One of the best ways to balance your infrastructure investments with revenue and gross profits is to develop basic costs and earning projections.
Admittedly, this is where many entrepreneurs start to panic and may hyperventilate. To quote the immortal words of Douglas Adams, “Don’t Panic.”
Developing a basic costs and earning projection is not as difficult or stressful as it seems. In fact, once you develop a basic financial model for your business, you may actually feel more in control of your business and have a better handle on how to grow your business.
A basic financial projection will give you a new (and often overlooked) view of your business. It has often been said that if your employees and operations are the heart of your business, then cash flow is the lifeblood. By developing a basic preliminary cash flow model for your business, you will be able to better understand what investments are required to get your business off the ground. In the same sense, you will also know what investments are NOT required to support the growth of your business.
Here are the basics on developing solid pro forma projections:
Cost Projections – best practices
Whether you are a new venture or established company with years of operations under your belt, you should consistently understand your costs to operate.
For established businesses, every new product offering and every new market opportunity brings with it new infrastructure investments that need to be made in order to bring that new product or service to market.
In the example of a new technology product, sales team members must learn the features, attributes and benefits of that new product. From a marketing perspective, you need to develop a message and position for that product. Perhaps the engineering team needs to be trained on how to support that product or the technical team will need to spend more time in the lab redeveloping a business solution.
In all cases, time and money are spent bringing any new product or service to market. Generally the larger the scope of the product / service, the more you will invest to bring that product or service to market.
As a best practice, you should conduct what we call an “IBO” or internal business opportunity before making any change to your product or service offerings.
Very simply put, an IBO (internal business opportunity) does the following:
- Clearly defines the products and or services
- Clearly defines the market opportunity associated with the new offering(s) with documented assumptions
- Clearly defines what steps or action items are required to bring the new offering(s) to market
- Provides a basic cost projection for adding infrastructure or the time to bring that product or service to market
- Provides a basic, conservative, earnings projection of what revenues to anticipate from the new offering.
- Combines the costs and gross profit revenue opportunities projected out for a standard period of time (1-3 years) and develops a basic cash flow model for the new offering
- Provides a way to prequalify opportunities and to identify the costs associated with capitalizing on that opportunity, via success metrics and return on investment (ROI) expectations.
The IBO process is just one example of where basic cost projections prove to be beneficial to effectively manage the operations of an existing business.
By understanding how a basic cost projection works and developing a working financial model for your business through integrating your financials (covered later in this series), you will be able to see how the impact of adding new employees, making new marketing expenditures, or adding equipment to your existing overhead affects the profitability of your business.
In addition; when you truly understand your operating costs, you will be able to better understand how to price your products and services.
For new ventures, understanding your basic operating costs and having a cost projection for your business is of paramount importance. Unlike established businesses with years of operating history, new ventures MUST have a way to understand the costs of doing business, the investment necessary to offer products and services; and finally, how those costs ultimately affect their pricing.
One of the most common pitfalls that new businesses face is underestimating the costs and the time that it will take to generate revenue. By developing an accurate cost projection, you will be in a far better position to see potential revenue shortfalls and understand when to make infrastructure investments.
Best practices for developing cost projections:
- Keep in mind the cost of time and human resources
- Be complete – remember that when adding new infrastructure, you must consider all cost factors. For example: when adding a new employee, consider office furniture, office equipment, computer, software, etc
- Start big and then scale down. Sometimes it is easier to begin by adding everything that you want, then to scale down to what you absolutely need. It is better to overestimate than underestimate costs.
Developing a revenue projection for your business is equally important, as it will help you to conservatively guess how much revenue your business will be able to generate to fund your operations. The revenue that you will earn will help you to build a complete picture of when to expect that money (income) will flow into your business. By reconciling your revenue projections (or your top line) against your costs, you have an idea about what your bottom line will look like for your business.
Now for some bad news: there really is only one constant with developing revenue projections. Simply put: you will be wrong. This does not mean that you will never hit the number, but rather that you will most likely come below or above it. The most important factor is to use a “bottom up” approach and a well thought-out method for developing your projection with documented assumptions.
If you are looking for outside capital or investment, remember that your potential investors will be less inclined to allow you to defend the numbers as they are to have you defend the process and assumptions used to arrive at those numbers.
Best practices for earnings / revenue projections:
- Have a completed list of the products and services that you will be offering
- Establish a starting cost for your products and services
- Be conservative and remember to keep a “bottom up” approach when projecting revenues for your business
- Factor in sales cycle time and “ramp up” of your sales effort. Remember that you will most likely not be closing deals on day one. It could take weeks or even months to make your first sale.
- Check revenue projections against employee utilization. This is especially important for services businesses. Be sure to keep in mind the utilization of your technical and sales teams. This is in reference to utilizing a “bottom up” approach.
- Use past history or solid market research as proof points to back your numbers and assumptions.
- Document the assumptions that you make when developing your revenue projections.
- Remember to determine your cost of goods on products and subtract your cost of goods from your gross revenues to determine your gross profit. Gross Profit = (Gross Revenue – Cost of Goods)
How to use “Top Line” and “Bottom Line” projections:
Now that you have developed your cost and revenue projections, you will be able to determine the most important aspect of your business: your projected bottom line. By comparing or reconciling your projected gross profits (gross revenue minus cost of goods) against your projected costs, you should be able to build a picture of what out of pocket expenditure or investment is required to capitalize your business.
For example, let’s just say that your first month’s costs are $25,000. Say your projection is to earn $3,000 in gross profit revenue for month one. This means that you will have a deficit of $22,000 in your first month. You would continue this same analysis until you hit your company’s BEP (break-even point).
By adding your deficits, you will have a rough idea about how much capital you will need to fund your business. Once you have this number, we suggest adding (at least) an additional 50%. This will build a “cushion” if your revenue projections are below what you expect.
This is where you need to make a decision. You can raise the money that you need to fund the business or you can adjust your operations infrastructure to be leaner; thus reducing the amount of capital that you need to invest in the business or the business opportunity.
Regardless of which direction you choose, you will have an educated guess as to what investments to make, where to make cuts and (most importantly) where there are financial shortfalls. This will allow you to make plans to adequately capitalize your business.