The Delusion of Revenue Forecasting
By: Roger Martin
Tags: Strategy, Revenue, Forecasting, Playing To Win

Playing To Win

The Delusion of Revenue Forecasting

Source: G2 Learn Hub (https://learn.g2.com/income-statement-example)

The epitome of waste occurs when human effort is expended on an activity that produces worse outcomes than doing nothing at all. I have already chronicled one of the biggest wastages of effort in business: pay for performance (PfP) systems. The other giant waste of time and energy is revenue forecasting, which makes it harder to have an effective strategy. Because I can’t stand wasted human effort, I am dedicating my 40th Playing to Win/Practitioners Insights (PTW/PI) to The Delusion of Revenue Forecasting. (Links for the rest of the PTW/PI series can be found here.)

Two Sections of the Income Statement

Every company has costs and revenues. Since they occupy the two sections of the same income statement, revenues and costs are typically viewed and treated similarly. It appears logical that companies should plan and forecast for each. The product is a budget, and every company has one.

As everyone knows, immense amount of work goes into budgeting. There is an annual budget cycle with meeting after meeting, review after review. If it is a public company, eventually the budget goes to the board for approval. There is always very detailed work on costs — what number of people to employ, at what salaries; what amount of raw materials to procure; how much to advertise; how much R&D to perform; what volume of space to lease or rent, etc. No stone is left unturned in forecasting and budgeting for costs. The same holds for revenues — how much of each product/service will we sell at what prices, to which customers, in which regions, through which distribution channels.

The forecasting goes back and forth with extensive negotiations because the revenue budget is typically tied to PfP goals. The task is to get to an agreed upon and approved budget to which you can commit, and your commitment is secured by making your compensation depend on achieving the forecast.

The Big Difference Between Sections

Despite being similar and in many ways equal parts of the same income statement, revenues and costs have one giant difference that has a profound impact on forecasting. That difference is with respect to the identity of the customer.

Who is the customer of your costs? You are. You decide everything. Sure, there are surcharges. If you procure a square foot of office space, the municipality imposes a property tax cost on you. But it is entirely a function of your choice to procure the square foot and that tax surcharge is known with precision in advance of your decision. Since costs are entirely within your control, forecasting and budgeting costs makes a lot of sense. In addition, there is no reason not to be able to manage costs precisely during the year and to hit your cost forecast/budget because you make all the choices.

Who, on the other hand, is the customer of your revenues? Of course, customers are. They decide everything. There is no reason to think that you should be able to forecast, budget or manage revenues because customers make all the choices. Precision in revenue forecasting is a pipe dream. Whereas you can be precise in cost forecasting, you can’t with revenue forecasting. It is delusional for you to think that you can know in advance what customers are going to do in the coming year. They are free agents who make their own decisions. They couldn’t care what your revenue forecast or budget is. They will buy what they want to buy.

Making Revenues Show Up

What makes revenues show up? It is your strategy. A strategy that creates a compelling value proposition for the customer is what makes revenues show up on your income statement. If you have a How-to-Win (HTW), backed up by the Must-Have Capabilities (MHC) and Enabling Management Systems (EMS), in a given Where-to-Play (WTP), revenue will show up. If you don’t, it won’t. This is why cost planning is so important. Your costs describe your investment in the EMS and MHC that produce your HTW in your WTP. That is the only thing that will make revenues show up.

Having a revenue budget has no positive impact on your strategy. In fact, the impact is negative. If your strategy happens to compel more revenue than planned to show up, having a budget will encourage slacking off and not delivering the strategy to its fullest potential. If the strategy compels less revenues than forecast to show up, having a budget target will cause destructive behavior. It will cause you to try to make customers do something that your strategy doesn’t compel them to do, like cutting prices to a level that makes the strategy unprofitable or pulling forward to this budget year revenues that would have naturally occurred next budget year. Smart customers will recognize when you are desperate for revenues at budget year end and ruthlessly exploit you to take advantage of the pressure you feel to make your revenue budget. In fact, the very cleverest wait until they know you are desperate before they buy anything at all.

If revenue forecasting and budgeting took zero time, the lack of any benefit and presence of many detriments would be less egregious. But revenue forecasting and budgeting absorbs millions (if not tens or hundreds of millions) of person-hours every year across the business world. Those millions of yearly person-hours could much more productively be applied to serving customers, building capabilities, refining strategy, etc. — all things that would actually compel customers to send you more revenues.

A Better Way

This one is simple: don’t forecast revenue. Don’t try to predict something that you can’t predict. And don’t tie your delusional predictions to a PfP system. Avoid forcing managers to commit to things to which no human should commit. It just creates fundamentally destructive behavior starting with endless budget gaming and then moving on to destructive revenue gaming.

Instead model your revenues. Change the question from what we imagine to be true (i.e., a forecast) to what would have to be true (WWHTBT). That is, given the costs that we are applying against our strategy, what volume of products/services would we need to sell at what price levels to earn a satisfactory return on the investments in our strategy. It is not a forecast. It is a measuring stick that will help you to judge whether your strategy is working or not by measuring progress against it. It will help you to adjust costs as you go and avoid taking desperate actions that will damage your business longer term.

Practitioner Insights

It is hard to eliminate sacred cows, and revenue forecasting/revenue budgeting is one of the most sacred of all management cows. I liken it to a pacifier. Like a pacifier, having a revenue forecast that has been converted into a revenue budget provides a calming, soothing effect. Having one makes managers think they have increased the chances of achieving it even if there just isn’t evidence to support that notion — just like a pacifier really doesn’t do anything except provide the baby with a comforting distraction.

If you oversee a budget unit, try an experiment for a single budget cycle. Don’t make any pretense of forecasting revenues. Just model the revenues that you would require to have attractive profitability and set that as your target. Keep track of your progress toward the target and make sure to share it with everybody in the organization. Encourage everyone in the organization to do what they can in their area of responsibility to help the organization achieve the revenue target — but without deviating from the strategy. Make it their base job — not the subject of PfP. Try it. Run an experiment. People will tell you that without a rigorous revenue budget, life as we know it on the planet will end and we will be cast into a thousand years of darkness. When they do, hand them each a pacifier!

If you are lower down in the hierarchy, you are just going to have to suck it up. Revenue forecasting is just another crazy business practice which you must endure. But try not to get caught up in the game and waste too much of your time on revenue forecasting rituals. From a customer perspective, none of the time you spend in revenue forecasting provides value to them. So put into it the minimum effort with which you can get away and continue to put the maximal effort into serving the customer. Attempt to avoid revenue manipulation games. That will cost you in the short term because those who play budget and revenue games most skillfully will benefit most in the short term. But if you pay attention to your strategy and your customer, your career will benefit in the long term. And when you are in charge, you can eliminate delusional revenue forecasting.