Earlier this month in this space, we discussed the importance of developing a good Financial Projection for your small business. You start by defining (as best you can) your long-term idea of where the business is headed. If armed with a solid vision of your “finish line”, your trusted advisor can help you create (or renew) the business model that points you in that direction.
So, what about that business model? How does it become a Projection that sets you on the right course? First, don’t confuse a “Budget” with a “Projection.” A “Budget” is only meaningful if it is tied to a solid Projection. A Budget is simply how much financial resource you are willing to spend in a certain area of your business, within a certain time frame. A Projection is your entire business model, expressed in numbers (not words). I often say, “Accounting is a language” and your financial projection tells a story of where you are going, and how you are going to get there.
Start your financial projection at the top of the Income Statement, with Gross Revenues. The first thing you need to determine is:
- How Many – what number of products or services are you going to sell in the coming year); and
- Times Price – the prices that you obtain for those goods and services.
This is not an easy task. Instead of doing the hard work above (scheduling out your expected Revenue based on a work pipeline, pre-orders, and/or knowing your customers’ demand), many business owners take the “too quick and easy” approach of simply taking last year’s numbers and adding some arbitrary growth percentage. You need to get more granular than that – more detailed. Remember, this Projection is (or should be) the document you use to measure success and inform your decisions – precision is not a luxury, it is a necessity!
Now, we need Cost of Revenue (a.k.a. “Cost of Goods Sold”). In accounting, every time you make a Sale, you make an entry in the books for how much it cost you to create that Sale (cost of materials, labor, and maybe equipment). When you have successfully described how much is your Cost of Goods Sold relative to Sales, you have firmly established your Gross Profit and your Gross Margin (which is Gross Profit/Total Revenues). And that is important, because Gross Profit is what pays the bills.
Those bills are commonly known as Overhead. Overhead encompasses all of those “costs of being in business” that are not directly related to every single Sale. As we noted above, many business owners make the mistake here of projecting “off of last year’s” numbers. Resist that impulse. This is where the Budget component comes in. Each area of Overhead (e.g. “Sales and Marketing,” “Rent/Occupancy,”, etc.) should command a purposeful and clearly defined share of the business’ Gross Profit.
Your trusted advisor can help you develop this forward-looking projection of Gross Profit and Overhead, leading, of course, to the calculation of the bottom-line profit that is your Return on Investment – also known as “the reason you are in business in the first place!” Get a handle on those projections before another so-so year in business passes you by.