BIBLIOGRAPHY AND REFERENCES
5. Net Debt
4.4 FORECASTING COSTS
Ht is the home sales forecast of the year t, and
et is an error term measuring the extent to which the model cannot fully explain the steel market.
Then the objective of the macroeconomist or the econometrician would be to obtain estimates of the parameters a, b, c, and d; these estimated parameter values, when used in the model’s equation, should enable predictions for future values of the steel market to be made contingent upon the prior year’s GDP and future year’s production and home sales. I would like to stress here that the construction and preparation of macroeconomic forecasts is one of the most publicly visible activities of professional economists as they concern many aspects of economic life including financial planning, state budgeting, and monetary and fiscal policy. The production of these kinds of forecasts requires a clear understanding of the associated econometric tools even though it results in forecasts which tend to be little better than intelligent guesswork – and that is a fact. During the years before the Great Recession of 1929 forecasts might have appeared to improve, but that was only because most economies became less volatile. As is well known, the Great Recession was completely missed, not to mention the 2007 financial crisis which started as an asset bubble. In any case macroeconomic or econometric forecasting is far beyond the scope of this book.
We have now adequately covered the topic of forecasting sales for both new and existing businesses, products, and services and it is time to move on to forecasting costs.
OPEX Cost Categories
Payroll Cleaning
Transport (e.g. fuel, car rentals, tolls, etc.) Printing, photocopies, stationery Electricity and utilities Insurances
Office supplies Telecoms
Indirect materials (e.g. packaging) Training and development
Rent Professional fees
Dues and subscriptions Travel and accommodation Marketing, advertising, and promotion Distribution
Contract services
and are spread between different functions or departments according to the type of industry in which the company operates:
OPEX Functional Categories
Finance Human Resources
Sales and Marketing Corporate Services
Information Technology Legal
Production Operations.
For a new business the above costs have to be estimated from scratch (from a zero base) or to be approximated based on industry averages. For example, you may use Aswath Damo-daran’s web page from the Stern School of Business at New York University to download the following data set which lists the SG&A cost as a percentage of sales for more than 20 industries (http://people.stern.nyu.edu/adamodar/pc/datasets/uValuedata.xls).8 For an existing business several approaches can be used ranging from the percent-of-sales to full regression analysis between SG&A costs and sales. In Chapter 3 we broke down costs between fixed and variable. The fixed costs remained relatively constant and increased in line with the inflation rate whereas the variable costs increased according to the sales volume increases. The break-down between fixed and variable costs was based on the actual cost analysis of past years’
cost data of SteelCo. The approximation was made that 30% of SG&A was fixed and the other 70% was variable.
Fixed costs are the costs that a company has to pay regardless of the level of sales activity. Typical fixed costs include rent, utilities (e.g. electricity consumed in the offices and not during the production), insurance, service costs (e.g. accountancy costs), and salaries of the full time personnel.
Variable costs, on the other hand, depend on production volumes. They are lower when there is less production or lower sales and higher when there is more production or higher sales. They include raw materials, labour (mainly in terms of hourly wages), utilities (e.g. electricity that relates to the operation of machinery for production purposes), packaging, and delivery costs.
In practice very few costs are totally fixed or vary directly with production volume. The majority of the costs are either step fixed or step variable. An example of a step fixed cost is the rent the company pays for its offices or the salaries of full-time administration personnel.
As the company grows, more and more administrative staff need to be added to accomplish its operations. After a certain increase in the activity of the company more personnel and greater office space will be needed to accommodate it so those costs that were considered fixed will be increased. That is, these costs are more or less constant over a low level shift in activity, but increase incrementally when activity shifts substantially. Similarly, an example of a step vari-able cost is the hiring of additional workers to produce a certain amount of products (units).
If, for example, each worker is capable of producing 100 units per day and the company plans to produce 150 units per day then 2 extra workers are needed. As long as the number of units remains under 200 no other worker is needed. When the level of activity shifts above 200 units per day an extra worker needs to be hired.
Let us now return to the SteelCo case and try to forecast the operating expenses (SG&A costs) with (a) the percent-of-sales method and (b) by using regression analysis.
Exhibit 4.21 shows the operating expenses already forecast in Chapter 3 using the approach of fixed and variable costs described above. We see that OPEX as a percentage of sales change from 6.8% in 2014 to 8.4% in 2017. That is, we see an increasing trend.
We could take the average OPEX as a percentage of sales for years 2011 to 2013 (5.5%) or that of 2013 (6.2%) and use it as a proxy for the forecast years 2014 to 2017. If we choose 6.2%, then the OPEX for 2014 would be (see Exhibit 4.23):
OPEX2014= 6.2% × Sales2014= 6.2% × €117,546k = €7,260k Following the same approach we get the following OPEX figures:
OPEX2015= 6.2% × Sales2015= €6.570k OPEX2016= 6.2% × Sales2016= €6.062k OPEX2017= 6.2% × Sales2017= €5.701k
We see that with this approach OPEX in 2017 is substantially lower than the one we forecast in Chapter 3. Let us now try the regression approach. First we have to plot using an XY (Scatter) graph the actual data of sales (Annual Revenue) – X-axis versus OPEX – Y-axis.
This is the dark line of the graph in Exhibit 4.22. Then we add a linear trendline in the way we demonstrated in Section 4.2. We see that the trendline, which is the gray line overlapping the dark one, fits almost perfectly (R2= 0.99).
EXHIBIT 4.21 OPerating EXpenses estimation as a percentage of sales
8,912 y = 0.013x + 6377,
R2 = 0.998 8,600
8,800 9,000
Annual
Revenue OPEX 8,516
8,182
7,905 8,000
8,200 8,400
185,500 8,912 154,684 8,516 132,500 8,182 117,564 7,905 106,395 7,760
98,171 7,653
92,322 7,577
Actual data
Forecasted data
7,760 7,653 7,577 7,400
7,600 7,800
70,000 90,000 110,000 130,000 150,000 170,000 190,000 210,000
EXHIBIT 4.22 Using regression analysis to forecast OPEX (SG&A costs)
We then use the trendline of the top right corner of Exhibit 4.22 in order to forecast OPEX for 2014 based on annual revenue of 2014:
OPEX2014= 0.013 × Sales2014 + 6,377 = 0.013 × 117,564 + 6,377 = €7,905k Similarly OPEX for 2015, 2016, and 2017 equals:
OPEX2015= €7,760k OPEX2016= €7,653k OPEX2017= €7,577k
Exhibit 4.23 presents OPEX (the SG&A costs) following the 3 different approaches we have already discussed. We see that the first one (breakdown of costs between fixed and vari-able) and the third one (linear regression between sales and OPEX) give similar results.
We could simply have selected cells D26:F26 of Exhibit 4.21, that is the actual figures of OPEX as a percentage of sales, and dragged them to the right to cells G26:J26. In this way
Percentage of sales Fixed & variable costs
Approach
Regression analysis
EXHIBIT 4.23 Forecasting SG&A costs (OPEX) with 3 different approaches
the forecast OPEX as a percentage of sales would be: 6.9%, 7.6%, 8.2%, and 8.9% for years 2014, 2015, 2016, and 2017 respectively. This would give the highest increase in OPEX as a percentage of sales.
So far we have covered the Selling, General, and Administrative costs (SG&A) which are classified as periodic expenses. In the next section we will cover another cost category, Capital Expenditure (CAPEX), which gives rise to the fixed assets of a company. Only a portion of CAPEX and fixed asset costs, in contrast to SG&A costs, are classified through depreciation as periodic expenses.