This Is the Biggest Mistake Made in Forecasting

April 4, 2016

I can put today’s tip in a few words. Having reviewed many business plans, there is on common error that leads to disaster if not addressed. It starts with overly optimistic forecasting. That leads to bad budgeting which quickly ends in negative cash flow. Why are so many projections wrong? Read on…
 
Let’s look at data for an imaginary industry. We’ll call it the widget industry. A new study says the industry is expected to grow by 50% per year over the next 5 years! Wow! We are in the right business. But because we are smart operators, we’ll take a closer look at this data.
 
Digging deeper, we find that the widget business in our region is expected grow at a rate slightly larger than the national average. It gets better and better!
 
We can start the expansion plans. Business is going to be good for the next 5 years. If we are just average, we’ll see a 50% increase! Time to start saving those yacht brochures.
 
But there’s a problem.
 
When an industry is projected to grow, remember that will attract more businesses into the industry. Everyone wants in on a 50% year over year boom. In an expanding universe, everything expands, not just sales.
 
You’ll face at least 50% more competition. 50% more price pressure. 50% more pressure on margin and profit. 50% more pressure from your own customer base. And, experience shows that those pressures will expand at a rate greater than the projected increase in sales. Why? The more attractive it sounds, the more new players rush in.
 
Boom periods are always followed by shake-outs. Look at any industry that experienced rapid growth and you’ll see a lot of failure approaching the peak of the growth phase. New businesses start that are over-capitalized because they have no fear of risk. They soon find the huge start-up costs to be more than they can cover.
 
Those established in an industry projected to boom will often expand more than prudent. Better to have too much capacity than too little, right? Wrong. It is far easier and cheaper to add capacity than to get out from under excess capacity.
 
When the bust starts, and it will, there are buying opportunities everywhere you look. The boom starts with real estate skyrocketing in price. The bust is always marked by the availability of cheap buildings.
 
Here’s the take away. When projecting into the future, keep in mind that the entire system will expand. When you read that your industry is poised for growth over the coming years, plan for increased competition and market stress.
 
Do that and your business will survive the correction that always follows.

Chris Reich

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