During a recent quarterly review call with one of ITR Economics' consulting clients, the business owner and I had a discussion on the implications of pricing changes on the firm’s revenue performance. It led me to a realization: Many businesses use revenue forecasts for capacity planning, but they don’t realize how much changes in their prices influence those revenue expectations. What he really wanted was a volume forecast; that is the true measure of market demand and better accommodates capacity planning.
Price as a Revenue Driver
Consider a sample company’s Revenue performance. When company Revenue is plotted against Steel Prices on a rate-of-change basis, we can see that the cyclical relationship is nearly identical (fig 1). The company’s management team therefore faces a challenge when they rely only on their Revenue forecast to predict their labor and plant capacity needs into the future. Multiple factors need to be considered.
Predicting Underlying Market Demand
When the company’s Revenue is plotted against the performance of their main vertical market, US Mining Production (excluding oil and gas), it’s evident that basing capacity expectations on Revenue performance may not be the most prudent approach. There are multiple occurrences of Revenue growth peaking much higher than the corresponding peaks in the industry data (fig 2). This suggests that pricing was underscoring at least some of the company's Revenue ascent (with the company’s relative size also a factor), as opposed to capacity ramping up that high. The company’s performance in 2018 may have been primarily price driven given the industry trend; we would need to analyze a volume metric at the company level to know for sure.
What Does This Mean to You?
The main conclusion of this analysis can be summarized in three points:
- Revenue forecasts are often influenced by pricing fluctuations and are not always suited for capacity planning.
- Data sets that represent the volume of activity, rather than the dollars associated with this activity, may be better predictors of market share, labor needs, and equipment utilization within the company.
- Companies must ensure that they are leveraging the right data, both internal and external, in their strategic planning for the future.
If you’re interested in discussing this topic as it pertains to your own company forecasts, please contact us — we’d love to help!