact. But it is in their interest
to do so since they need assured supplies of product at lowest price.
We need to establish our credibility and ensure that what they tell
us does not leak to their competition. This takes time, but, in my
experience, once I earn a buyer's trust, s/he cooperates.
To illustrate, consider the forecast of consumption shown in Table
1. Note there is an up-tick in period one. (Optimism is in the air
because the economy is expanding.) Since sales are expected to grow,
now is a great time to get into this business. Three distributors
comprise our customer base and two already anticipate increasing
|Distributor|| || || || || || || || || || || |
To complete a preliminary pro forma, we need to estimate what share
of this market we can take at what price. This is where price elasticity
comes in. If we already know how unit sales volume relates to price,
we are home free. We plug those numbers into our pro forma and find
the price that best fits our short and long-term abilities and goals.
But venturing is rarely so simple; we have no experience yet with
price elasticity for our product.
Figure 1 shows a typical price elasticity relationship for a product
in demand such as a mixer for a home kitchen. This relationship holds
for most commodities. Note how quickly sales can appear or disappear,
depending on pricing. Most competitive markets adopt prices in the
lower left region of the curve, $100 - $200 in this example.
The good news here is that we have some real control over our sales.
But, if we have R&D, patent, facilities and other costs to recover
as quickly as we can, our pricing equation is burdened with a fixed
overhead. This feature is illustrated in Figure 2.
Fig 3 shows the joint effects of price elasticity and fixed cost
on profits. Note how steeply margins rise on the low end. It is beyond
my scope here, but overall return usually peaks in this area also.
Remember, this is how a free market behaves. Cartels and monopolies
change these rules in their favor and we might not even know it.
Figure 3 is greatly simplified from real life but is illustrative
of the underlying dynamics. If we miss badly on our initial pricing
and forecast, we will have a headache. Priced in the knee region
of Fig 1, our product should sell, but, if we are too greedy, it
may not. And contrary to current dot.com preaching, if we under-price
our product, we may shortly be explaining things to our stakeholders
or a bankruptcy judge.
Let's just assume that things will be stable and that our potential
customers will receive us well at a price of $150/unit and that our
competition will not start a price war and keep us out. If we do
not try to take too much of their turf too quickly, we may be able
to maintain the present market discipline and pick up the expected
growth. Table 2 illustrates a bare bones pro forma representing this
Table 2 Pro Forma Based on Consumption Forecast
|Market: Total Units||1005||1050||1095||1140||1185||1230|
|Market share (Units)||50||100||150||200||250||300|
|Net at our price*||3150||6300||9450||12600||15750||18900|
*From Fig 3.
The two key lines are the top and bottom. What goes in between should
be the work of a competent accountant. Remember also, a pro forma
is no better than the information fed into it. In starting The ALTA
Group, we went through 30 odd pro formas before we broke ground with
a model that fit the real world. Between 1986 and 1992, annual sales
grew at a rate of 76% per year. Pro formas in this instance paid
off through the guidance they provided.
Now that we have a product with real sales potential, it is time
to think about protecting our intellectual property-our subject next
© Copyright 2000 by Harry Rosenberg. All rights reserved.
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