Understanding Revenue Drivers in Financial Forecasting

Defining Revenue Drivers: The Levers of Growth

The most basic definition of a Revenue Driver is any factor that has a direct impact and can be measured on a company's top line revenue. Consider the company to be a complex machine with revenue drivers being the gears, pulleys, and switches that activate or adjust the output of the machine; revenue and sales are the outputs. Revenue drivers are the Causes behind revenue movement in a specific direction.

Metrics are just formulas that produce results. An example of a metric would be "Total Revenue", which is an end result. New customer acquisition, Average Purchase Amount, Price of Key Product are examples of Revenue Drivers. Revenue Drivers represent the actions that Management can take to increase revenue through Strategic Plans, Marketing Plans, Sales Initiatives, and Operating Changes. When determining which Revenue Drivers to focus on, it is important for the business to go beyond what they see on a surface level (which are typically Financial Numbers), and dig deep into the business model and Customer Behavior.

In the SaaS world, the number of subscribers, or Monthly Recurring Revenue is typically the primary Revenue Driver for a SaaS company. Manufacturing Companies tend to have a Revenue Driver of Unit Sales Volume and Raw Material Price. Thus, Revenue Drivers are unique to their respective Industry, as well as to their respective companies.

The Critical Link: Revenue Drivers and Financial Forecasting

Using a systematic approach that identifies and quantifies revenue sources, Financial Forecasting establishes a clear basis for making informed long-term budgeting and strategic planning decisions. The integrity and accuracy of future revenue estimates are reliant upon the proper identification and modelling of revenue sources. Without a clear understanding of a company's core revenue generating sources, all forecasts will be simplistically linear in nature, merely extrapolating from historical trends without accounting for the ever-changing external factors that impact on businesses today. As such, the Financial Forecasting process utilizes the core revenue sources to define and shaping all future strategic and operational decisions.

Using “what-if” scenarios, Financial Modelers can use driver-based Financial Forecasting models to assess various combinations of the core revenue levers (drivers) that generate revenue for a business. Potential future revenues can be modelled and measured at various levels of expense management, pricing flexibility, customer retention and acquisition, etc., according to how changes to these drivers will affect the company's revenue in the future. In this way, the Financial Forecasting Model also provides an easy-to-understand causal explanation for the revenue estimates produced by the Financial Model.

This creates greater transparency, defensibility and overall usefulness of the Financial Forecasting Model for inform and improve management decision making through an understanding of the key drivers of revenue. The shift from a simple statement of “we expect to generate X amount of revenue” to a detailed discussion of “we believe we will generate revenue based on the numerous ways in which the core revenue drivers interact” indicates a huge improvement in the ongoing effectiveness of an established financial operating framework.

External and Macroeconomic Revenue Drivers

Predicting future revenue can be very complex, especially when evaluating all the external factors (macroeconomics, regulations, etc.) that could influence an organization’s revenues. Most organizations implement a forecast methodology that considers the effects of external factors to create more reliable forecasts using scenarios and/or sensitivity analyses.

Forecasting with consideration of external variables is the best practice for developing accurate, defensible forecasts for organizations. Further, developing scenarios for upside and downside circumstances will allow organizations to take proactive measures to mitigate risk/reduce the impact of potentially negative scenarios and capitalize on opportunities created by potentially positive scenarios. As a result, organizations identify the key vulnerabilities associated with external factors and the opportunities to maximize revenues through capitalizing on those opportunities.

The Process of Building a Driver-Based Revenue Forecast

Developing a revenue-based forecast requires a thoughtful, iterative approach that begins with a comprehensive review of historical data. The first step in this process is to review the history of a company and its revenue sources (volume, price and mix) in order to identify trends. Following this, the second step is an identification of the revenue drivers: by working closely with departments such as Sales, Marketing, Operations, and Strategy, a finance analyst will compile a list of all of the factors/vehicles that may affect future revenue.

Having an understanding of the marketplace is essential when determining which factors/vehicles will have the largest impact on revenue. The next step is to develop the quantitative assumptions (how many sales employees will be hired, what will be the increase in conversion rates as a result of upgrades to the company’s website, how much will the flagship product cost when it is introduced to the market, etc.).

All of these assumptions must be realistic, documented and clearly aligned to the company’s current and future operational plans. The final step involves the creation of mathematical relationships (either through a simple multiplication formula or a more complex mathematical function) between the identified revenue drivers and future revenue outcomes. The mathematical relationships will then be subjected to stress testing and sensitivity analysis to understand which revenue drivers will generate the greatest potential for increased future revenue.

The Tangible Benefits: Why Revenue Driver Analysis Matters

Having established a driver-based forecasting model will lead to increased benefits throughout an organization. Primarily, there will be significant increases in forecast accuracy and reliability. Through the use of the driver-based model to represent revenue drivers, forecasts will be more directly correlated with actual business events and market conditions; therefore, reducing the gap between forecast and actual results. Second, it will provide better strategic decision-making and planning.

By using the model, business leaders will be able to evaluate the projected financial impacts of potential strategic decisions prior to committing to a particular course of action, resulting in fact-based, confident decisions. Third, it will allow for improved resource allocation and budgeting. Business leaders will have a clear understanding of which drivers provide the most return on investment, and therefore, will be able to allocate their capital and operational budgets toward the most effective initiatives (i.e., hiring more sales people, investing in research and development, investing more in digital advertising).

Fourth, it will allow for better proactive risk management and contingency planning. Business leaders will be able to identify the internal and external drivers of risk and develop a plan to mitigate those risks before they occur. Finally, it will promote organizational alignment and accountability. The sales team will better understand that the forecast is based on their anticipated rate of acquiring new customers, and marketing will understand that the sales forecast is based on their anticipated leads, leading to greater investment in the forecast as a mutual goal.

Real-World Applications and Common Pitfalls

Driver analysis is used in many different business models, and as a result, there is no one-size-fits-all approach to driver analysis. For example, an analysis of drivers for a retail chain may identify factors such as store visit traffic, average order quantity and same-store sales increases. On the other hand, a driver analysis for a consulting firm could focus on aspects like billable utilization percentage and average billing rate for consultants. For a pharmaceutical organization, driver analysis would look at factors that influence drug uptake, patent longevity and payment reimbursement.

However, there are some common failings that can hinder the efficiency of driver-based forecasting. An example of this would be creating a driver model that is too complicated to use or maintain by having too many drivers in a model. It is essential that only a selected few significant drivers are included, not every conceivable factor. Another pitfall would be using out-of-date or bad data; it's important to remember that a model is only as good as the data inputs.

Another critical pitfall is the omission of regularly reviewing and updating driver models to ensure continued relevance in a rapidly changing business and market environment. The most significant pitfall of driver forecasting would be when operational leaders do not contribute to and/or endorse the driver model. In this case, a financial forecast becomes an isolated financial exercise that carries little relevance to the operations of the business.

Conclusion

Revenue drivers are one of the most important aspects of a business that determines a company’s financial outcome. Revenue drivers are the link between a company’s day to-day business activities and the financial performance of that company. For the finance professional, the skills needed to identify, analyze, and model revenue drivers represent a core competency as a forecaster. Revenue drivers give finance professionals insight into how a company can increase shareholder value.

At institutions such as FinXL, where the emphasis is on having insight and foresight, the cultivation of a culture of driver-based thinking will allow the finance team to move from being historical reporters of a company’s performance to being creators of a company’s future. Revenue driver-based insights provide the tool and resources to manage complexity, seize opportunities, and build a business that achieves sustainable growth.

As you commence your finance internship and a subsequent career in the finance industry, it is vital to remember that every revenue number has a story. The revenue driver stories of a business, as told through your work in financial forecasting, will inform how a company makes decisions in the future. Through your knowledge of revenue drivers, you will not only have the ability to predict what is coming, but you will also be able to affect what is coming.