Background

In the fall of each year, our management team ceremoniously huddles in our wise chairman's office to review results year-to-date against our plan and, perhaps most importantly, to gaze into the crystal ball that has been handed down through generations of management at Berkheimer, to discover what will transpire in the coming year.

Not unlike many economists, this very elegant process has accurately predicted six of the last three housing booms and eight of the last five recessions! Given its remarkable track record, the process has served the company well during its many years in business, and has spared management the need to spend many hours sifting through and analyzing the multitude of economic, market, customer and financial data available. We're just being facetious of course, but often wish it were this easy!

In reality, for 2011, we are forecasting growth of approximating 8 percent — consisting of 3 percent inflation and 5 percent real demand growth. How did we get to that number? Well, in some circles, they might consider the approach we use somewhat unorthodox, in that we largely “begin with the end in mind” and essentially work backward from that point.

The approach consists of asking three basic questions: (1) What do we want the forecast to be? (2) Is what we want realistically achievable? and (3) How do we make it happen?

I. Beginning with the End in Mind

In setting out to determine our forecast for 2011, we started out by looking at what we wanted to accomplish in terms of an overall return-on-investment objective for the company. As an ESOP company, we traditionally try to develop our forecast based on an adherence to fairly conservative principles and fundamental financial measures. We rely heavily on benchmark data we receive through HARDI and other trade associations — especially information provided through our participation in the HARDI Benchmarking programs as well as information from the Institute for Trend Research (ITR) disseminated through HARDI on a monthly and quarterly basis. Based on the most recent benchmarking data, the HARDI Profit Report indicates an average pretax ROI of 5 percent overall and about 20 percent for the high-profit group of HVACR wholesalers.

After establishing an ROI objective, we took a close look at our cost structure and made some reasonable assumptions or predictions as to where we think costs would be increasing or decreasing.

For a typical wholesaler such as ourselves, the primary categories are people (wages, salaries, benefits, etc.) and facilities. People and related costs often range between 55 to 65 percent of gross margin dollars; facilities and related costs often range between 10 to 15 percent of gross margin. So we give the greatest degree of focus to these areas but we also give careful attention to other expense areas. Some changes relating to these areas are quite predictable; others require us to make a few reasonable assumptions (for example, if we suspect that healthcare inflation and/or utilization will go up in 2011, as a result of recently legislated changes to coverage, we apply a figure to our current healthcare costs to arrive at where it will likely be in the coming year).

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After having made a good estimate of where we expect to be with respect to operating costs, we then “backed-in” to the gross profit dollars needed to be earned in order to cover those expenses and yield a net operating profit consistent with the goal we have set for ourselves. From that point, we applied an overall gross profit percentage figure that we believe can be reasonably achieved, and used that figure to calculate a net sales amount. We typically manipulated the net sales figure up or down a bit in order to hit the pretax return on our sales goal. Once we were reasonably satisfied as to what this “preliminary” net sales figure will be, we then compared it to the preceding year's expected results to arrive at the preliminary growth forecast for the coming year. Based on our analysis from an ROI perspective, the forecast result indicated desired growth in a range of 5 to 10 percent.

Of course, this represents the easiest step in the forecasting process. Our next big step was to make an assessment of whether or not “what we want” is grounded in reality in terms of what we can realistically achieve. This is where the true spade work actually began.

II. Bottoms-Up

With respect to forecasting, we have traditionally used a substantially “bottoms-up” approach to testing, whether or not our preliminary forecast is realistic and achievable. This is where formal and informal data and information are gathered, “where the action is,” primarily through input directly from our outside sales teams and branch operations. Each outside sales representative, working with branch and sales management, is responsible for developing a reasonable forecast for his or her respective sales territory for the coming year. This includes providing an estimate for sales to existing accounts and to prospective accounts. Much of this information comes directly or indirectly from the accounts those representatives are calling on.

We employ a similar process with branch managers in order to cover accounts that might not have specific assignments to an outside sales representative and our over-the-counter customers. This step serves two important purposes: 1) The information is, for the most part, “coming from the horse's mouth.” Some of that input may be subjective and anecdotal, and some is objective. Most of it is important in terms of gauging the attitude and relative confidence level of customers and prospects with respect to what they are anticipating for next year. 2) It begins the process of achieving “buy-in” and credibility at every level of the organization with respect to our ultimate forecast for the year. Although this part of our process is a work-in-progress at the time of this writing, preliminary indications show 2011 forecasts of a minimum 7 to 10 percent improvement over the current period, based on this bottoms-up approach to arriving at our 2011 forecast of growth.

III. Sanity Check

On average, HVACR industry performance generally tracks growth or contraction in the economy as a whole (with some regional variances and adjustments for inflation). So, it is also important to gauge how realistic our internal forecast for 2011 is relative to the economy as a whole, and in particular with respect to the regions in which we do business. As a result, another critical component driving our forecast for 2011 is our analysis of economic and trend data pertaining to our market regions especially and the economy in general. There are numerous and sundry sources for this information, some of it internally generated, but much of it derived from external resources.

From an internal perspective, we regularly track and review our 12-month rolling trend for absolute net sales dollars, and for percent change in the rolling 12-month net sales (i.e., year-over-year change). This data provides a good snapshot of the company's sales trend: Is it trending downward or upward; what is the relative slope of that trendline; is it basically flat — indicating slow or no growth; is it steep, or perhaps going off a cliff? For example, in the earlier part of 2010, this analysis revealed a very gradual, but nonetheless upward, trend in rolling 12-month performance, after having experienced several months of quite the opposite. In fact, it quickly becomes evident almost exactly when the downturn in the economy began to occur (at least in our regions); in many respects, this analysis is predictive of the current, gradual upward trend. (See chart below.)

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We also review trends in particular customer segments, product lines and geographic market areas: Are college towns performing better than metropolitan areas? Are hospitals and government institutions faring better or worse than residential or commercial contractor segments? Are parts and supplies performing better than replacement equipment?

Externally, we look closely at traditional economic indicators, especially housing starts and permit data, mortgage and lending rates, construction activity, unemployment expectations, disposable income, CPI trends, interest rates and other information readily available on a national, regional and, in some instances, local market level. For example, at the time of this writing, data from the U. S. Economic Outlook report from the BMO Capital Markets group indicated GDP growth of 2.2 percent for 2011, inflation of 1.3 percent, housing starts moving from 590,000 to 680,000 units, unemployment of 9.5 percent and relatively steady interest rates.

We also listen to our vendor partners, bankers and other professionals, who often provide information relevant to the markets we do business in. On the banking side, the J.P. Morgan North American Equity Research Group recently released a comprehensive and optimistic report on the HVACR industry, suggesting it should achieve a compound annual growth rate averaging 7 percent through 2013, based on their analysis of pent-up replacement demand and energy-efficiency initiatives. As a follow-up to that report, the group indicated that they believe the base case for demand growth in residential HVACR in 2011 will be 5 percent. Once again, we have relied on trade association data and information, particularly that provided through HARDI from ITR. In their Fall 2010 “T.R.E.N.D.S.” report, ITR predicted 2011 growth in housing permits for our market regions ranging from 4.1 percent to 7.6 percent. We have found their data to be helpful and an accurate reflection of what has ultimately occurred in our market areas.

Finally, in terms of applying a sanity check to our 2011 preliminary forecast, we looked at unique factors influencing the industry and our markets. For example, in 2011, the phenomena of dry-charge units, with generally favorable affordability and perceived installation advantages, will probably add incremental volume to the equipment side of the business, which may not have otherwise materialized. Other factors, such as pent-up demand for replacement units, continued consumer interest in better energy efficiency and other regulatory matters, were also brought into the equation in assessing the reasonableness of our 2011 forecast.

Consensus and Commencement

After considering all relevant factors, we “triangulated” to our final forecast of 8 percent growth for 2011. The next key step taken has been development and execution of the plan to achieve and hopefully exceed this goal in 2011. Here we actually looked at each of our key customer segments and product lines within each market area to determine where specific opportunities exist.

Most importantly, throughout our forecasting process, the sales and operations teams concurrently identified their specific business opportunities on a customer-by-customer, branch-by-branch and market-by-market basis. The results of these efforts were rolled together, culminating with the company's detailed full forecast for the year. Populating our system with this data puts us in a position to track, on a daily basis, our 2011 performance against forecast, and enables us to make adjustments to the business as necessary during the year.

Of course, because we have yet to determine how to predict the weather, we will occasionally revert to gazing into the crystal ball….


Jim Beecher is chief financial officer for Portage, IN-based G.W. Berkheimer Co. Inc. Contact him at 219/764-5200 or jimbeecher@gwberkheimer.com.