Forecasting costs, margins and working capital

How do you forecast cost of sales and the gross margin?

Cost of sales is usually the largest cost for a company that makes or sells products, and it is tied directly to sales. So forecast it as a percentage of sales, or equivalently as a gross margin . Disclosure of costs is usually thinner than disclosure of revenue, so analysts often forecast consolidated lines or summary measures such as earnings before interest, taxes, depreciation, and amortization (EBITDA) margins, but the cost forecast must stay coherent with the revenue forecast.

Costs and working capitalkeep coherent with the revenue forecast

• Cost of sales Memorize forecast as a % of sales (a gross margin)
  • Mix Use it faster growth in a low-margin line lowers the total margin
  • Competition Use it share lost to cheaper substitutes presses margin; differentiated launches lift it
  • Input costs Use it volume and price; lag and hedging before they reach customers
• SG&A Memorize a mix of variable and fixed parts
  • Selling and distribution Use it largely variable: % of sales
  • General corporate costs Use it largely fixed: grow with wage inflation
• Working capital Memorize days ratio × revenue or cost of sales ÷ 365
  • Receivables Memorize DSO × revenue
  • Inventory Memorize DIO × cost of sales
  • Payables Memorize DPO × cost of sales

Coherence has three parts.

• Product mix . If a low-margin product, segment or region is forecast to grow faster than the rest, the overall margin should fall, even if you do not know each margin precisely.
• Competition. A company losing share to cheaper substitutes will usually see margins fall. A company gaining share with differentiated products, especially if it also has a cost advantage, will usually see them rise.
• Input costs. Where input prices fluctuate and reach customers only after a lag, split sales and costs into volume and price, especially for low-margin businesses, where a sudden cost shock can move operating profit a lot. Check the company’s hedging policy: a company that buys a main input a year ahead feels a price rise a year late.

Small changes matter. Cost of sales is large, so even one percentage point of gross margin on a big revenue base moves operating profit and free cash flow materially.

What happens when a cost rise is passed on?

Memorize

Passing a cost increase on to customers sounds as if it protects the margin. It protects the money, not the percentage. Cost pass-through in money terms adds the same amount to the price and to the cost, so gross profit is unchanged, but the price, which is the base of the margin ratio, is now larger, so the gross margin percentage falls.

$$m = \frac{P - C}{P + \Delta C}$$

To keep the percentage, the price has to rise by the same percentage as the cost, which means by more than the money amount.

$$P^* = \frac{P\,(C + \Delta C)}{C}$$

Exam tip ”Same money added to price and cost”: gross profit unchanged, margin percentage down. “Same percentage added to both”: margin percentage unchanged.

Go deeper A mix effect with unchanged segment margins

A company has two lines. Line A has sales of 60 and a 40% margin; line B has sales of 40 and a 10% margin. Total gross profit is 24 + 4 = 28 on 100, a 28.0% margin. Next year A grows 5% to 63 and B grows 20% to 48, and each keeps its own margin. Gross profit is 25.2 + 4.8 = 30.0 on sales of 111: 27.0%. Neither line got less profitable, yet the total margin fell, because the low-margin line grew faster. That is why a revenue forecast by segment should come with a margin view.

Go deeper Why cheaper production does not always lift margins

If a new technology cuts manufacturing costs across a highly competitive industry, every producer gains the cost saving and competition passes most of it to customers in lower prices. The industry’s margins may not change at all. Only a company that gets the technology first, or that is protected from competition, keeps the saving.

How do you forecast SG&A?

SG&A expenses (selling, general and administrative) are the other main operating cost. They have a looser link with sales than cost of sales does, because they mix variable and fixed parts.

• Selling and distribution costs (commissions, delivery) are often largely variable and can be forecast as a percentage of sales.
• General corporate costs (head office, systems) are largely fixed and are better grown at a rate based on expected wage inflation.

The approaches from Lesson 1 apply: history, a peer base rate, guidance (management is usually good at forecasting costs it controls) or your own view. Keep one-off costs such as restructuring charges separate from the run rate.

With a large fixed part, SG&A as a percentage of sales falls when sales grow quickly. This is operating leverage.

How do you forecast working capital?

Working capital is forecast through the efficiency ratios you met in the last module, combined with the revenue and cost forecasts. Rearranging each ratio gives a balance.

• Receivables come from days sales outstanding (DSO), applied to revenue.
• Inventory comes from days of inventory on hand (DIO, for days inventory outstanding), applied to cost of sales.
• Payables come from days payables outstanding (DPO), applied to cost of sales.

$$\text{Receivables} = \frac{DSO \times \text{Revenue}}{365}$$

$$\text{Inventory} = \frac{DIO \times \text{Cost of sales}}{365}$$

$$\text{Payables} = \frac{DPO \times \text{Cost of sales}}{365}$$

Holding last year’s days ratios constant is the usual default (a historical-results approach). Change them only for a reason, such as new payment terms or a supply-chain change. A company converging to peers’ ratios could use a base rate instead. Do not simply grow every balance at the sales growth rate: each item has a different base and a different ratio.

Exam tip Receivables are about sales, so use revenue. Inventory and payables are about purchases, so use cost of sales.

Go deeper Hedging and the lag before a cost reaches the price

A company that hedges its main input a year ahead sees today’s market price only next year. A company that does not hedge sees it at once, and its margin moves with the commodity unless it can raise prices quickly. Hedging policy is usually described in the notes to the accounts, though positions are not. A short-term forecast for such a company needs volume and price split out. A long-term forecast can use the overall relationship between sales and input costs.