How to Base Expenses from Revenue
Suppose you are wondering how much you can spend next year. You wonder if you can afford to hire someone or if you have the cash flow for advertising, operating expenses, or possibly expanding.
Do these thoughts come to mind as you think about your business?
For example, this week I had a discussion with a client about the value and importance of revenue forecasting. See “It All Starts With Revenue” for more. He was only concerned with revenue he already knows. Although this is a conservative approach, it is missing out on revenue from prospects and unidentified sources. Why is this important? Are you wanting to hire people, spend money on advertising or cash flow? How can you answer any of this without revenue?
I will get into some quick expense forecasting soon, but I wanted to put another picture in your mind. We all look at the weather forecast. We know it is somewhat inaccurate, especially the further out the forecast goes. What if the weather forecast is made today for 2 weeks from now and never updated? This would be unreasonable. We are expecting the weather forecast to be updated multiple times a day and get more accurate as we get closer to the date 2 weeks from now. What if we did the same for our business? Would we just put together one forecast and leave it alone?
The smaller your business, the more flexible it needs to be.
We need to understand revenue, and once we get that ever changing forecast plan in place, forecast expenses.
Below are key categories for expenses:
1. Cost of Goods Sold or Services
In order to forecast Cost of Goods Sold or Services, have an understanding of your product or service margins. As your revenue increases, the Cost of Goods Sold or margin will change accordingly. The key to a good forecast is to forecast your margin percentage and have the Cost of Goods Sold or Services change automatically when revenue changes. Remember, you want to quickly update the forecast as things change.
2. Personnel Expenses
How can you possibly forecast this without knowing revenue? Hiring for most positions should be based on revenue. First, come up with a statistic such as revenue per employee to be a guide for when you should hire. It is helpful to list actual positions for staff planning. Suppose you don’t have time to do a full staff plan. Try the following:
- Come up with a monthly revenue per person you would like, such as $15,000.
- For each increase in $15,000 in revenue in the revenue plan, add a new person.
- Multiply all new people by the average pay per person.
- Any higher paid position will require adjustment.
- Calculate Payroll Tax, Insurance or Retirement costs as a percentage of Salary & Wages.
3. Operating Costs
Operating expense are usually marketing, travel, office expense, rent, depreciation, software and professional fees. There are other smaller expenses which you can put in a miscellaneous expense category. Don’t get too bogged down with the small expenses when putting a forecast together. Just make sure that the expenses in total are in the plan.
You can also forecast much of this as a percentage of revenue.
In short, you have to start with a good revenue forecast and make sure you can change this regularly. A good forecast will have most expenses automatically adjust as revenue changes. Also, forecast Cost of Goods Sold or Services, Personnel Expenses, and Operating Expenses to change based on revenue.
Now you have an Income Statement that is an important step for success.
What is keeping you from putting a plan like this together for your business?
By: Shane Bender
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