Tuesday, March 8, 2011

Excessive optimism of small businesses

The National Federation of Independent Businesses released today the results of the February survey of small businesses. You can read a summary here, or the original release here.

Among other things, the survey reports the net percentage of businesses that expect higher sales over the next three months--that is the percentage of businesses that expect higher sales minus the percentage of businesses that expect lower sales. The survey shows the same statistics regarding actual sales. I could not resist comparing actual versus expected sales. See the chart below. I present expected sales with a three-month lead, so that both actual and expected correspond to the same three-month period.

Click on the chart to enlarge it.

There is a positive correlation between the two, showing that, generally, higher expectations are followed by higher sales. However, the percentage reporting higher actual sales is almost always lower than the percentage reporting higher expected sales. On the chart, most of the data points fall below the NE-SW diagonal line.

Moreover, the slope of the linear relationship between actual and expected sales growth is far below 1 (0.75, with data between Feb. 1981 and Feb. 2011). For each additional 1% of managers expecting higher sales over the next three months, on net, the net percentage of businesses with actually rising sales is only 0.75%.

Why are small businesses biased about sales growth?

This is not the same as saying that actual sales always falls short of expected sales. I am using a binary variable here, not dollar sales. It is possible that the businesses that get their optimistic forecast right, regarding sales increases, experience a deviation of actual versus expected sales big enough to make up for the shortfall of businesses that get the forecast wrong. But I'm skeptical.

A word of caution is in order: self-reported sales forecasts of small businesses are probably a bit too rosy.

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