At the outset of the budgeting process, how do you assess what would be a reasonable profit? In my experience, most managers look backwards, to last year's profits, and say 'we need to make a bit more than that'. That might have been workable in more stable times, but these days, it is positively dangerous.
What constitutes a reasonable profit is a function, not of last year's profit, but of this year's cost of capital. As the cost of capital has been falling in recent years (thanks to low interest rates) trying to 'beat' last year's profits leads to seeking higher selling prices than are justified. Fine if you can make them stick, but what you are more likely to find is that competitors who are more alert to money market movements choose to undercut you, and take volume away from you. In economic terms, you are consciously under-estimating the elasticity of demand.
Companies quoted on the London stock market are especially prone to this failing. Under irrational pressure from institutional investors, they aim to show steadily rising profits. The big supermarkets are a good example in that - quite suddenly and to their surprise - they found themselves losing market share to the discounters. Initial reactions included putting pressure on suppliers to reduce their prices (below those charged to the discounters!) to accept later payment of amounts due, to pay lump sums to continue to supply, and - it would appear - distorting accounting policies in order to report profits earlier than would fit the prudence requirement. Heads rolled, and new strategies were adopted that were closer to reality, but this isn’t how capitalism is supposed to work!
As time goes by, you need to spend less time looking backwards and more looking forwards.
David Allen's latest course is entitled Forecasting for Financial Managers.
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