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 slaes 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.
Ideally, every line in a budget is assigned to somebody who is responsible for managing that budget. In most cases you'll have groups of budget lines assigned to specific people and a budgeting process that emphasizes commitment and responsibility. You'll also need to make sure that everybody involved knows that results will be followed up. The ideal plan relates the budgets to the milestones table, shown below. The milestones table takes all the important activities included in a business plan and assigns them to specific managers, with specific dates and budgets. It also tracks completion of the milestones and actual results compared with planned results.
The Milestones Table
The milestones are the heart and core of the business plan. Using the milestones table will assign responsibility and authority to the expense budget plans.
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.
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.
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.