Page 3: Making assumptions
A budget needs to make assumptions about how internal and external business conditions will develop and change. Once the effects of these assumptions have been evaluated, managers can set forecasts for sales turnover and costs to meet profit targets. Detailed planning can then follow to estimate the plant capacity, staffing, materials and marketing needed.
Managers use sensitivity analysis to review different scenarios. They ask questions and consider the impacts of various alternatives (the “what-ifs”). For example:
The economic outlook - What is the overall economic trend for the UK and Europe? For example, increased redundancies during a recession would mean less demand for workwear. A sharp rise in the value of the euro against the British pound would make earnings from Davis” European business more valuable to the company.
Competition - What is the likely strategy of key competitors? Is there a risk of any new entrant to the market or an existing competitor leaving the market? For example, if a new competitor appeared in the market, should Davis reduce its prices (affecting its profit) or invest in additional marketing activity? Davis had to react promptly and positively in the UK when two competitors left the market in 2007-8 (one from bankruptcy and one from a strategic decision to withdraw) to take advantage of the opportunity.
Customers - How are customer needs likely to change? For example, some larger clients have been moving from simply buying a textile service to wanting a complete solution to cleanliness and safety needs. Will demand from the hospital sector grow more than that from hotels and restaurants?
Staff - Is the company recruiting sufficient staff? Are salaries high enough to keep vital knowledge and experience within the Group or does Davis need to recruit additional expertise?
Suppliers What is happening in supplier markets? For example, what will be the effect of Far East imports on prices of workwear? What is the impact of increases or reductions in utility prices (energy and water)? How will exchange rates affect costs?
Davis Service Group often constructs two or three possible scenarios so it can analyse the effects of favourable and less favourable outcomes on the business. The illustrative data below highlights the effect on profit of this approach:
Scenario B (with new competitor)
In Scenario A. Davis increases market share and revenues. The larger volumes and relatively small increase in costs would give increased profits. In Scenario B, a competitor opens a new plant. Sales begin to fall and lower profits would result. Overheads or costs would need to be reduced to meet the gap.