Avoid This Common Mistake: Extrapolation
Business leaders often extrapolate past trends into the future. But what if next year will be very different from past years?
Mark Zuckerberg, CEO of Meta, Sundar Pichai, CEO of Google's parent Alphabet, and Andy Jassy, CEO of Amazon, attributed their announced layoffs with overhiring during the pandemic years because they had assumed that the surge in demand for their services was permanent.
It turned out differently because most of the additional business appeared to have been an anomaly requiring less staff after the spike receded.
As an outsider, I was surprised that these CEOs and their organizations seem to have fallen victim to a common mistake: extrapolation — the prediction of the future based on past trends.
Unfortunately, extrapolation is often used in business planning when companies base next year's budget on this year's results and past growth rates. It's a widespread shortcut that saves a lot of time. But it can be a dangerous shortcut, especially for small businesses with less margin of error.
For example, you consider signing a long-term lease for a larger store or office space, anticipating your business will continue to grow. Or you ponder taking out a loan to invest in new machinery, which would double your production capacity to meet a demand that you extrapolated from past trends in sales volume.
It might work out fine. But what if next year will be very different from past years? The onset of a severe recession, the entry of a new competitor, the emergence of disruptive technology, or the loss of a key customer could jeopardize any extrapolated plan. Do you know how much your sales volume and profit would change if any of these events occurred?
In addition to sudden downside risks, there could be upside opportunities that can come up unexpectedly. A competitor who wants to retire and is ready to sell, a co-branding partnership with a well-recognized company, or an endorsement from a famous social media influencer are opportunities that could suddenly change the trajectory of your business and render your plan obsolete.
Cost Cutting Is Not a Growth Strategy: Cutting costs can inadvertently make your profitability problem worse.
Think in Scenarios of Risks and Opportunities
Being an entrepreneur often means taking risks. But not any risk. Entrepreneurs are not gamblers. Entrepreneurs take calculated risks, those that wouldn't break their company if they materialized. They also dedicate much effort to mitigate any risk as much as possible. Should something still go wrong, they won't be surprised. On the contrary, they are prepared and know what to do because, in their planning, they have already played out a similar scenario.
In my experience, many small business owners often kick the can down the road and spend too little time thinking about risks and opportunities and how they could impact their business operationally and financially.
Instead, I recommend proactively dealing with the bad and good things that could happen.
Develop different scenarios for each risk and opportunity and try to predict the impact on your operations and finances.
Your predictions don't have to be meticulous; predicting the future is always imperfect. So, don't spend too much time on getting it right. Rather, the goal is for you to get a feel for the range of operational and financial outcomes. These scenarios can help you better understand which kinds of risks to avoid and which kinds of opportunities to pursue and serve as a reliable anchor for next year's plan(s). You'll soon discover these plans are more meaningful than those relying solely on extrapolations.
Why Margins Matter More Than Revenues: High-revenue orders tend to be more complex and therefore require additional staff to deal with problems as soon as they arise, reducing their profitability.
Do You Need a Business Plan? A business plan aligns your dreams with your financial means and company goals. But this is not the most important reason you should develop one.
