First, allow me to deal with a very common problem: Business owners are often afraid to forecast sales.
But, you shouldn't be. Don’t think there is some magic right answer that you don’t know. Don’t think that it’s a matter of training you don’t have. It doesn’t take spreadsheet modeling, much less econometric modeling, to estimate units and price per unit for future sales.
[see-also]How to Create an Expense Budget[/see-also]
I was a vice president of a market research firm for several years, doing expensive forecasts, and I saw many times that there’s nothing better than the educated guess of somebody who knows the business well. All those sophisticated techniques depend on data from the past. And the past, by itself, isn’t the best predictor of the future. You are.
And that also means you should not back off from forecasting because you have a new product, or new business, without past data.
New product or not, your sales forecast won’t accurately predict the future. We know that from the start. What you want is to lay out the sales drivers and interdependencies, to connect the dots, so that as you review plan versus actual results every month, you can easily make course corrections.
If you think sales forecasting is hard, try running a business without a forecast. That’s much harder.
Your sales forecast is also the backbone of your business plan. People measure a business and its growth by sales, and your sales forecast sets the standard for expenses, profits, and growth. The sales forecast is almost always going to be the first set of numbers you’ll track for plan versus actual use, even if you do no other numbers.
If nothing else, just forecast your sales, track plan versus actual results, and make corrections—that’s already business planning.
It’s simple math
For a business plan, make your sales forecast a matter of the next 12 months and the two years after that. Think of it as rows and columns as in the illustration here. Guess your unit, then price per unit, and multiply to get the sales that result. And this illustration is clipped for obvious reasons, but assume you have the rest of the months in your year one, plus your annual estimates for years two and three, flowing to the right.
You don’t sell units? In a pinch, you can just forecast the sales without the units, but consider time as units the way attorneys and accountants do, or trips like taxis and airlines do, or projects or engagements the way consultants do. That makes forecasting easier.
But how do you know what numbers to put into your sales forecast?
The math may be simple, yes, but this is predicting the future, and humans don’t do that well. Don’t try to guess the future accurately for months in advance.
Instead, aim for making clear assumptions and understanding what drives sales, such as web traffic and conversions, in one example, or the direct sales pipeline and leads, in another. And you review results every month, and revise your forecast. Your educated guesses become more accurate over time.
- Experience in the field is a huge advantage. In the example above, Garrett the bike store owner has ample experience with past sales. He doesn’t know accounting or technical forecasting, but he knows his bicycle store and the bicycle business. He’s aware of changes in the market, and his own store’s promotions, and other factors that business owners know. He’s comfortable making educated guesses. In another example, the café startup entrepreneur makes guesses based on her experience as an employee.
- Use past results as a guide. Use results from the recent past if your business has them. Start a forecast by putting last year’s numbers into next year’s forecast, and then focus on what might be different this year from next. Do you have new opportunities that will make sales grow? New marketing activities, promotions? Then increase the forecast. New competition, and new problems? Nobody wants to forecast decreasing sales, but if that’s likely, you need to deal with it by cutting costs or changing your focus.
- Look for drivers. To forecast sales for a new restaurant, first draw a map of tables and chairs and then estimate how many meals per mealtime at capacity, and in the beginning. It’s not a random number; it’s a matter of how many people come in. To forecast sales for a new mobile app, you might get data from the Apple and Android mobile app stores about average downloads for different apps. And a good web search might reveal some anecdotal evidence, blog posts and news stories perhaps, about the ramp-up of existing apps that were successful. Get those numbers and think about how your case might be different. And maybe you drive downloads with a website, so you can predict traffic on your website from past experience and then assume a percentage of web visitors who will download the app.
[see-also]How to Forecast Cash Flow[/see-also]
Estimate direct costs
Direct costs are also called cost of goods sold (COGS) and per-unit costs. Direct costs are important because they help calculate gross margin, which is used as a basis for comparison in financial benchmarks, and are an instant measure (sales less direct costs) of your underlying profitability. For example, I know from benchmarks that an average sporting goods store makes a 34% gross margin. That means that they spend $66 on average to buy the goods they sell for $100.
Not all businesses have direct costs. Service businesses supposedly don't have direct costs, so they have a gross margin of 100%. That may be true for some professionals like accountants and lawyers, but a lot of services do have direct costs. For example, taxis have gasoline and maintenance. So do airlines.
A normal sales forecast includes units, price per unit, sales, direct cost per unit, and direct costs. The math is simple, with the direct costs per unit related to total direct costs the same way price per unit relates to total sales. Multiply the units projected for any time period by the unit direct costs, and that gives you total direct costs. And here too, assume this view is just a cut-out, it flows to the right. And in this example, I projected the direct costs based on the assumption of 68% of sales.
Never forecast in a vacuum
Never think of your sales forecast in a vacuum. It flows from the strategic action plans with their assumptions, milestones, and metrics. Your marketing milestones affect your sales. Your business offering milestones affect your sales. When you change milestones—and you will, because all business plans change—you should change your sales forecast to match.
[see-also]The Key Elements of the Financial Plan[/see-also]
Your sales are supposed to refer to when the ownership changes hands (for products) or when the service is performed (for services). It isn’t a sale when it's ordered, or promised, or even when it’s contracted.
With proper accrual accounting, it is a sale even if it hasn’t been paid for. With so-called cash-based accounting, by the way, it isn’t a sale until it’s paid for. Accrual is better because it gives you a more accurate picture, unless you’re very small and do all your business, both buying and selling, with cash only.
I know that seems simple, but it’s surprising how many people decide to do something different. And the penalty of doing things differently is that then you don’t match the standard, and the bankers, analysts, and investors can’t tell what you meant.
And that goes for direct costs too. The direct costs in your monthly Profit and Loss Statement are supposed to be just the costs associated with that month's sales. Please notice how, in the examples above, the direct costs for the sample bicycle store are linked to the actual unit sales.
Live with your assumptions
Sales forecasting is not about accurately guessing the future. It's about laying out your assumptions so you can manage changes effectively as sales and direct costs come out different from what you expected. Use this to adjust your sales forecast and improve your business by making course corrections to deal with what is working and what isn't.
I believe that even if you do nothing else, by the time you use a sales forecast and review plan versus actual results every month, you are already managing with a business plan. You can't review actual results without looking at what happened, why, and what to do next.
Do you have questions on how to forecast sales for your business? Let us know in the comments.
I like to think of defining flesh and bones as setting the steps. You have a strategy, you've got the heart of your business settled, but you want to set it down into concrete steps you can follow and track.
To follow up on a plan and turn it into effective management, you have to have specifics that you can track and manage. This turns a plan into a planning process, and it makes for management. This chapter deals with the specific steps you can take to make things happen. Remember:
Good business planning is nine parts implementation for every one part strategy.
So here's what's in this chapter.
I call it an action plan but in some ways that's just another buzzword. The real flesh and bones of your plan is what's going to happen, when, who's going to do it, how much is it going to cost, and how much sales will it generate. Strategy is nice, but the real plan-as-you-go business plan is about specifics that you can track and manage. And that's the flesh and bones of the plan.
Here's one element of the plan-as-you-go business plan that you won't see automatically on most other business plan outlines or formats: the review schedule.
One of the lesser know, but more important, facts about planning is that every business plan needs a review schedule. People have to know when the plan will be reviewed, and by whom.
For example, in Palo Alto Software we established the third Thursday of every month as the "plan review meeting" day. In the old days we brought in lunch and took over the conference room. It wasn't a big deal. We were done in 90 minutes. But we scheduled all the meetings as part of the next year's plan, and key team members knew they should be there, and wanted to be there. Absences happened, but only when they were unavoidable.
I speak in the past tense only because after our UK subsidiary managing director was added to the group, those lunch meetings became morning meetings. Our 9 in the morning is London's 5 in the afternoon. Then in 2007 when the new management team took over, the review meetings moved to Wednesdays. But we still have them.
Remember, there's no reason to plan without plan review. I hope I've made that clear throughout this book. A few more tips:
- Try to always start your review meetings with an initial discussion of key assumptions. This is why I say elsewhere that it's so important to list those assumptions where they stay on top of mind.
- Mind the discipline of keeping changes in strategy and changes in assumptions related to each other.
- Keep review meetings as short as possible. One of the biggest threats to efficient effective planning process is too much time in meetings discussing the same things.
- Emphasize metrics. Focus on concrete specific details. Metrics are most important. How do actual metrics compare to plan metrics. Variances, meaning the differences between plan and actual, should be discussed. The obvious metrics are the financial results, but don't let those be the only metrics (refer to Develop Metrics).
- Be keenly aware of the "crystal ball and chain" phenomenon. The risk is that planning becomes a no-win game in which people commit to future metrics that come back to bite them. It's as if it were a management trick to hold over people's heads. Don't let that happen. Make sure planning is collaborative, so that it is always understood that change can happen and when it's managed, is good. Planning helps us manage change; it isn't really just to keep track of how bad we are at predicting the future. Remember, your business plan is always wrong.
Identifying assumptions is extremely important for planning process and the plan-as-you-go business plan. Planning is about managing change, and in today's world, change happens very fast. Assumptions solve the paradox between managing consistency over time, and not banging your head against a brick wall.
Assumptions might be different for each company. There is no set list. What's best is to think about those assumptions as you build your metrics, including sales forecasts and expense budgets, and write them out as much as possible.
The key here is to be able to identity and distinguish between changed assumptions and the difference between planned and actual performance. You don't truly build accountability into a planning process until you have a good list of assumptions that might change.
Some of these assumptions go into a table, with numbers, if you want. For example, you might have a table with interest rates if you're paying off debt, or tax rates, and so on.
Many assumptions deserve special attention. Maybe in bullet points. Maybe in slides. Maybe just a simple list. Keep them on top of your mind, somewhere where they'll come up quickly at review meetings.
Think about event assumptions. Or date assumptions.
- Maybe you're assuming starting dates of one project or another, and these affect other projects. Contingencies pile up.
- Maybe you're assuming product release, or liquor license, or finding a location, or winning the dealership, or choosing the partner, or finding the missing link on the team.
- Maybe you're assuming some technology coming on line at a certain time.
- You're probably assuming some factors in your sales forecast, or your expense budget; if they change, note it, and deal with them as changed assumptions.
- You may be assuming something about competition. How long do you have before the competition does something unexpected? Do you have that on your assumptions list?
Metrics are a critical element of the plan-as-you-go business plan. The planning process requires pulling people into the regular review schedule and helping them care about performance and results. For that, you need to develop metrics.
Recently I listened to an HBR Ideacast interview with Patrick Lencioni, author of The Three Signs of a Miserable Job. Here's a quote from that podcast:
All human beings in any kind of a job need some way to assess their own performance that's objective. It might not be numerical or easily quantitative, but it's somewhat objective and observable by them, because then they are not left to depend upon the opinion or the whim of a manager once a year during a performance appraisal. People need to be able to go home from work every night, or every week, or every month, and know where they stand, and know what they can do to influence how they're working. This is why sales people are generally very satisfied in their job, because they have very clear evidence of their performance. Most people think they are coin operated, but in fact a quota is a wonderful scoreboard for them evaluating themselves, and all people need that.
Sometimes it requires a manager to be very creative in how they come up with that. In my book this one guy works at the drive-through window in a fast-food restaurant and the manager helps him realize that the best way he can measure the impact of his success is to find how many times he can make somebody smile or laugh that comes through his line. So he writes down or records for himself how often he can do that.
We have to give people that sense that they have some measure of control.
This is about metrics. Find ways to help people track progress towards goals. Build numbers into your plan so people can see their own progress, and peers can see each other's progress.
The most obvious metrics are in the financial reports: sales, cost of sales, expenses, and so on.
As you build your planning process, look for metrics throughout the business, aside from what shows up in the financial reports. It's different for every business, and every function in the business. For example:
- What about measuring sales beyond the sales numbers? How about what leads to sales, such as leads, or presentations, or proposals?
- You can measure calls taken, minutes per call.
- Some companies set an objective poll or survey, maybe even something as simple as what you can do at www.surveymonkey.com to measure intangibles like customer satisfaction.
- A software company might measure product quality by tracking support incidents, or incidents by type. It might also measure the effectiveness of support providers by measuring minutes per call, or calls per incident, or by taking a survey of customers after their service transaction is finished.
I find that in general, developing the metrics required to bring your people into the planning process is very important. Get the people involved in how they are going to be measured. Often the team leaders fail to realize how well the players on the team know their specific functions, and how they should be measured.
If you like trendy terms, the buzzword these days is scorecard. Business analysts use scorecard techniques to measure and track performance beyond the simple financial reports.
I love metrics. Metrics in business means some specific set of numbers you measure and get measured by, ideally numbers that anybody can understand. You know you have metrics when you find yourself checking the numbers every morning, every day, or every hour.
I think it's a good thing. It makes a game of it. You get a score. I'm a person who times myself when I run, and I run very slowly, but I still note whether it takes me more or less time on the days I do it. I like scores. I like to compete. I usually compete against myself and my past, but still, I like to compete.
When I was with United Press International in Mexico City, many years ago, every day when we came into the office we had "the logs" as a metric. The logs were a scoring of how many newspapers used our story and how many used the competition's (Associated Press) story. The logs were like a football score. If more newspapers used my story than the AP story, I'd won. Scores were like 12-7, 4-3, 20-1 ... you get the idea. I still remember the one I won 23-1, a story about a mudslide. My lead was people "buried in a tomb of mud" and the newspapers liked it.
Fast-forward to business today. Ideally, every person in the company has his or her own metric to watch. The CEO watches a bunch of them, of course, but the bunch is composed of lots of separate metrics. The customer service rep counts calls taken, or orders. The tech support rep counts issues resolved every day. The product development people watch returns, tech support issues per capita, and issue flow. The finance people watch balances, interest income, and margins. The online webmaster watch visits, pages, pay-per-click yield, orders, sales volume, and search placements.
My vision of a company working well is people checking and sharing their metrics. They are accountable for metrics, and proud when they do well. The goals are built into the plan, and the actual results are compared against the plan regularly. The plan is reviewed and revised and the course is corrected based on, among other things, the metrics.
Of course the metrics have to be the right metrics. Don't track somebody on things they can't control, and don't accidentally use metrics to push the wrong buttons. For example, years ago I had a sales manager who was tracked on sales dollars alone, who also controlled expenses and pricing. Sales went up but margins went way down. That was predictable. Track a customer service agent on call volume alone, or a tech support rep on issues handled, and customer satisfaction will suffer.
The metrics should also be built around a reasonable plan. They need to be aligned with the plan, so they tie directly into strategy.
And metrics have to be tracked. They are part of a larger planning process in which plans are kept alive and reviewed and courses are corrected as assumptions change.
These days I am particularly happy with the flow of the metrics in my job. Until recently I was responsible for the entire company, the CEO. My metrics were all over the map. Sales, profits, cash flow, unit sales, payroll, health, wealth, and the pursuit of happiness, all of which was pretty vague and hard to track. Today I'm still president, but my job is about teaching, writing, speaking, and blogging. And blogging gives me a single set of metrics (traffic, page views, subscribers, etc.) I can watch and enjoy, or suffer, every day. Like back in the old days, at UPI. That's cool.
Adapted from blog.timberry.com
How Analytics Help Build this Champion
Posted by Tom Davenport on January 31, 2008 8:54 AM
Last spring, on baseball’s Opening Day, I confidently identified the Boston Red Sox on these very pages as the eventual World Series winner—based in part on their analytical prowess. You may recall that I was correct in that prediction. This Sunday, I will go out on a much more solid limb and pick the Patriots to triumph in the Super Bowl. I’m more of a baseball guy than a football nut, but fortunately both of the Boston teams I cheer for are not only winners of late, but also heavy users of analytical approaches to their respective games (the Celtics aren’t doing badly either, but I think Kevin Garnett is more of a factor in their success than any statistician).
Like the Red Sox (or any analytically-oriented sports team, for that matter) the primary analytical application for the Pats is selecting the best players for the lowest price. This is particularly critical in the NFL, with its stringent salary cap. In-depth analytics helped the team select its players and conserve its dough. (Until last year the team had only a middle-ranking payroll in the National Football League, but now Tom Brady is getting expensive!) The team selects players using its own scouting services rather than the NFL-generic one that other teams employ; Brady, for example, was the 199th pick in 2000. They rate potential draft choices on such nontraditional factors as intelligence and willingness to subsume personal ego for the benefit of the team (though I had my doubts about their fidelity to that variable when they signed the famously mercurial Randy Moss before this season).
The Patriots also make extensive use of analytics for on-the-field decisions. They employ statistics, for example, to decide whether to punt or “go for it” on fourth down, whether to try for one point or two after a touchdown, and whether to throw out the yellow flag and challenge a referee’s ruling. Both its coaches and players (particularly quarterback Tom Brady) are renowned for their extensive study of game video and statistics, and head coach Bill Belichick has been known to peruse articles by academic economists on statistical probabilities of football outcomes—over breakfast cereal, the legend goes.
Off the field, the team uses detailed analytics to assess and improve the “total fan experience.” At every home game, for example, twenty to twenty-five people have specific assignments to make quantitative measurements of the stadium food, parking, personnel, bathroom cleanliness, and other factors. The team prides itself not only on scoring the most points ever this season, but also on having the lowest wait time for women’s restrooms in the NFL. External vendors of services are monitored for contract renewal and have incentives to improve their performance. This won’t help them win the Super Bowl, but it helps fill Gillette Stadium every home game.
Belichick deserves a lot of credit for the analytical emphasis (God knows, he can’t get by on charm), but so do the team’s owners. Just as the Red Sox owner John Henry moved the Sox in an analytical direction, Bob and (especially, I’m told) Jonathan Kraft believed that analytics could make a difference in football. Jonathan is a Harvard Business School alumnus and a former management consultant. In addition to Belichick, they hired Scott Pioli, a former Wall Street investment analyst and now the “player personnel” guru.
The only thing the Patriots lack is an analytical secret weapon equivalent to Bill James, the god of baseball statistics who acts as a “senior adviser” to the Sox. I’m not sure there is a Bill James of football. If there is, the Pats need to hire him (or her). Such a move could keep the Patriots dynasty going for many years to come.
From Harvard Business' discussionleader.hbsp.com, posted by Tom Davenport on January 31, 2008. URL http://discussionleader.hbsp.com/davenport/2008/01/how_analytics_help_build_this.html
Use a milestones table to plan what's actually going to happen. I have a simple example here. It's not much more than a list of what's supposed to happen, when it starts, when it finished, what's the budget, who's in charge, and -- in this example, at least -- which department is responsible. To me it's the most important table in a business plan, because it's so obviously important for tracking progress and making your planning part of your management.
You don't need to get sophisticated with the milestones. A good list is enough.
Using simple software (meaning Microsoft Excel, Apple iWork, Lotus 1-2-3, and of course, Business Plan Pro), you can sort the list by date, by manager, by department, so you can, for example, use these milestones as agenda setters for the review meetings. Sort by manager to set the discussion points when you work with the people on your team to set expectations and follow up by reviewing results.
When and if you're thinking about plan document output, a set of milestones makes a good chart, like the one below.
This is the bread and butter of real business planning. You can't build implementation unless you put it into meaningful steps. Then, of course, you have to follow up on it, make it happen. Management is setting expectations and following up on results.
This is a simple framework to help you think through the steps to take. The question is how to go from strategy to concrete and practical steps. I developed this idea, and named it the strategy pyramid back in the mid-'80s. I was consulting with the Latin American group of Apple Computer, led by Hector Saldana. I had done the group's annual business plan for three years when Saldana issued a challenge: "We want you to manage our annual plan again this year, but with a difference. This year we want you to sit with us the rest of the year and make sure we actually implement it."
The repeat business for my consulting was good news, but there was a catch. The Apple Latin America group at that time was a collection of a couple dozen young, well-educated, brilliant people. Saldana and I were the only ones over 30 years old. It was hard to keep that group focused. Strategy takes boring consistency to implement. The strategy was desktop publishing, but we'd been working with that for so long that multimedia was much more interesting -- to the managers, but not to the market.
So I came up with the strategy pyramid, which made it possible to track implementation and work on strategic alignment. We used it to build a database of business activities that we called programs and track them back up through tactics and strategy. One strategy, for example, was to emphasize desktop publishing. Tactics used included advertising, pricing of bundles, and distribution channels. The detailed programs were things like advertising insertions, seminar marketing, bundling of hardware and software, and distributor pricing. Each program was assigned a manager, a start date, an end date, and a budget. Sometimes the budget was zero. The database incorporated an input spending amount for every activity, but that didn't involve spending. Leaving a zero was allowed.
The result was strategic alignment. The next year we were able to sort and manage programs according to strategies and tactics. We could show a spending pie divided into pieces representing each of our strategic priorities. We could also track implementation to the level of specific tasks assigned to specific managers, with performance on start date, finish date and budget. In some cases we could even track sales back to projections in the plan. So seminar programs that began with sales projections had to live with sales results.
You can use the strategy pyramid in your own planning. Focus on three or four main strategic priorities and build a conceptual pyramid for each one. Don't sweat the details like definitions of strategies and tactics; just make it work for you, in your business, with your pyramid. Do sweat the details like making programs with specific responsibilities, budgets and projected outputs when possible.
You don't have to be a big company. Apple was a huge company to me in the mid-'80s, because it had more than 1,000 employees; yet the Latin American group had fewer than two dozen people. We made the pyramid work because we wanted to make it work; we wanted to build strategy, not just great parties.
Remember, good business planning is nine parts implementation for every one part strategy.
Adapted from a column for Entrepreneur.com
This is just a thought, a tip, not something you're supposed to do or you have to do. But it might help. The idea of value-based marketing can help you figure out what to do to take your core strategy into specific activities to reach your customers.
- It starts with what the experts call a value proposition. In its simplest forms that is benefit offered minus price charged. Price is relative. So an automaker might offer a more comfortable car at a price premium. Or a safer car or a faster car. A national fast food chain probably offers the value of convenience and reliability, probably at a slight price premium (at least when compared to the weaker chains). A prestigious local restaurant, on the other hand, is offering a completely different set of benefits (luxury, elegance, prestige, for example) at a marked price premium. A graphic designer is probably selling benefits related to communication and advertising, not just drawings.
[see-also]How to Create a Unique Value Proposition[/see-also]
- Then you communicate the value proposition to your customers. The restaurants communicate with customers using their location (drive-through facility, perhaps, or a playground for kids), their menu, and also decor (bright colors for one, fancy table dressings and white tablecloths for another) and signage and lots of other messages. What do you think about a mosty-crab restaurant that plays loud music and has peanut shells covering the floor? And of course there's the more obvious advertising, collaterals, websites, and what employees say, and do, and how they are dressed. For example, if a computer store's business proposition has to do with reliable service for small businesses, peace of mind, and long-term relationships, then it probably shouldn't be taking out full-page newspaper advertisements promising the lowest prices in town on brand-name hardware. It probably should communicate its proposition with sales literature that emphasizes how the computer store will become a strategic ally of its clients. It might also think twice about how it handles overdue bills from customers, who might really be holding out for more service or better support. Look at specific business activities.
- None of this works if you don't deliver on the promise. The expensive restaurant needs to deliver good food well, with good service. The fast-food restaurant needs to deliver food quickly. The automaker claiming safety, speed, reliability, or whatever, has to deliver on those claims.
Where all of this becomes particularly interesting is when what you do doesn't line up with what you say. Or what you promise isn't what you deliver. I worked with a computer store that promised reliability and peace of mind to small-business customers but didn't deliver until it finally revamped its business plan to include more service training, more installation, white delivery vans, and the promise not to cut prices to compete with every box-pushing office superstore.
And the value proposition shows up in all functional areas of the business, not just the sales pitch. For example, do the people who collect the bills know that you are trying to offer your customers superior service? How about the people who receive returns at the customer service counter?
Value-based marketing should be included in the action plan, the activities, most of which are listed on the milestones table. It's a way to give some logic to the actual sales and marketing and administration and related everyday business activities.
You have a marketing strategy. It's the heart of your plan. You've talked it out, probably written it out. You may have done the market research and industry research, or maybe you're just sure of yourself in your market. We used to call it marketing mix, or the three Ps (pricing, promotion, and an artificially forced place to stand for distribution and make the alliteration work). Then it became fashionable to make it four Ps by adding product. And even 5 Ps, to include packaging. The problem, at this point, is knowing what do I do, specifically with each of those Ps. That's the heart of the action plan. One the biggest problems many businesses face is strategic alignment. By that I mean making what you do every day match what you say is your strategy. It's amazing to me how often the daily activities don't match the strategy. That's why I've included the strategy pyramid and the value-based marketing as part of this book. More than that, though, as you fill out the what's-supposed-to-happen parts of your plan-as-you-go plan, I hope you get turned on to new ways of marketing.
Marketing has changed. It's about being remarkable. Don't fill in your marketing plan until you've been through at least one of Seth Godin's books from the list here. I don't know which to recommend. Purple Cow is perhaps the best summary of a new kind of marketing, but All Marketers Are Liars is great reading and makes its points in a more direct way, and Meatball Sundae is the latest, released early in 2008. John Jantsch's Duct Tape Marketing has transformed service marketing for small and medium companies. It's more method than approach. It's full of specific steps to take. And it's very much rooted in the new world of blogs and social media and Web 2.0. Conrad Levinsonand Al Lautenslager's Guerilla Marketing in 30 Days has had remarkable staying power for more than 20 years. It was written before the Internet became widely available, but still managed to foresee a lot of what has happened since then. Levinson was probably the first to free marketing from the corporate budget. What's still critical is the message and how to deliver it, to whom, for how much money. It has to do with focusing on your key target market, figuring out the media, and getting that message across. Marketing is delightfully creative. What you want in your business plan at this point is something specific about what you're going to do, and how much it's going to cost.
||Purple Cow: Transform Your Business by Being Remarkable by Seth GodinRead more about this book...
||Guerilla Marketing in 30 Days (Guerrilla Marketing) by Levinson, Al LautenslagerRead more about this book...
||Duct Tape Marketing: The World's Most Practical Small Business Marketing Guide by John JantschRead more about this book...
||Meatball Sundae: Is Your Marketing out of Sync? by Seth GodinRead more about this book...
||All Marketers Are Liars: The Power of Telling Authentic Stories in a Low-Trust World by Seth GodinRead more about this book...
Aside from the target market strategy, your marketing strategy might also include the positioning statement, pricing, promotion, and whatever else you want to add. You might also want to look at media strategy, business development, or other factors. Strategy is creative and hard to predict. Some of the following sections will give you more ideas.
Positioning Still Matters
Positioning is an old-fashioned buzzword, but it still works. I talked about positioning in the heart of the plan. The question is how do you do it? You can use advertising, marketing collaterals, your website, your employees, so many different methods. Try this positioning statement to help: For [target market description] who [target market need], [this product] [how it meets the need]. Unlike [key competition], it [most important distinguishing feature]. For example, the positioning statement for the original Business Plan Pro, was: "For the businessperson who is starting a new company, launching new products or seeking funding or partners, Business Plan Pro is software that produces professional business plans quickly and easily. Unlike [name omitted], Business Plan Pro does a real business plan, with real insights, not just cookie-cutter fill-in-the-blanks templates."
One of the strongest messages you deliver is your price. It's also the most important tool for positioning. Don't be afraid to price at a premium if you're offering a premium product. In today's world, it isn't true that lower price necessarily delivers higher volume. That may be a standard of microeconomics, but it doesn't happen that often in the real world. Consider your value proposition. Does your pricing fit your strategy?
Promotion Means Telling Your Story
Promotion is a pompous word. I could call it telling your story, or spreading the word. It isn't just what Seth Godin calls shouting, which he uses to refer to traditional advertising that interrupts people. For a lot of today's business, it's very much a matter of website positioning and guessing about search terms to buy from Google. In retail, it's about location, signage, interior design, and the kind of positioning that has to do with what you sell and to whom, for what price. For products going into distribution channels and eventually to retail, packaging is still critical. Consumers in stores make so many of their buying decisions based on packaging. Does the packaging support the underlying story? Do you have strategic alignment with the packaging. Does it match the rest of your positioning? And of course you still have the old standbys, for more traditional marketing.
- Do you look for expensive ads in mass media, or targeted marketing in specialized publications, or even more targeted, with direct mail?
- Do you have a way to leverage the news media, or reviewers?
- Do you advertise more effectively through public relations events, trade shows, newspaper, or radio?
- What about telemarketing, the Web, or even multilevel marketing?
Jim Blasingame, Small Business Advocate, has a website at www.smallbusinessadvocate.com and has an important new book out called The Age of the Customer. I'm on his radio talk show roughly once a month. As I was preparing this section for this book, I was on the radio with Blasingame talking about it and he referred to one of his newsletter articles, which he summarized as "You Say Your Business Plan Every Day."
In that newsletter article he imagines the following conversation:
Me: Hi Joe. Heard you are starting a new business. What kind?
You: Oh, hi Jim. Thanks for asking. Yeah, John and I are going to be selling square widgets to round widget distributors.
Me: How're you going to do that?
You: I found out that no one has thought to offer square widgets to these guys. I asked around, and it looks like these guys not only NEED square widgets, but they will pay a premium for them.
Me: Sounds good. Where are you going to get your square widgets?
You: I found out that the round widget guys don't need the perfect square widgets, so I am buying seconds, cleaning them up a little, and repackaging them for my round widget customers.
Me: Sounds like you found a niche. How many can you sell in a year?
You: We've identified the need for 15,000 this year, and with the trend in the market, we think we can double that within three years. Gotta go. See you later.
How long did this conversation take -- two minutes from start to end? Let's look at what was said. You identified your
- management team;
- business focus (your niche);
- customer profile;
- vendor profile;
- pricing strategy;
- market research; and
- growth plans.
See? You probably "say" your business plan every day, you just might not be getting it down on paper, or in your computer.
This kind of core value is one of your business drivers. This is a lot of what I mean by the heart of the plan, the elevator speech. If you're normal, you're interested in this, you think about it a lot, and you refine and revise it as necessary in a changing world, changing market. Build your business plan around this core, like leaves surrounding the artichoke's heart.
You may not have the need for a complete financial forecast, but it's just a shame to run a business without managing a simple sales forecast, expense budget, and -- if and only if you're planning a startup -- an estimate of startup costs. These are all relatively simple estimates, with relatively simple math, that anybody who is smart enough to run a business can handle.
After all, a lot of the real value of the plan-as-you-go business plan is the tracking, following up, seeing what was different between what actually happened and what was planned. That's much more likely to happen if you have numbers, like sales and expenses, that you can track.
Furthermore, you really should also be aware of the very important cash traps that can kill your business even if it's growing and profitable. These traps are avoidable.
So in this section what I want is to get you into the basic numbers that can run your business. There is so much benefit from tracking the difference between sales forecasts and actual sales; this is where you really get into planning process and managing your business better.
Don't worry, this isn't (yet) a full-blown financial forecast. Don't call your local accountant or management consultant. The math is simple, and although the educated guessing isn't, you can do it, and you are uniquely qualified. Here's what we're going to look at:
- A sales forecast. How to do it, why to do it, what to look for, how much to do.
- Your spending budget. You need to know -- and track changes in -- the money flowing out of your business. This is related to burn rate, fixed and variable costs, and milestones. It's real management. This ought to include just a few of the most important parts of spending:
- costs of sales
- a simple expense budget
- starting costs (this is only if you're planning a startup. If so, you have expenses that will get deducted from future income, and you'll have assets that you'll have to buy. You want to have a good idea of what it takes to get started, before you get halfway there.)
- Cash flow traps. Just so you know, we're going to leave the full-blown financial forecast, with its standard formats, and balances, and accrual accounting and definitions and all, for the following chapter about dressing the plan as needed. But we can't pretend we have you in good shape with numbers if we aren't anticipating the cash-flow traps that can kill even profitable and growing businesses.
There's a scene in one of the Monty Python movies in which the woman on the operating table is about to give birth. Frightened, she asks the doctor--a memorable John Cleese character--"Doctor, doctor, what do I do?"
The doctor, looking down at her with a sneer, answers "You? Nothing. You're not qualified!"
It's a very funny scene. I'm a man. I've been present for several births. I know who does everything. Not the doctor.
And the same strange hesitance shows up a lot when people in business need to forecast. They think somebody else, somebody with more schooling, knows better. Someone else can run the numbers, do an econometric analysis, look at the data better, find the trends.
The truth, however, is that nobody is more qualified than a business owner to forecast her business. You've been there, you've lived through the ups and downs of it, you have the sense of it better than anybody.
For the record, I spent several years as a vice president in a brand-name market research consulting company. Our clients often thought we knew better, because that's how we made our living. And most of the time we were just making educated guesses, like you do when you forecast your own business.
You are qualified. Trust yourself.
And I'm sorry, I just found the scene in YouTube. You can click the link if you don't see the video below. I couldn't resist adding it here. The specific "You're not qualified" moment is at about 1:25:
Think of the weather forecast. You don't have to study the process to know what's going on. In the background, there's a community of meteorologists and public sector agencies gathering lots of data, constantly, on winds and clouds and pressure. The forecast takes that data into account and guesses the future, usually adding human judgment to the mix. For example, in the past, when things looked like this, it usually rained. So they call that a 70 precent chance of rain.
Do you think every weather forecast requires some defined amount of data processing? Or, to ask that question another way, do you ever look at the horizon and see clouds looming or rain in the hills and predict, accurately, that it's going to rain where you are? Of course you do.
Here's an interesting statistic: in Palo Alto, CA, if you predicted today's weather by saying, "It will be the same as yesterday" you'd be right more than 75 percent of the days in a normal year.
Sometimes almost everybody knows the weather by looking at the sky. Sometimes only the data-rich people know the weather because what's coming shows up in the data -- radar, pressures, wind speeds, storms off shore, etc. -- but not in the sky.
Now take this idea to business forecasting. I think you have to get used to the idea that business forecasting, like weather forecasting, is a combination of data gathering and guessing. You want to have as much data as possible before you make an educated guess, because those guesses should be educated.
- You use past results of your own company first -- if you have a company and you have past results -- and think through how and why future results might be different.
- Whether you have past results, you use available industry averages as well. Find out about sales per employee or sales per square foot for your industry. Or use the reverse telephone tree (see sidebar) to get help from people with more industry experience. Look at financial reports published by the publicly traded companies in your industry, because they are required by law to report details.
And remember as you forecast, that it's just the first step. You're not going to live with your forecast for that long, because (at least with the plan-as-you-go business plan) you'll be reviewing and revising as soon as you get results.
So you want to know something you don't know. Here's one way to find out.
Get on the phone. Think of somebody to call first. Come on, you can think of somebody. Somebody who might have some idea. No ideas at all? Then call up the local Small Business Development Center, if you have one near you, or the equivalent development agency, if you're not in the United States. Or call a local bank and ask for somebody who works with business loans. Call the nearest business school. Call your cousin who owns her own business. Call somebody.
Unless you're really lucky, that first person won't have the answers you need. Don't worry. Ask her whom she knows who might have the answer.
Every person you call, ask who else might know.
Eventually, you'll find out as much as you're going to. It's not magic. You don't get to know everything about every subject. Particularly with business planning, sometimes you have to guess.
Your sales forecast is the backbone of your business plan. People measure a business and its growth by sales, and your sales forecast sets the standard for expenses, profits and growth. The sales forecast is almost always going to be the first set of numbers you'll track for plan vs. actual use. This is what you'll do even if you do no other numbers.
When it comes to forecasting sales, don't fall for the trap that says forecasting takes training, mathematics or advanced degrees. Forecasting is mainly educated guessing. So don't expect to get it perfect; just make it reasonable. There's no business owner who isn't qualified to forecast sales -- you don't need a business degree or accountant's certification. What you need is common sense, research of the factors, and motivation to make an educated guess.
Your sales forecast in a business plan should show sales by month for the next 12 months -- at least -- and then by year for the following two to five years. Three years, total, is generally enough for most business plans.
If you have more than one line of sales, show each line separately and add them up. If you have more than ten or so lines of sales, summarize them and consolidate. Remember, this is business planning, not accounting, so it has to be reasonable, but it doesn't need too much detail. Here's an example, from a sales forecast for a local computer retail store.
It's a simple example. You should recognize the arrangement of rows and columns. I'm just showing you a portion of the spreadsheet, because it has to fit on the page.
Notice the predictable structure. First you have units, then prices, then you multiply price times units to get sales. It's simple math, but breaking it up like that makes things easier later on, when you look at what went wrong (and remember, something will go wrong; business plans are always wrong).
Even if you've never done a spreadsheet, you can do this one. The hard part is remembering that you can estimate, you are qualified, and nobody else can do it better. Just take a deep breath, calm down, and make an estimate.
Or, if you prefer, read on. Let's talk about working from past data, estimating entirely new products, your data analysis qualifications, and some other factors. Then you can make your forecast.
You probably know this already, but I'll go over it just in case. I recommend using Business Plan Pro software so you don't have to do this, but it's good to know anyhow, and you can certainly do everything in this book without that software. So here's a bit about spreadsheets.
Spreadsheets are normally arranged in rows and columns, with rows numbered from 1 to whatever, and columns labeled from A to whatever. Simple mathematical formulas refer to the cells that are identified by row and column. For example:
So what we see here is a simple formula that adds the 34 in cell B2 to the 45 in cell C2 to get the sum of those two, which is 79. That number is in cell D2, so you see the formula showing at the top when you click on D2. Also the number in the upper left corner indicates which cell the displayed formula belongs to.
Here's another simple example:
In this case the cell named B5 is highlighted, and its formula says to sum up all the cells from B2 to B4. That's three cells, and the numbers they contain sum up to 128.
There are lots of books and websites and different instructions and tutorials available for spreadsheets. This is enough for now, so you can understand my simple forecast examples.
So you make a sale. When you deliver the goods, you record it as a sale. If the customer didn't pay you immediately, you record the accrued amount as Accounts Receivable.
You order some goods. When you receive them, you don't pay for them. Instead, you record the accrued amount as Accounts Payable.
At the end of the tax year you have some expenses outstanding, like professional services you know you'll be billed for but you haven't been billed yet. You accrue those expenses into the current tax year. They are deductible against income.
In so-called cash basis accounting, the opposite of accrual accounting, you don't put the sale or the purchase onto your books until the money changes hands. With business-to-business sales, the norm is the money changes hands later. So accrual accounting is better. It gives your books a more accurate picture of your financial flow and financial position.
Why does this matter here? Because timing of sales, costs, and expenses makes a difference. Start your forecasts correctly so the can be part of a more formal financial forecast when you finally need one.
Just a quick note. I hope it's obvious. With examples in this book I'm not showing you the full columns of the spreadsheets, because that would be awkward. Numbers would have to be very small and difficult to read. I use my spreadsheets for sales forecasting and other normal monthly projections with a standard layout.
I base my tables on the standard spreadsheet layout as used in Microsoft Excel, Lotus 1-2-3, AppleWorks, Quattro Pro, and even the true pioneer, VisiCalc, the first spreadsheet, from 30 years ago. The rows are labeled from 1 to whatever, and the columns are labeled from A to whatever. When you get past the 26 letters of the alphabet you start over again, with AA, AB, AC, etc.
|Labels in Column A
||Special uses for Column B
||12 Months Monthly in Columns C-N
||Annual Columns as Needed.
|I run the labels along the lefthand side. These might be Sales, Expenses, Profits, etc.
||I keep column B open for variables like growth rates and such. This is convenient for starting balances too.
||My months go off toward the right, one by one, in 12 columns.
||The first year's totals of the numbers from the previous 12 months. Then come the additional years as needed.
Don't reinvent wheels. Please. As you do your sales forecast, be aware that accountants and financial analysts have definite meanings for timing of sales. If you don't deal with this their way, then when you do eventually incorporate the work you've already done on the sales forecast into more formal financial projections, you'll have it wrong. It will look bad.
Timing of Sales
Your sales are supposed to refer to when the ownership changes hands (for products) or when the service is performed (for services). It isn't a sale when it is ordered, or promised, or even when it's contracted. With proper accrual accounting, it is a sale even if it hasn't been paid for. With so-called cash-based accounting, by the way, it isn't a sale until it's paid for. Accrual is better because it gives you a more accurate picture, unless you're very small and do all your business, both buying and selling, with cash only.
I know that seems simple, but it's surprising how many people decide to do something different. And the penalty of doing things differently is that then you don't match the standard, and the bankers, analysts, and investors can't tell what you meant.
Timing of Costs
Costs of sales or direct costs or costs of goods sold are supposed to be timed to match the sale.
For example, when you buy a book from a bookstore, whatever that book cost the store to purchase was an amount added to inventory until you purchased it, and only then, with the purchase, it became an amount added to cost of goods sold.
Notice the timing. It sits in inventory for as long as it takes, but it doesn't get out of inventory and turn into cost of sales until it gets sold.
Messing that up can mess up your financial projections. When sales for the month are $25,000 and cost of goods sold are $10,000, you want the $10,000 to be the costs it took to buy whatever was sold for $25,000. If this month's costs are for things sold last month, or things sold next month, you get bad information.
It's harder to keep track of this sometimes with services. The cost of sales for a taxi ride should be the gas, the maintenance, and the driver's compensation. But accountants would go crazy trying to match the exact gasoline costs to the exact trip, so they estimate a lot. They are always trying to match the months though; costs should be recorded in the same months as the corresponding sales.
Timing of Expenses
Expenses are supposed to show up in the month that they happen. Ideally, travel expenses are attributed to the month you travel, even if you paid the airfare two months earlier. Ideally, advertising expenses are recorded for the month that the ad appears in print, rather than the month when you submitted the ad. And they certainly should not appear in the month in which you pay for the ad, which often is two or three months later. You want the timing to match.
"But I have a new product, how can I forecast for that. There's no history."
Join the club. Lots of people start new businesses, or new groups or divisions or products or territories within existing businesses, and can't turn to existing data to use for forecasting the future.
You're still going to forecast, and don't worry so much about it, because although you'll do it for the next 12 months, you're only going to be grossly inaccurate for the first month. By the second month, you'll have data to use to revise your forecast.
Think of journalists covering a free election. They don't want to wait for the formal official results to be published, so they ask people coming out of polling places how they voted. Maybe those people tell the truth, and maybe not, but there's information to be gathered. They call this exit polls. And if the exit polls surprise people -- they thought Jones was going to win by a landslide but the exit polls indicate Smith is winning -- then the reporters investigate further. Are these early results coming from just one kind of voter (rich, poor, rural, urban, early voter, whatever) and does that one kind of voter favor Smith more than the rest of the voters? Time to apply common sense.
You do the same thing with your forecast that journalists do with elections. You can get what data is available and apply common sense to it, human judgment, and then make your educated guesses. As more information becomes available -- like the first month's sales, for example, then you add that into the mix, and revise or not, depending on how well it matches your expectations.
It's not a one-time forecast that you have to live with as the months go by. It's all part of the plan-as-you-go process.
One of the more powerful drags on business planning in general is what I call fear of forecasting. Lots of people have it.
"How could I possibly know?" is one of the more popular complaints. After all, who can predict the future? How can you know what's going to happen in the market, with the competition, or with new technologies. Isn't it just wasting your time to try to guess?
No, it isn't just wasting your time, because one thing harder to do than forecasting is running a company without a forecast. The real question isn't, How can I possibly know what's going to happen? but, rather, How can I possibly know whether what actually does happen is good or bad or better than expected if I don't know what I thought would happen?
Confusing? Think of it this way: although you forecast for at least a year, you actually go out on a limb only for the next month. In a month, you're going to review that forecast. You're going to see what is different from the forecast, and revise the forecast. Your year doesn't stay static after the first month if results of the first month cast doubt on the whole year.
So don't worry so much; get started with your forecast, and you'll be revising.
Remember, there is no single way to forecast any business. It's often very creative.
Magda was looking at forecasting sales for a small restaurant. She hadn't locked in the location at that point, but she had a pretty good idea of the small size she wanted. She decided she would be able to seat six tables of four people each as a starting point. She knew that things might change when she actually decided on the space to rent, but she had to start somewhere, so six tables of four it was.
Then she did some simple math: six tables of four meant at capacity she would be serving 24 meals. Meals take about an hour at lunch, and about two hours at dinner. She figured she'd have one serving of lunch and two of dinner, roughly calculating the 5 to 5:30 crowd as the first serving, and the 7:30 to 8:00 crowd as the second serving. So an absolutely full lunch service in a day would be 24 lunches. An absolutely full dinner service in a day would be 48 dinners.
She decided that an average lunch would be $10 of food and $2 of beverages. And that an average dinner would be $20 of food and $4 of beverages.
Now let's stop for a second to consider this. Magda isn't turning to some magic information source to find out what her sales will be. She isn't using quadratic equations and she doesn't need an advanced degree in calculus. She does need to have some sense of what to realistically expect. Ideally she's worked in a restaurant or knows somebody who has, so she has some reasonable information to draw on.
So, Magda can do a simple calculation to figure a good day's sales, when she is running at full capacity:
- Lunches are 24 x 10 + 24 x 2, which equals $288.
- Dinners are 48 x 20 + 48 x 4, which equals $1,152.
Having figured out what sales might be in a maximum day, Magda looks at how sales might vary for the days of the week. The provides a weekly base line. It isn't just four weeks per month; multiply an average week times 52, then divide that product by 12 to get an average month. In the example, you can see how Magda estimated conservatively, with fewer dinners on Monday, and closing at lunch on Saturday and Sunday. She knows she's not going to get a full capacity day that often. So she's calculated a baseline month, with around 370 lunches and 1,044 dinners. But she's also just starting up, so she comes up with an educated guess for a lot lower than that, around half the capacity.
These numbers are not magic. The point of this example is simply that Magda has to find a way to make sense of her forecast. As you work with yours, don't look for some answer out there in the world, like a right answer to a puzzle; look for ways to break your assumptions down into the logic you need to work with them.
Magda should get on a computer and put her forecast in a spreadsheet. Make it four rows labeled Lunches, Lunch Beverages, Dinners, and Dinner Beverages. She should also add a row for Other, because there are always miscellaneous sales. Then she can spread these assumptions out with the simple math so she can see them on a month-by-month basis. (See the example below.)
If you don't know how to work a spreadsheet, using formulas for rows and columns, read Spreadsheet Basics. Don't fear the math, or the financing.
By the way, you can represent your forecast graphically, with the right tools. You might draw the line to help yourself visualize the way the numbers flow. Here's an example of how a simple line graph can forecast Magda's lunch sales for the first year.
Remember, please, these are not scientific numbers. They are based on assumptions. Magdo will review these numbers every month and tune them against reality. So therefore she doesn't have to guess right for long stretches into the future; she just has to start with a reasonable guess and then start tracking.
Furthermore, you don't have to be right from the beginning because as your business goes on, you constantly improve your forecast. After the first month, as you look at the second month and all the rest of the forecast, you have the results from the first month to work with. Always review, and revise as the review indicates.
Let's say that when Magda's first-month results are in, lunch sales are much lower than she thought, but dinner sales are slightly higher. (See the figure below.)
This next illustration shows the difference between what was planned and what happened.
Using these numbers, Magda revises her sales forecast for the rest of the year. Why wait? She had a logical first guess based on some simple numbers, but now she already has real-world results. See the next illustration.
And now her sales forecast is up and running. Plan as you go.
Although we probably agree that the best way to forecast sales is by looking at past experience, I know that you can't always count on having that kind of information available to you. So let's think about some other examples. It's never as exact as it sounds. There's a lot of creative guessing. Following are a few ways you might forecast sales of a new business. The point isn't to list the only acceptable methods, but rather to suggest that anything logical might work.
- You want to sell products over your website? OK, find a way to predict traffic. Maybe you can buy search terms. For example, with Google advertising, Google AdWords can help you estimate how many will see the link you buy on the search terms. Then you estimate how many of those people actually click your link. Estimate a very low percentage, less than 1 percent, unless you have the world's most compelling link. Then estimate how many of those actually buy what you're selling. That's a low percentage too. At least with this you've got some mathematical basis for unit sales. And if you're estimating more than one per thousand, be careful -- it's probably too high.
- Doing retail business? Find some estimates of sales per square foot for your type of business. You can do a Web search for that, and you might find something useful. I found annual sales per square foot for Best Buy, Apple, Neiman Marcus, and Tiffany, and learned that Apple does $4,000 per square foot, compared to $2,600 for Tiffany and less than $1,000 for the other two.
- Let's say you've self-published a book you wrote and paid to have the book printed. Forecast your sales through different channels: Amazon.com and competing websites first, then perhaps through distributors to physical bookstores. But can you get that book into distribution? Will bookstores accept you? Use the reverse tree method and call other authors from the same print to see how they did. Do a Web search on self publishing. Start a blog and use search-term advertising to generate readers. Estimate how many people who visit your blog will click a link on it to buy your book. Build your sales forecast according to the places where people can buy the book: online at your site, online at other sites, and physically in stores. Be realistic about how long it takes to get into stores.
- You are opening up a bicycle store in a summer tourist destination. Find an estimate of tourists, then estimate what percent end up renting a bike, then how many units that means, and go from there. Or count bike rentals per day, and build up a forecast from there.
- Selling products through channels of distribution? Maybe estimate unit sales by channels.
- During professional consulting? Estimate by the job, the day, or by the hour. Make assumptions based on leads.
- Lots of companies use pipeline analysis: how many leads per marketing effort, how many presentations per lead, how many closes per presentation.
Whatever your business is, find some numbers and logic for it. Break your assumptions down into units, and price per unit, and make sure there's some way you can check on the logic and revise and track as the numbers flow in. The key to this is watching the actual results.
Business charts are excellent tools for understanding and estimating numbers. Use them to evaluate the projected numbers. When you view your forecast on a business chart, does it look real? Does it make sense? It turns out that most humans sense the relative size of shapes better than they sense numbers, so we see a sales forecast differently when it shows up in a chart. Use the power of the computer to help you visualize your numbers.
For example, consider the monthly sales chart below. You can look at this chart and immediately see the ebbs and flows of sales during the year. Sales go up from January into April, then down from spring into summer, then up again beginning in September. When you look at a chart like that, you should ask yourself whether that pattern is correct. Is that the way your sales go?
Monthly Sales Chart
The next chart shows a comparison of forecasted sales for three years. Here again you can sense the relative size of the numbers in the chart. If you knew the company involved, you'd be able to evaluate and discuss this sales forecast just by looking at the chart. Of course you'd probably want to know more detail about the assumptions behind the forecast, but you'd have a very good initial sense of the numbers.
Annual Sales Chart
When we did the sample restaurant sales forecast, we used a line graph to estimate the seasonality for the restaurant.
If you can, whenever you can, start this year's forecast by putting last year's forecast onto this year's spreadsheet. Then revise as needed. One of the real luxuries of the existing and ongoing company, compared with the startup, is that there is data. You have experience.
As soon as you have a forecast with last year's numbers in it, then you starting thinking about what's going to be different.
- What's new and different this year compared with last year? New products? New business relationships, new channels, new locations maybe?
- What about bad news? Sometimes things are cooling, some new problems are developing. Maybe new competition shows up.
- Will pricing change?
You can look at costs and expenses, too. Normally we assume costs and expenses rising gradually. That's just a general matter of inflation. Is it going to apply for your business in the next year? Why? Or why not?
Costs are among the financial and accounting terms that have specific meanings. You can't just decide to think of them as what makes sense to you, because the accountants and analysts won't understand you. They'll say you are wrong. Ouch. Not pleasant.
So, here are some definitions.
Cost of Sales
The cost of sales is not the expenses related to making a sale. It isn't that lunch with the customer or the trip to go visit the customer and make a pitch. Costs of sales means what it costs you to make or deliver whatever it is you sell. If you don't sell, you don't have any costs. The costs are variable by definition.
- Costs are supposed to be directly related to sales. They are about what it costs you to have or build or deliver what you're selling.
- Costs of a manufactured product include materials and labor. So, for example, the computer costs $200 to build, including $150 in parts and $50 in labor.
- If you just buy an already-built computer and then sell it, the cost is what you paid to buy it.
- If you deliver a service, you still have costs. The taxi or airline has fuel, maintenance, and personnel costs. The law firm has what it pays the lawyers, plus legal assistants, and photocopying and research.
- Costs depend on who and when. For example.
- When you buy a book for $19.95 at the local bookstore, the store's cost of goods sold are whatever it paid to buy that book from the distributor. Let's say it paid $10.50 plus shipping. The store's sales are $19.95 and it's cost of goods sold is $10.50 plus shipping.
- If the distributor bought the book from the publisher for $6.25, then it's sales for the book is $10.50, and its cost of goods sold is $6.25.
- Let's say the publisher had the book printed for $2.00 per copy and it pays the author a royalty of 10%. It's sales for the book is $6.25 and its cost of goods sold is the $2.00 plus $0.652 for royalty. And the publisher probably paid to ship the book to the distributor, which would add another small amount, maybe $0.25 to the cost of goods sold.
- Understand inventory. This comes up again as a cash-flow trap.
- Stuff that's going to become cost of goods sold when it sells starts out as inventory, which is an asset. It sits there in inventory until it sells.
- Think about this in terms of timing and cash flow. The publisher buys the books from the printer and pays for them, which makes them inventory. They sit there for months until the distributor buys them, at which point they become cost of sales. The distributor has them as inventory until it sells them to the store. Then they become cost of sales. The store has the book for as long as it takes, from when it receives it and puts it on the shelf until you buy it.
- The cash-flow trap is that the whole inventory asset doesn't show up on your income statement until you sell the stuff. In the meantime, whether you've paid for it or not, the income statement doesn't care. The money is gone, but the sale hasn't been made. This is a classic cash-flow trap. You won't see it on the income statements. It is completely outside of the realm of profit and loss. But you have spent the money.
Here's where you rate yourself. If these ideas are obvious, then skip this next part; don't worry about it. If you're uncomfortable with these terms, vaguely worried you don't know what they mean, then read on, and in about five minutes, you will.
Fixed vs. Variable Costs
Part One: The Real Case -- Manufacturing Costs
Sometimes this matters, many times it doesn't. Technically, fixed costs are costs that you pay regardless of whether or not you sell anything, or how much you sell. For example, the monthly rental of an installation used exclusively to build stuff would be a fixed cost. It gets technical and surprisingly creative as cost accountants figure out how to allocate fixed costs to the related sales. That was a special course in business school. I found it fascinating, but for business planning purposes, let it go.
We're doing planning, not accounting. Remember?
Part Two Fixed vs. Variable and Risk
Don't worry too much about financial definitions, because in this case at least, they are inherently confusing. Analyists tend to talk about fixed vs. variable costs, but most of the time they are talking about variable costs (as in cost of sales, direct cost of goods, costs of goods sold) vs. fixed expenses (such as payroll and rent). This is not a useful context for distinguishing between costs and expenses. Basically what this is about is trying to figure out how much risk you have in the business.
The big picture is relatively straightforward. The underlying assumption is that your spending has two parts: the fixed part, that you spend no matter what, and the variable part, that you spend only if you make the sale, and for which the level of spending depends (hence the term variable) entirely on the level of sales.
For an example of that, here's a true story. Back in the formative years of Palo Alto Software we chose to pay an outside sales representation company 6 percent of our retail sales, after the fact, rather than hire somebody as an employee to manage retail sales.
The trade-off should be obvious. There's a lot less risk with the variable cost. If we don't get the sale, we paid nothing. If we did get the sale, then we had money from the sale that we could use to pay the variable cost.
Some of your spending is almost always fixed: rent, insurance, payroll, for example. Some of your spending is almost always variable: direct cost of sales, for example.
And some of your spending is hard to classify. The plumber pays the Yellow Page advertisement in the telephone book once a year, regardless of sales levels; but if sales go up because of the ad, she might be tempted to increase the ad size next year. Your website seems like a fixed cost, but many of us in the Web business pay commissions to affiliated sites that help us make the sale.
It's fine-tuning like this that has given us the term "burn rate." That term became particularly popular during the first dotcom boom in the late 1990s. Some Internet companies that had no sales or revenue had lots of money from investors. So they would divide the money they had in the bank by their monthly burn rate (how much money they were spending every month) to calculate how many months of life they had. Without sales or revenue, burn rate became very important. They'd use it to know when to look for more investment, or, in some cases, when to look for a new job. Burn Rate, by Michael Wolff, is a very entertaining book about it. You counted your future as how many months' worth of burn rate you had in the bank, from the investors.
I like using the term burn rate instead of fixed costs. Technically, fixed costs are costs that would stop if you didn't sell. But the burn rate, on the other hand, is how much money you spend every month, without quibbling over whether it's technically fixed costs or not. They are closely related.
All of this becomes more than just idle debate and definitions if you try to do a break-even analysis. I think of break-even as mostly optional, but it's still a good illustration of your basic financial picture. So you might find it worth the effort for a break-even analysis tool. Look in the business calculators of bplans.com. There's also a detailed break-even explanation at hurdlebook.com.
Your Burn Rate
|Suggested Reading Burn Rate
Michael Wolff was by no means the first or the only one to popularize the term burn rate, but his book, Burn Rate: How I Survived the Gold Rush Years on the Internet, cemented the term into the post-Internet dotcom boom business vocabulary.Read more about this book...
Your burn rate is how much you have to spend on an average month to keep your company up and running. That normally includes rent, payroll, and -- unlike the concepts of fixed vs. variable costs -- whatever else you spend in a normal month that isn't directly tied to your sales, which means it isn't automatically paid for by sales, whether it's fixed or variable. So it includes your standard marketing expenses, which would technically be called variable expenses.
I think you should always know your burn rate. I hope you have sales and revenue as well. If your plan calls for burning more money than you're bringing in, then you know you need to be borrowing or finding investment capital.
I also like the burn rate instead of fixed costs as a good number to use in a break-even analysis. In classic financial projections, the kind they still teach in financial analysis courses in business school, you'd use your fixed costs to calculate your break-even point. Burn rate is a newer and better idea.
Some cost estimates go directly along with the sales forecast, because these are costs that you don't incur unless you make the sale. If you haven't already, you might want to read the Understanding Fixed and Variable Costs and Burn Rate, section, with some important definitions. The sidebar here will help too.
So I assume you already have your sales forecast. One of the first things you do with a spending budget is figure out how much it costs you to deliver what you're selling. As I explained in that previous section, this is cost of sales, sometimes called cost of goods sold (COGS) or direct costs, and traditionally means the costs of materials and production of the goods a business sells. In accounting, cost of sales belongs in the month in which the goods or services are actually sold, regardless of when they were purchased or produced.
For a manufacturing company, this refers to materials, labor, and factory overhead. For a retail shop, it would be what the store pays to buy the goods that it sells to its customers. For a consulting company, the cost of sales would be the remuneration paid to the consultants plus costs of research, phocopying, and production of reports and presentations.
If you projected sales in units for your sales forecast, then it should be fairly easy (for most businesses) to figure out what each unit costs you. Then you can multiply that per-unit amount by the units to estimate the costs associated with exactly that month's worth of sales, which is the point. See the illustration below.
If you just project sales by the total amount, then try to estimate the related costs and -- at least as much as you can -- keep the costs in these cases as much as you can in the same month as the related sales. Don't go crazy with it, but try.
|Sample Cost of Sales
|In this sample, there is a unit cost for each of the items the store sells,so you multiply the units from the sales forecast times the per-unit cost to automatically calculate the direct costs of sales.
OK, maybe my example in the last illustration is a bit much, but planning is for everybody, all companies, not just the startups, so what the heck. It's a not-so-small company, but the math is still pretty obvious.
The point is that budgeting expenses is a matter of simple math, common sense, and reasonable guesses, without statistical analysis, mathematical techniques, or any past data. The mathematics is simple; sums of the rows and columns. You've seen it before.
And, as with the sales forecast, you really need to have some idea of these numbers. Either you get it from past data, or you get it from your experience in the industry, or from a partner or team member with experience, or you do some shoe-leather research. Try the reverse telephone tree technique. Look for standard industry data.
Also, remember that even in the worst case, with the roughest estimates, you have to go only one month without having any idea, because by the second month, with plan-as-you-go planning, you have the first month's results to help review and revise.
See the next illustration for a simple expense budget.
Match the depth and detail of your budget to the control and accountability you have on your team. Make it so that the rows are useful for following up later, looking at what was different from the plan and why.
Does your spending match your priorities? Remember the strategy pyramid, intended to help you keep your activities aligned with your strategy? This is where you begin to see it in action.
Aim for the right level of detail for following up. Too much detail makes it very hard to manage and track, and too much aggregation makes it hard to develop accountability. Do you know, in your business, who is responsible for each row in the budget? Does everybody else on the team know?
Before I go too much further, I'd like you to consider how important payroll is as part of you budget. Let's see where those numbers came from. I recommend you record these amounts in a separate table, whose totals flow into the expense budget table.
Payroll is really the most important of your expenses, right? Unless you'reworking all alone, when things get fuzzier, the worst thing that can happen is missing payroll. So that's a number that should really be in your plan, among the simple basic numbers. I hope you agree.
Here too the math, the spreadsheet elements, are pretty simple. It doesn't take advanced analysis or specialized equations. If you have past data and history, it becomes very easy (which is not to say that projecting future pay increases is an easy part of business, but the math and estimation is relatively simple).
This is just one easy way to do organize the data. Lots of people add sophistication to it, like dividing the payroll up into departments, or estimating how many people are in each functional area, then the average pay per person, then multiplying. For now, though, I want to keep things simple as we go.
It's funny how the words come together. Few people do projections, but lots of people do budgeting. They are not that much different. Lots of people hate to forecast. Lots of people hate budgets.
Even the word "budget" conjures up images of disapproving accountants and denied requests: "It's not in the budget" is one of the world's more familiar negatives. No, by any other name, would smell as sour.
But, despite their bad reputation, budgets are always useful tools and are almost essential to the proper running of a business. Budgets are used for planning and for tracking performance against plans. Your plan-as-you-go business plan should always include your spending budget, and that, by the way, when you rename it, is one of your building blocks for your projected income.
Some people think of budgets as normal, not scary. Some people think of forecasts as scary. They are basically the same thing. Take it however it seems easier for you. It shouldn't be that hard to do.
The best and easiest way to create a useful expense budget is to take last year's expenses and run them forward.
Start with an empty spreadsheet, the columns set up to show the months you're running for your plan, presumably 12 months. Then use the row labels on the leftmost column to assign categories. Start with something simple, like rent. Estimate your rent and get it into a standard format. Don't say you don't know, or you have no idea. Take it a little bit at a time, and you'll have something you can work with.
Here's a simple step-by-step way to increase the importance of budgeting and implementation within your business.
- Budget preliminary meeting: Start your budgeting process with a preliminary meeting that brings your main managers together. Discuss strategy and priorities, realistic amounts, and the planning process. Distribute a simple template and ask each manager to prepare a proposed budget for his or her area. Ask the managers to create a proposal that includes monthly numbers, and descriptions of the programs and activities involved.
- Budget development: Allow a period for managers to develop their budgets, working with the standard template. Enforce deadlines for preliminary proposal and revisions. Consolidate the proposed budgets into a single budget table that lists all of the proposed programs and activities. In most cases the total of all proposals will be tow or three times the real amount your company can spend. Share that consolidated table with all managers. Share with them the difference between proposed budgets and actual spending limits, and ask them to think about it.
- Budget discussion: Bring your managers back together to discuss the budget table. Ideally, you set up a conference room with a projector and the consolidated proposed budget. Then you go through the budget, item by item, and pare it down to a realistic amount. Your managers will be together in a group, so they will have to defend different proposals, and as they do they will build up their personal commitments and their ownership of budget items and programs. They will explain why one program is more valuable than another, they will argue about relative value, and they will increase the level of peer-group commitment.
When this process works well, you have a more accurate, more realistic, and more useful budget. You also have a high level of commitment from your managers, who are now motivated to implement the budget as well as possible.
There's a lot of potential confusion about startup costs. You tend to jump right into one of those accounting vocabulary problems that often trip people up, because they want to make things mean what they ought to mean, instead of what standard accounting and financial analysis make them mean.
Startup costs include two kinds of spending. You might not care about the distinction, but standard accounting and finance do, and, more important, the government does. It affects taxes. So take a couple minutes to understand the distinction.
- Expenses. These will be deductible against future profits, so they will eventually reduce taxes; at least they will if you ever make a profit. So keep track of expenses as expenses. These include spending on rent, payroll, travel, meals, consulting, most (but not all) legal expenses, and so on.
- Assets. Money you spend on assets isn't deductible against taxable income, so the bookkeeping is different, like it or not. Assets are things like signs, furniture, fixtures, cars, trucks, buildings, land, and -- harder to deal with -- cash on hand and inventory on hand.
It seems like the toughest estimate to make is what you will need as cash on hand when you start the business. On the one hand, you have people telling you that you need working capital, and on the other, you have to raise it somehow or take it from your own savings and invest it in the business to make it cash on hand.
For expenses, timing is very important. Expenses like rent and payroll are startup expenses until your business is up and running; after that, they are just running expenses, that come out of your profits as deductible against income, so they reduce your taxable income. The only difference between rent paid before the company starts (which is a startup expense) and rent paid during the normal course of the business is timing. When it happens before day one, it's a startup expense. Afterwards, it's a regular business expense.
If you are a startup, then your basic business numbers should include startup costs. Make two simple lists, one of expenses and the other one of assets. You'll need this information to set up initial business balances and to estimate start-up expenses, such as legal fees, stationery design, brochures. Don't underestimate costs.
The following illustration is a typical start-up table for a homebased office, service business -- in this case a resume writing service. The assumptions used in this illustration show how even simple, service-based businesses need some start-up money.
You can see in the illustration how you have two simple lists, one for expenses, and one for assets.
|Startup Costs Table
|Use the start-up requirements worksheet to plan your initial financing
These are estimates. Where do they come from? Part of the planning for a startup is figuring these numbers out. Either you already have a pretty good idea, because you've worked in this area before, or you have somebody in the know, as partner, team member, advisor, or friend, who is helping you. You can also find some industry-specific startup information on the Web and in bookstores. Sometimes a carefully selected sample business plan will help, but if you try that, be careful, because sample business plans are just about one case for one business at one specific location some time in the past. They are not intended to stand for all businesses; you have to know your own case.
You might also make a separate list of the assets instead of just this summary. Other current assets, for example, are things that you need to buy but don't last long enough to be depreciated. That might be coffeemaking equipment, packaging equipment, some printing and layout materials, maybe chairs and tables as well.
If you're looking at starting a company that has significant long-term assets, such as manufacturing equipment, vehicles, or land and buildings, you can also make a list of those.
You don't want to start a company without having a pretty good idea of what you have to spend to get it started.
While budget numbers are simple, budget management is not. To make a budget work, you need to add real management:
- Understand that it's about people. Successful budgeting depends on people management more than anything else. Every budgeted item must be owned by somebody, meaning that the owner has responsibility for spending, authority to spend, and the belief that the spending limit is realistic. People who don't believe in a budget won't try to implement it. People who don't believe that it matters won't worry about a budget either.
- Budget ownership is critical. To own a budget item is to have the authority to spend, and the responsibility for that spending.
- Budgets need to be realistic. Nobody really owns a budget item until she believe the budget amount is realistic. You can't really commit to a budget you don't believe in.
- It's also about following up. Unless the people involved know that somebody will be tracking and following up, they won't honor a budget. Publishing budget plan vs. actual results will make a world of difference. Rewards for budget success and penalties for budget failures can be as simple as meetings where peer group managers share results.
This is a true story, although the names and places have been changed. Everything ended up OK, but there was a lot of unnecessary stress, all of which could have been easily prevented by just a minimum of business planning. This kind of problem happens all the time, and it's so easily preventable, it’s a shame it happens at all. The lesson: Don’t be a victim of unplanned growth.
The story takes place in a midsize university town on the West Coast, during the mid '90s, as the Internet boom took off and most everybody in business and education was getting connected. The main players are Leslie and Terry, co-owners of a consulting business offering computer and network services mostly to local businesses.
At the beginning of this story, Leslie and Terry had a small but comfortable office a few blocks off Main Street, near the university, and a comfortable business, averaging about $20,000 in sales per month with a few steady clients and not a lot of seasonal variations in sales. They had one employee who did the bookkeeping and general administration tasks, maintained office hours and made appointments.
Then came the big, wonderful new job--a contract with a large and fast-growing company to install new Internet facilities in offices on its corporate campus, ten miles up the freeway. This was a $200,000 contract that had to be delivered quickly and opened up an important new relationship with a potential business-changing client. There was great celebration. Leslie and Terry and their spouses started with a fancy dinner in the best restaurant in the area.
Both partners readily got going on fulfilling the contract, delivering the network, connecting the systems, making good on their promises. To make sure the new relationship would be a permanent increase in business, they took on five contractor consultants to deal with the needs of installation, training, and the general increase in business demands.
Within two months, it seemed clear to both partners that they’d made the leap. Systems were being installed, clients were happy, and they were on the road to doubling their business volume in a very short period of time. The contractors were doing good work, and four of the five were happy to consider becoming permanent employees. Leslie and Terry decided they could celebrate more, so they both went to the local car dealer and leased new Mercedes sedans.
Then things started going bad. Like a television loosing its connection, things got fuzzy, then blank. Though sales and profits were way up, jobs were done and invoicing was underway, Leslie and Terry had no money. The contractors -- good people who Leslie and Terry wanted to keep -- needed to be paid, but there was no money. They rushed to their local bank, waving their increased sales and profits, but banks need time. The business suffered the classic problems of unplanned growth. Just as the accounting reports looked brightest, the coffers were empty. People were barely done celebrating, and suddenly they were looking at the disaster of unpaid bills and, much worse, unpaid people.
What happened? Unplanned cash flow problems happened. The new, larger client had a slow process when it came to paying bills, so the jump in sales didn’t mean an immediate jump in cash in the bank. Leslie and Terry were more concerned about delivering good service than delivering necessary paperwork, so their own invoicing process was slow. They were owed about $85,000, but they couldn’t go straight to their new client to get the money -- she said she’d already authorized payment and sent them to the company’s finance department for answers. The people in the finance department were slow to respond and not particularly concerned about vendors getting paid quickly; their job was to pay slowly, but not so slowly as to get a bad credit rating.
Leslie and Terry had a bad case of “receivables starvation" -- money that was owed to them was already showing in sales and profits, but not in the bank. It would have been predictable, and preventable, with a good plan.
In this case, fortunately, the two partners had enough house equity to get a quick loan and pay their contractors. The business was saved and grew, but not without a great deal of stress and strain, and even second mortgages.
The worst moment is worth remembering: One of the partners' spouses was particularly eloquent about the irony of taking on a new mortgage while driving that [profanity omitted] Mercedes.
The moral of the story: Always have a good cash flow plan. Never get caught not knowing the impact of a sudden rush of new business. Get to the bank early, as soon as you know about new business, and start processing a credit line on receivables. And never lease a Mercedes until you’re sure you won’t have to take out a new mortgage a few weeks later.
Adapted from Entrepreneur.com column by Tim Berry, January 10, 2007
Many people can be confused by the accounting distinction between expenses and assets. For example, they would like to record research and development as assets instead of expenses, because those expenses create intellectual property. However, standard accounting and taxation law are both strict on the distinction:
- Expenses are deductible against income, so they reduce taxable income, but expenses cannot be depreciated, ever.
- Assets are not deductible against income, but assets whose value declines over time (usually long-term assets) can be depreciated.
Some people are also confused by the specific definition of startup expenses, startup assets, and startup financing. They would prefer to have a broader, more generic definition that includes, say, expenses incurred during the first year, or the first few months, of the plan. Unfortunately, this would also lead to double counting of expenses and nonstandard financial statements. All the expenses incurred during the first year have to appear in the profit and loss statement of the first year, and all expenses incurred before that have to appear as startup expenses.
This treatment is the only way to correctly deal with the tax implications and the proper assigning of expenses to the time periods in which they belong. Tax authorities and accounting standards are clear on this.
What a company spends to acquire assets is not deductible against income. For example, money spent on inventory is not deductible as an expense at the point when you buy it. Only when the inventory is sold, and therefore becomes cost of goods sold or cost of sales, does it reduce income.
Why You Do Not Want to Capitalize Expenses
Sometimes people want to treat expenses as assets. Ironically, that is usually a bad idea, for several reasons:
- Money spent buying assets is not tax deductible. Money spent on expenses is deductible.
- Capitalizing expenses creates the danger of overstating assets.
- If you capitalize the expense, it appears on your books as an asset. Having useless assets on the accounting books is not a good thing.
Does it matter if you wait longer to get paid by your customers? Only about a million dollars' worth. In this example, the company on the left gets paid by its customers in 45 days on average, and the one on the right in 90 days. Nothing else changes. Assumptions for sales, costs, expenses, and everything else are exactly the same. In the first case, the minimum cash balance is just less than half a million dollars, and in the second case, the one on the right, the cash balance is actually a deficit of more than half a million dollars.
This of the implications. Both scenarios have the same sales of about $6 million per year, with the same profits of about 7% on sales. But the company on the left is doing just fine, and the company on the right is in real trouble, possibly going under.
|Source: Business Plan Pro, AMT Sample Plan, Cash Pilot View. The cash pilot allows instant adjustment of critical cash variables including sales on credit as a percent of sales, collection days, inventory on hand, and payment days. This view shows the scenario on the left with 45 days collection says on average, and the one on the right with 90 days on average.
Profits aren't cash. Profits are an accounting concept; cash is what we spend. We pay the bills and payroll with cash. While the plan-as-you-go business plan doesn't necessarily include a full-blown financial forecast (at least not until needed) it should still be aware of cash balances and cash flow.
This should be a pretty simple concept, but it gets hard because we're trained to think about profits more than cash. It's the general way of the world. When they do the mythical business plan on a napkin, they think about what it costs to build something, and how much more they can sell it for, which means profits.
However, you can be profitable without having any money in the bank. And what's worse is that it tends to happen a lot when you're growing, which turns good news into bad news and catches people unprepared.
Here are some traps you can watch for, to catch cash flow problems before they happen.
Every Dollar of Receivables is A Dollar Less Cash
Although it's not intuitive, it's true that more receivables mean less cash. You can do the analysis pretty quickly. Assets have to be equal to capital minus liabilities, so if you have a dollar of receivables as an asset, that pretty much means you have one dollar less in cash. If your customers had paid you, it would be money, not accounts receivable.
This comes up all the time is business-to-business sales. In most of the world, when a business delivers goods or services to another business, instead of getting the money for the sale right away, there is an invoice and the business customer pays later. That's not always true, but it is the rule, not the exception. We call that sales on credit, by the way, and it has nothing to do with sales paid for by credit card (which, ironically, is usually the same as cash less a couple of days and a couple of percentage points as fees).
We can use this in making financial projections: the more assets you have in receivables, the less in cash.
Example: A company running smoothly with an average of 45 days wait for its receivables has a steady cash flow with a minimum balance of just a little less than $500,000. The same company is more than half a million dollars in deficit when its collection days goes to 90 instead of 45. That's a swing of more than a million dollars between the two assumptions. And that's in a company with less than $10 million annual sales, and fewer than 50 employees.
And the trick is that the profit and loss doesn't care about receivables. You have as much profit when you sell $1,000 that your customers haven't paid yet as when you sell $1,000 that your customers paid instantly in cash. Obviously, the cash flow implications are different in either case.
Every Dollar of Inventory is a Dollar Less Cash
When your business has to buy stuff before it can sell it, that's called inventory. It's one of your assets. And keeping a lot of inventory can do bad things to your cash flow, unless you don't pay for it.
This can be pretty simple math. If having nothing in inventory leaves you with $20,000 in cash, then having $19,000 in inventory leaves you with only $1,000 in cash. That is, if you've paid for the inventory. That's because your other assets, your liabilities, and your capital are all the same.
Sometimes, of course, you cannot pay for that inventory, which means you have more payables, and your cash balance is supported by those payables.
The difference in cash with different assumptions can be startling. You can look ahead to see that in a graphic called What a Difference Two Months Makes.
Every Dollar of Payables is a Dollar More of Cash
While receivables and inventory suck up money by dedicating assets to things that might have been cash but aren't, paying your own bills late is a standard way to protect your cash flow. The same basic math applies, so it you leave your money in cash instead of using it to pay your bills, you have more cash.
It's called accounts payable, meaning money that you owe. Every dollar in accounts payable is a dollar you have in cash that won't be there if you pay that bill. The same problem you have when you sell to businesses is an advantage you have when you are a business. The seller's accounts receivable is the buyer's accounts payable.
Now I don't want to imply that you don't pay your bills, or that it doesn't matter. Your business will have credit problems and a bad reputation if it doesn't pay bills on time, or if it is chronically late with the bills. Still, a lot of businesses use accounts payable to help finance themselves.
The most important problem is getting people who haven't been running companies to believe that cash flow and profits are different. That's so vitally important because, on the surface, it doesn't add up. It isn't believable.
I developed business planning software originally as templates for business-planning clients to deal with the following amazingly typical exchange:
Me: So if you grow faster, then you'll need to get more financing.
They: No, that can't be true, because we're profitable. We make money with each sale, so the more we sell, the more we can fund ourselves.
Me: Bingo! Please sit down here for a few minutes and deal with these numbers.
And so it would go. As soon as you're managing inventory or selling on credit -- which means just about any sale you make to a business -- then your cash flow is waiting in the wings, a silent killer, to foul you up.
I learned this first in business school and then forgot about it. I learned it later again, the hard way, when Palo Alto Software sales tripled in 1995 and that nearly killed the company. Why? How? Well, we experienced a huge sales increase by selling a software product through traditional channels of distribution, meaning stores, and that means selling to distributors who then resell to stores, and that means that it can take five months between selling the product and being paid for the product. In the meantime, you've got to make payroll and pay your vendors.
Yes, it's a good problem to have -- we all want to increase our sales and profits -- but it's a whole lot easier to deal with if you plan the cash implications well.
Often in presentations I use one of my favorite metaphors, the Willamette River as it runs through Eugene, Oregon, where I live. The river slows down coming out of the Cascade Mountains and into Eugene, and it looks deep, slow, and peaceful, but it's much more dangerous there than when it's throwing up white water through the rapids. Why? Because it seems so calm and welcoming. People disrespect its currents, get caught in weeds, branches, or rocks, and ... well that's a good metaphor for the way cash flow hits small businesses when things are good, when sales are growing.
What's particularly painful about the cash-flow problems that come with growth is that, precisely because there is growth, these problems can be prevented by planning.
You can see how the sales are growing, then determine what your cost of sales will be, and look at what you have to pay, to whom, and when. See how your checking account will balance go down and down. Next, chart out when your customers will pay you. It will be obvious if you will run out of money before those profits actually reach your hands. You can then plan how to find the financing to float your boat before you actually hit the snag and sink.
We've had growth spurts since then that were far less painful because we understood the dangers of cash flow, planned for the cash implications of growth, and worked with our bank ahead of time to make sure the working capital was there.
Adapted from an article originally published on blog.timberry.com. All rights reserved.
Image: courtesy of University of Oregon Department of Journalism
In this example, the company on the left keeps one month's worth of inventory, and the one on the right keeps three months. That's the only difference between both of these cash scenarios. The result of the three-month inventory assumption in this case is almost a million dollars of deficit by the end of the year.
|Source: Business Plan Pro, AMT Sample Plan, Cash Pilot View. The cash pilot allows instant adjustment of critical cash variables including sales on credit as a percent of sales, collection days, inventory on hand, and payment days. This view shows the scenario on the left with a month of inventory on average, and the one on the right with three months of inventory on average.
Cash flow problems can kill businesses that might otherwise survive. According to a U.S. Bank study, 82 percent of business failures are due to poor cash management. To prevent this from happening to your business, here are my ten cash flow rules to remember.
- Profits aren't cash; they're accounting. And accounting is a lot more creative than you think. You can't pay bills with profits. Actually, profits can lull you to sleep. If you pay your bills and your customers don't, it's suddenly business hell. You can make profits without making any money.
- Cash flow isn't intuitive. Don't try to do it in your head. Making the sales doesn't necessarily mean you have the money. Incurring the expense doesn't necessarily mean you paid for it already. Inventory is usually bought and paid for and then stored until it becomes cost of sales.
- Growth sucks up cash. It's paradoxical. The best of times can be hiding the worst of times. One of the toughest years my company had was when we doubled sales and almost went broke. We were building things two months in advance and getting the money from sales six months late. Add growth to that and it can be like a Trojan horse, hiding a problem inside a solution. Yes, of course you want to grow; we all want to grow our businesses. But be careful because growth costs cash. It's a matter of working capital. The faster you grow, the more financing you need.
- Business-to-business sales suck up your cash. The simple view is that sales mean money, but when you're a business selling to another business, it's rarely that simple. You deliver the goods or services along with an invoice, and they pay the invoice later. Usually that's months later. And businesses are good customers, so you can't just throw them into collections because then they'll never buy from you again. So you wait. When you sell something to a distributor that sells it to a retailer, you typically get the money four or five months later if you're lucky.
- Inventory sucks up cash. You have to buy your product or build it before you can sell it. Even if you put the product on your shelves and wait to sell it, your suppliers expect to get paid. Here's a simple rule of thumb: Every dollar you have in inventory is a dollar you don't have in cash.
- Working capital is your best survival skill. Technically, working capital is an accounting term for what's left over when you subtract current liabilities from current assets. Practically, it's money in the bank that you use to pay your running costs and expenses and buy inventory while waiting to get paid by your business customers.
- "Receivables" is a four-letter word. (See rule 4.) The money your customers owe you is called accounts receivable. Here's a shortcut to cash planning: Every dollar in accounts receivable is a dollar less cash.
- Bankers hate surprises. Plan ahead. You get no extra points for spontaneity when dealing with banks. If you see a growth spurt coming, a new product opportunity or a problem with customers paying, the sooner you get to the bank armed with charts and a realistic plan, the better off you'll be.
- Watch these three vital metrics: Collection days is a measure of how long you wait to get paid. Inventory turnover is a measure of how long your inventory sits on your working capital and clogs your cash flow. Payment days is how long you wait to pay your vendors. Always monitor these three vital signs of cash flow. Project them 12 months ahead and compare your plan with what actually happens.
- If you're the exception rather than the rule, hooray for you. If all your customers pay you immediately when they buy from you, and you don't buy things before you sell them, then relax. But if you sell to businesses, keep in mind that they usually don't pay immediately.
Adapted with permission from an Entrepreneur.com column. All rights reserved.
This headline caught you because you're planning something new. If you're planning something that's been around for a while, then you do know, or somebody knows, what you've been spending. That gives you past data to help with your planning.
So, for you newbies, first you should know that you're not the first. Everybody who plans something new has to go through that initial stage when you don't have past results as a base. So you estimate.
I get this complaint a lot. "I don't know what my costs are." Or, the interestingly naive alternative to that: "What will my costs be?" The answer is, you'd better know. Here again, if you're never going to get this and don't want to, but you believe in the business, then you either already have somebody who does this or you better find somebody and get him on the team. Teams, remember? Businesses don't have to be teams, but then most of them are, and that's because people are different.
One way or another, if you're going to run your business you're going to have to plan the ebb and flow of money. Deal with it. It's not that hard. Just break it down into pieces. Guess your rent first, or maybe your salaries. Utilities are fairly easy. Health insurance. Don't try to globally guess how much it will be altogether; break it into pieces. Your car. Gasoline and insurance. Maintenance.
And then follow up. Check your plan once a month, compare the plan with the actual results, and improve the plan. Nobody's supposed to know everything, and nobody knows the future, but you can keep making your projections better. The hardest is the first, before you have any results. From there, things improve.
Please, recognize that you either have a pretty good idea of these numbers, or you'd better find out, or you aren't really running a business and you don't actually want to. Or there is somebody on your team that can do this. Or you have to find somebody on your team.