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A Practical Alternative to Traditional Sales Forecasting

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Recently in one of Justin Roff-Marsh’s SPE Practitioner Tips (which you can subscribe to here), he asserted that salespeople and their managers spend too much time trying to forecast sales revenue.

Most sales groups forecast revenue by adding the value of all opportunities and then adjusting them for risk. To make the adjustment, they assign a probability that each deal in their pipeline will close, multiply the product of the probability and the deal size, and add them all together.

The calculations look something like this:

Credit: Justin Roff-Marsh

This statistical method of forecasting is inherently unreliable because the sales group has combined uncertain risk-adjustments with small sample sizes.

Roff-Marsh identifies the main problem with this method. The risk adjustments are nearly always a guess. They are often manipulated to achieve a forecast that will satisfy sales management.

Even though the sales forecast is unreliable and requires a lot of time to estimate, sales teams are under pressure to produce this number month after month. Why is that?

Executives, financial planners, and production planners all want to see an estimate of future revenue. They naturally ask sales to provide this estimate to them.

There is a further reason that sales teams use this method to forecast revenue. They are chronically starved for good sales opportunities, so they scrutinize every deal for its potential to convert. If they had a bigger pipeline then each single deal would not have to be scrutinized so closely.

The consequence: The whole company needs an accurate revenue  forecast, but sales uses an unreliable method. This approach to sales forecasting leaves the company unable to accurately plan for its production and financial needs.

Roff-Marsh suggests a different approach. His method uses scenario planning instead of statistics.

The Scenario Planning Method for Sales Forecasting

In his approach, Roff-Marsh coaches salespeople to do several things differently:

  1. They carefully align each deal with the pipeline stage that reflects objective observations of customer behavior.
  2. Instead of building a forecast based on all deals in the pipeline, they ignore early stage opportunities and focus only on late stage opportunities. By restricting themselves to late stage opportunities, they have less need to assign a probability to the deal because these are all high-probability opportunities.
  3. The scenario planners review the late stage opportunities and assign them to one of three categories: possible, probable, and highly likely.
  4. Next they assign each deal to the month in which it is expected to close and they give each deal a dollar amount.
  5. With this knowledge the team can produce three month-by-month scenarios for business that is highly likely, probable, and possible to close.

Visually this can be presented in a chart like Roff-Marsh’s chart below. This chart conveys a lot of information because it’s limited to late-stage deals which have been broken out month-by-month into three scenarios.

Credit: Justin Roff-Marsh

The Conflict Between Sales Forecasters and Scenario Planners

Although some of his clients use the scenario-planning method for forecasting, the Roff-Marsh solution would create conflict in organizations that currently use conventional sales forecasts to plan for future revenue.

While it’s true that those who support conventional sales forecasting and those who advocate for a scenario-planning method would agree on the same goal, the need to plan for future revenue, they would disagree strongly on how to achieve the goal.

The sales forecasters would say that they need to give management a forecast that it can incorporate into their planning systems in order to forecast future revenue. Further, to give management a forecast, they must provide a single number that can be entered into the planning system. The way they arrive at a single number is by calculating the risk-adjusted aggregate  estimate of future revenue from all salespeople.

On the other hand, the scenario planners would say that they must give management a truthful forecast of an unknown future in order to plan for future revenue. Further, to give management a full picture of a truthful forecast, they must produce multiple scenarios of the future.

These two approaches to achieving the same end, the ability to plan for future revenue, are in direct conflict. One approach forecasts revenue based on calculating a single risk-adjusted number and the second forecasts revenue based on a set of scenarios. A company can’t do both simultaneously.

Is there any way to resolve this conflict? To do so, we have to look at the assumptions that each side makes and see if any of them are faulty. If they are, then we might be able to inject an alternative way of working that resolves the conflict.

Questioning Our Assumptions

Let’s look at the assumptions that each group makes and see if any of them can be called into question.

The sales forecasters want to forecast a number that they can incorporate into their planning system. The plans for production, financing and staffing all depend on the revenue forecast. Further, they use the planning system to report to the Board and shareholders.

Sales is the only group that can supply information about customer purchasing plans. However, they could supply this information in many ways. It doesn’t have to be a single forecast number (especially if we suspect the accuracy of the number).

Next we’ll look at the scenario planners. What assumptions do they make?

The scenario planners want to give management a truthful forecast to plan for future revenue because many other plans are dependent on the truth of the forecast. If the forecast is too optimistic or too pessimistic or simply doesn’t convey the range of possible outcomes, financial planners and production planners will make significant errors.

The scenario planners make the assumption that it’s better to illustrate the uncertainty in the forecast rather than hide this uncertainty and possibly mislead planners and management.

They base their forecast only on late stage opportunities and they believe management should see a range of potential scenarios. They also believe that we should increase the size of the pipeline so that sales is no longer chronically starved for opportunities. A bigger pipeline would make it no longer necessary to place so much emphasis on each deal and its probability of closing.

The Resolution

A. Sales needs to be the one that forecasts revenue, but it doesn’t have to be a single number in order for the forecast to be useful.

B. Sales does not have enough information to estimate the probability of deals closing. The only thing they can do with confidence is take the late stage deals and break them out qualitatively into three buckets.

C. Executives and planners need forecast accuracy more than they need a single number. By giving them a range of scenarios, they can combine this knowledge with other information and make their own estimate of the forecast. This method lets sales provide a richer set of useful information to the planners and it does not force sales to make impossible predictions.

Why Time and Materials Billing Is Not the Way to Grow Your Company

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Justin Roff-Marsh once wrote about the inefficiencies and value-destruction of time-and-materials billing. He recommends that companies avoid pricing their product based on a calculation of minutes worked. Instead, he proposes that we price according the value we deliver to the customer.

Companies that use time-and-materials billing will find this argument difficult to accept, so let’s look at the dilemma more closely.

People sell their products on a time and materials basis in order to protect themselves from the risk of uncertain project times. They are concerned that they cannot estimate the size of the project or that the project requirements will change. They believe they must protect themselves from these risks in order for their company to grow and be profitable.

On the other hand, Roff-Marsh recommends that companies sell their products on a project or job basis. He says they must sell this way in order to increase their project throughput and to lower their operating expenses. He believes a pricing model that emphasizes an increase in throughput and lower operating expenses is a prerequisite for a company to grow and be profitable.

Both approaches share a common goal: to help the company to grow and be profitable. But the methods they use are in direct conflict. A company cannot sell the same project on a time-and-materials basis and on a project basis.

Is it possible to resolve this dilemma, to protect ourselves from project risk and simultaneously increase throughput and lower our operating expenses?

Let’s look at the assumptions behind each side of this conflict and see if we can find any that can be called into question. If there are some incorrect assumptions, we may be able to resolve the dilemma.

First let’s look at the assumptions behind the need to manage our risk. We need to protect ourselves from project risk because:

  1. The nature of our work is such that we can’t predict how long a project will take. Therefore we cannot estimate the price of our product (the project).
  2. Neither we nor our customers are willing to take the risk of this uncertainty with a fixed project.
  3. We need to make a profit on each project.
  4. Every person needs to meet their billable hours goals.
  5. We will calculate the price of our product by counting the number of minutes to produce it.

On the other hand, we need to increase project throughput and lower operating expenses because:

  1. We will price projects based on the value they bring to the client and how much the market will pay, not on our costs or our labor hours.
  2. We will look for alternatives to time as a proxy for value (transactions, lines of code, words).
  3. Wherever possible we want to delegate work from expensive employees to less expensive employees.
  4. We want teams of people to do projects and to encourage relay-race behavior where people sprint to hand off work to the next person.
  5. We want to make money on our portfolio of projects. We are willing to risk that some projects will make less, some will make more. We will get better and better and estimating and bringing value to our clients.

Now let’s see if we can challenge some of the time-and-materials assumptions.

  • Instead of selling the entire project on a time-and-materials basis, can we break the project down into smaller sub-projects? Then we could sell these smaller chunks on a project basis instead of time-and-materials.
  • Instead of counting work by the minute, Roff-Marsh suggests that we use no shorter time increment than a half-day. Or use something besides time (like transactions).
  • Instead of focusing on making a profit on every project, look for ways to make a profit on our portfolio of projects. We will make more profit on some projects and less (or even negative) profits on others. But we’ll get better and better at pricing and selling project value.

All three of these changes reduce the risk of selling projects. We sell smaller projects (easier to estimate), we use longer time increments, and we spread profit risk across our portfolio of projects.

These changes also make it possible to meet the need to improve throughput and lower operational expenses.

Since we are focused on doing projects as quickly as possible, there is more incentive to spread more of the work from expensive people (like partners) to less expensive people, which lowers the operating expense.

If we spread the work to more people, then we can organize the project like a relay where people hand off their work. This speeds the work as a person waits for the handoff, sprints to do their portion, and hands it off to the next person. Quick handoffs improve throughput.

Roff-Marsh concludes his article by encouraging us to behave more like a Formula 1 pit crew:

You don’t make money by keeping your team busy. You make money by delivering jobs. And the two are NOT the same thing. People work best in fits and starts. And team work necessitates relay-racer behavior (person B hovers, waiting for person A to finish his work – and then sprints to hand-off the job to person C).

You need to mobilize your team to get jobs out. Think of the pit crew in a Formula 1 team. Timesheets are not conducive to this environment.

How Can Your Organization Learn to Challenge Assumptions?

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“Be patient toward all that is unsolved in your heart and to try to love the questions themselves like locked rooms and like books that are written in a very foreign tongue.” Rainer Maria Rilke, 1903

Successful use of process improvement tools requires that we be open to learning. We can’t challenge our assumptions if we’re not ready to accept new observations and new thoughts.

Lisa Scheinkopf explains that we use the Thinking Process tools in the Theory of Constraints to discover, express, and confront assumptions. We begin with our own assumptions. To discover and challenge our assumptions requires that we adopt a questioning attitude.

A questioning attitude about our assumptions is quite different from the attitude we have been taught to hold. All our lives we have been taught that people expect us to know the answer. In school as children and at work as adults, we have been rewarded when we are confident in our knowledge.

When we make a presentation at work, the audience assumes that we have done our research and resolved all the questions. If we receive a lot of questions or challenges to our proposal, everyone takes it as a sure sign that we weren’t fully prepared.

But how can we improve if we already know the answers? Scheinkopf isn’t saying we shouldn’t prepare well when we make a presentation. She’s saying that we have to take it a step further. If we want our organization to improve, we have to go to the places where we are not doing as well as we want. We have to go there and look for the assumptions that can be challenged.

Scheinkopf suggests that we follow Peter Senge’s advice in The Fifth Discipline to become a learning organization. These are organizations where “new and expansive patterns of thinking are nurtured.” They are places where “people are continually learning how to learn together.”

Organizations are composed of people. There’s no abstract entity that sets a purpose, deploys technology, solves problems, and develops workflows. People do these things. To state the obvious, if we want to be part of a learning organization, then we have to all become learners.

That means we have to shift our attitudes. Instead of believing that we need to have all the answers, we have to be open to learning. Scheinkopf says that “it’s time to challenge your assumptions, explore possibilities that your assumptions prevent you from seeing, and listen to others challenge you in a very rewarding way.”

First, Define the System, Its Purpose, and Its Measurements

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For many years, Lisa Scheinkopf has been teaching, coaching, and implementing improvement projects using the theory of constraints.

She has identified two critical prerequisites to process improvement projects. In some projects these prerequisites are obvious and people intuitively understand their importance. But in other projects they are not so clear and they are easily ignored.

Ignoring these two prerequisites leads to trouble. You could optimize only part of the system in a way that causes detriment to the system as a whole. Or you could spend your energy on the wrong steps in the process.

What are the prerequisites that Scheinkopf has identified?

1. Define the system and its purpose.

Before you can make any improvements, you have to know what you are trying to fix.

Where are you drawing your lines around the box that represents your system? Is it around your company? A department? Yourself?

What are the inputs into this system and what are its outputs? What is the goal of the system? What are you trying to accomplish?

In some cases, these questions are easily answered. If you are working with a whole company, it’s likely that the goal of the system is to “make more money, now and in the future.”

The company has other goals related to employees, stockholders, and customers. But the primary goal for the system is financial success in the present and in the future.

But what if the system is not the entire company? What if the system is a part of a company that provides a service to other parts of a company?

Scheinkopf describes a project she did with the distribution system in a large, multisite chemical company. At the beginning of the project Scheinkopf asked the team to examine the larger system and the role that distribution played in that larger system.

This examination caused the team to focus on changes to the distribution system that would improve the throughput of the entire corporation.

Had the team not looked at the larger system and its goal in relation to that system, the team might have made changes in distribution that did not help, or even harmed, the larger system of the corporation.

2. Determine the system’s fundamental measurements

What improvements do you hope to make in the system? Once you have defined the system and its purpose, how do you measure success or failure of the system?

Let’s say the system is a company and its purpose is to make money, now and in the future. You then have to ask, what does that mean “to make money, now and in the future?” What should we measure to know how well we are doing? In this case, you will be watching profitability and return-on-assets to see if they are improving over time.

But what about the distribution system we discussed earlier? The company doesn’t directly measure the profitability of the distribution system. And the profitability of the entire corporation doesn’t tell you anything about how well the distribution system is performing.

In the case of the distribution system, the team found some measures that tracked how distribution influenced the corporation’s constraint. In addition, they identified some financial metrics inside distribution that they had the ability to control.

Scheinkopf is not suggesting that we should spend unnecessary time defining the system, its purpose, and its measures before we even start on an improvement project. It would be easy to spend too much time refining the answer to these question and never get started on the improvement itself.

She is simply suggesting that the team enter into a dialog about purpose and measurement in order to bring focus to your project.

How to Identify and Fix Process Constraints

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The Theory of Constraints says that the path to improvement in an organization is not to make improvements everywhere. Instead, TOC says to find the constraint in your process and focus your improvements on that step in the process. Once you have improved throughput for that step, then find the next constraint. By working on one constraint at a time, you are able to focus your efforts and immediately raise the level of system performance.

To find and break the constraint, use these five focusing steps.

  1. Identify the constraint.
  2. Decide how to exploit the constraint.
  3. Subordinate everything else to the decision in Step 2.
  4. Elevate the constraint.
  5. Go back to Step 1, but avoid inertia.

Let’s look at these steps in more detail and see how William Dettmer explains this method to find and break constraints.

1. Identify the constraint. First examine the system and look for the weakest link. Which step in the process needs to be changed? It could be a physical constraint. Or the constraint could be a policy that is constraining the flow of work.

2. Decide how to exploit the constraint. Before you make any changes to the configuration of the constraint, find every way you can to extract efficiency from the constraint in its current configuration. If the constraint is a machine you might do things like eliminate idle time, do preventive maintenance at night, and make sure that all inputs to the machine meet your quality standard. If the constraint were a sales coordinator, you would give non-sales coordination tasks to other people and you would make sure that all sales opportunities going to the sales coordinator are high quality.

3. Subordinate everything else. Once you’ve identified the constraint and have done everything you can to maximize efficiency in its current form, find ways to synchronize the other steps in the system with the constraint. Avoid producing more in other steps than the constraint can accommodate. You might have to let some machines be idle for part of the day. Or have some people at other steps in the system do other tasks for part of the day. Be forewarned, managers have been trained to maximize local efficiencies and so they find it difficult to subordinate to another step in the process.

4. Elevate the constraint. Now that you’ve done everything you can to make the constraint more efficient and subordinated everything else to the constraint, it’s time to re-evaluate. Have your  actions so far been enough to break the constraint? Is the constraint you identified no longer limiting the performance of the system? If so, you can go to Step 5 and start looking for the next constraint to identify.

If the constraint you identified is still the weak link in the chain, then you can elevate the constraint by increasing its capacity. Investments to elevate the constraint could be to buy additional equipment or to add additional staff.

The reason we exploit the constraint before we elevate the constraint is that exploiting the constraint requires no additional investment. We simply wring as much efficiency as we can out of the constraint before spending any more money. Once all those efficiencies have been accomplished, then we can consider ways to spend more money on the constraint.

5. Go back to step one, but avoid inertia. Once you have broken the constraint, it’s time to go back to step one and identify the next constraint. Each time you break a constraint it’s important to avoid resting on your laurels. Avoid inertia by returning each time to step one.

Use the five focusing steps to focus on the really important tasks in your organization: the system’s constraint. Why is the constraint the most important target? Because the constraint sets the pace for the entire system. If you want to increase the pace of the system, you must increase the pace of the constraint.

What Happens When Your Production Rate Exceeds Market Demand?

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The concept of a system in the Theory of Constraints is analogous to a chain with one weakest link. If you pull from both ends of the chain, one link, and one link only, will eventually snap. In the chain, the weakest link that snapped was the constraint.

If you can strengthen the weakest link in a chain, then the chain can accept a greater load. Similarly, if you strengthen the weakest step in a process, then the process as a whole is strengthened and the load it can carry is improved.

What happens when you strengthen one of the links in the chain? Then another link becomes the weakest link. Similarly, if you improve the capacity of the constraint in a process, then the constraint moves to another stage in the process.

Look at the example below of a simple process in a dental laboratory from William Dettmer’s Breaking the Constraints to World-Class Performance. Each stage in the process can produce a certain number of units each day.

Can you see the step in the process that produces the lowest number of units? At 15 units per day, the Porcelain step produces the fewest units. Therefore Step E is the constraint in this simple process. Even though the market demand is 35 units per day, this company can only manufacture 15 units per day. If it accepts more than 15 orders per day, it won’t be able to deliver its orders on time.

What if the dental lab focuses on the constraint and doubles the capacity of Step E to 30 units per day? In that case the constraint would move to Step B which produces 25 units per day. Step B is now the new constraint. The overall production capacity of the process has moved from 15 units per day to 25 units per day.

The market demand remains 35 units per day. At 25 units per day the lab is still producing less than the number of potential orders from customers.

Now what if the lab continues to improve the production capacity at each of the internal constraints to the point where it can produce more than the market demand of 35 units per day? Now where does the constraint lie?

The constraint is no longer in your system; it lies in an external source, the market. About 70% of companies find themselves in the position where they have excess capacity and the market demand is their constraint.

Knowledge of Constraints Holds the Key to Process Improvement

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When we think of constraints in a system, the first image that usually pops into our mind is a physical constraint, like a machine that holds up the workflow. But this isn’t the only kind of constraint. And physical constraints are not usually what cause problems in a sales organization. So let’s learn more about the three kinds of constraints.

The three types of constraints are physical, policy and paradigm. All three of these inter-related constraints exist in any system.

Physical constraints

Physical constraints are resources that physically hold the system back from increasing its throughput.

To locate the physical constraint, Lisa Scheinkopf says we need to ask this question: What is the resource, that if we had more of it, we could increase the throughput of the system?

 

 

 

 

This physical constraint can be internal to the system or it can be external.

Where inputs enter your system, external physical constraints could be due to a shortage of raw materials. If you cannot purchase enough of what you need from your vendors, then you have a constraint.

At the other end of your system, where you release your transformed products to customers, you could be constrained by lack of sales. In this case your constraint lies in the market. You have plenty of raw material and plenty of capacity, but not enough customers to consume what you can produce. Most organizations today are constrained by the market.

Internally, you may be limited by a lack of capabilities or a shortage of capacity inside your organization. We likely first think of being constrained by a machine but today it’s more typical that our constraining resource is people or skills—not enough of the right kind of software engineer or the inability to hire enough quality customer service agents.

Organizations are composed of a system of interdependent resources. The system is designed to perform the process that enable the organization to accomplish its goal. Every organization has one primary physical constraint. If you can improve the throughput of this constraint, you improve the throughput of the entire system.

Many organizations have successfully used the five focusing steps to improve the throughput of their physical constraints.

Policy Constraints

Policy constraints are harder to visualize than physical constraints. They are the rules and the metrics that an organization uses to govern how it goes about its business. You could call them managerial constraints.

Policies define the source of your inputs—who you buy from, how much you are willing to pay, and the terms of your agreements.

They also define the direction of the output of your system—which markets you will serve, how you will compete, and your selling model.

Internally, policy constraints include the myriad of work rules inside your organization.

If you ask anyone in a company, they can tell you about many stupid policies in their organization. No one intentionally develops a stupid policy. People work in groups and through their belief systems they develop policies that seem correct at the time. Once policies are in place, they take on a life of their own and people feel obligated to follow them. We believe that these policies will enable us to make decisions and take actions that will produce the results we want for our organization.

Paradigm Constraints

Paradigm constraints are the beliefs, attitudes, and assumptions that inform the policy constraints we develop and follow. These paradigm constraints cause us to see the world in certain ways and prevent us from considering alternatives. In a famous example, companies that ran railroads viewed themselves as being in the railroad business. They couldn’t see an alternative paradigm until Theodore Levitt pointed out that they could view themselves as being in the transportation business.

Process Improvement

The three types of constraints affect each other. Lisa Scheinkopf says that “paradigm constraints cause policy constraints, and policy constraints result in mismanagement or misplaced physical constraints.”

The five forces have been used widely to manage the physical constraint and improve the throughput in their organization. They are relatively easy to improve because they are easier to see.

Policy and paradigm constraints are harder to see and harder to improve. But they also hold the most opportunity for significant improvement in organizations today.

How to Improve the Throughput (Sales) of Your Organization

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What is your organization trying to accomplish? What is its goal?

In a business, the financial goal will typically be to make more money, now and in the future. Of course, organizations have additional goals:to hire and retain the best people, to be competitive in their industry, and to bring innovative products to market. But operationally, the financial goal will be to make more money, now and in the future.

Lisa Scheinkopf explains that we connect our metrics to our goal by measuring the primary process of the organization—the inputs, the transformation of inputs into outputs, the outputs—in a way that connects to the goal.

A premise: organizations convert money into more money by adding value

The process begins when we buy inputs from vendors. This is money that we put into the system so that we can convert the money we spent into more money.

We convert this money by transforming the inputs and selling the result to customers at a higher price than the cost of our inputs.

This knowledge allows us to define “value added” as the difference between the amount that customers pay us for the outputs of our system and the amount we paid vendors for the inputs.

If we generate more “value added” than the amount we pay for the ongoing operation of the system, then we make a profit.

The Theory of Constraints defines the fundamental financial components of an organization in this way:

  • Throughput: The rate at which the organization adds value to the system by generating money through sales.
  • Inventory: The money spent on purchases from vendors that the organization will turn into throughput.
  • Operating Expense: All of the money that the organization spends to do the work of turning inventory into throughput. This includes everything spent to run the enterprise—wages and salaries, buildings, equipment, insurance and taxes.

The constraint holds organizations back from increasing their throughput

When we look for the constraint in the system, we are searching for the element in the system that is holding us back from increasing the rate of throughput.

The constraint could be anything in the system that limits better performance in relation to the goal. Improvements that reduce the constraint are measured as increases in throughput.

If we talk to people in the different functions of the company, we are likely to be given a long list of possible constraints. Everyone has their perception of the important problems in the company.

But if we change our view to the system as a whole we can see that the organization is composed of an interdependent collection of resources. Throughput flows through this chain at a given rate. That rate is determined by the constraint in the system.

Like a chain that can be no stronger than its weakest link, the throughput in the system can be no faster than what the constraint permits.

Find the constraint, improve its throughput, and you improve the throughput of the entire system.