Ramon Ecung's Personal Blog

In Lesson two on revenue forecasting, I introduced the notion of Type 1 and Type 2 errors. What would you expect would be the implications for Fred’s business if he expected the volume of repair work to be $400,000 the first year and it was only half that? On the other hand, what are the implications of forecasting for $200,00 in business and his sales ramp up to twice that rate?

As a follow-up to my last post I’m going to explore the Type 1 and Type 2 errors a business owner can make.

Type 1 – Overestimating Revenues

Let’s say a person estimated $400,000 in revenues, but only sold half of that. That would obviously be a problem because they would also be planning their expenses to match that revenue level. Once the owner realized they weren’t going to meet the expected revenues (through monthly or quarterly reviews of the books) they would have to make the appropriate adjustments to their spending by assessing the problem. If the weren’t meeting their goals because of marketing, the would need to increase their marketing budget, hire sales people, or do whatever else was appropriate for their situation to increase income, while scaling their operations and plant expenses down to help minimize cash outflows. If the shortfall was due to economic or other reasons that are out of the control of the company, they would need to cut expenses to meet the revised goal. This may be reducing fixed costs, converting salaried employees to hourly, selling plant equipment, discounting merchandise to near at-cost levels to minimize their inventory levels and increase cash assets. If the situation was drastic enough, they may even need to implement layoffs or other more creative measures to save money on salary expenses.

This really hits home when a public company announces layoffs. Their stock drops, not because the company isn’t a good one, but because with all the resources at the company’s disposal something happened that the company hadn’t anticipated which makes it have to reduce costs. This shows that consistency and the ability to accurately forecast revenues is a metric that investors look at when evaluating a company.

Type 2 – Underestimating Revenues

Even though you might not think that underestimating revenues is a major cause for strategy re-alignment, it can be as difficult to manage as a type 1 error. If you estimated revenues of $200,000, and ended up making twice that, it could be devastating for your business.

The types of problems that can come about depend on the type of business you run. If you run a retail outlet, you could end up turning customers away because you don’t have the product to sell. If you run a service, you might have to hire more employees in a time-crunch which might lead to deteriorated quality of your employee skill-set and your customers may not be happy. It might also lead to increased customer complaints and negatively effect the goodwill asset of your organization. This was the case with AOL, the internet service provider when it sold unlimited internet for a fixed price. Shortly after gaining millions of customers their infrastructure was maxed out and their customers couldn’t use their service. AOL got bad press about their service and they had to spend money on marketing to show that they were trying to fix the issues so they didn’t lose more customers. Even though they were selling more than expected, they were unable to deliver and incurred additional expenses because of it.

Issues with a manufacturing business would include consuming their plant assets above predicted rates and causing hardware/equipment malfunctions which would increase repair and equipment costs.

Accurately predicting revenues is hard to do, especially in a high-tech business. Being able to assess a business’s current situation and make predictions about the future and react when your predictions are off is a requirement to manage cash-flow effectively.