this week’s biz ladies post comes from lynne robinson of the UK-based shop papermash. as an accountant, lynne has had many years of number crunching and analysis, and now shares with us some key budgeting and forecasting principles for running a profitable business. thanks lynne for teaching us the ins-and-outs of financial planning!-stephanie
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Making a financial plan
You should make a financial plan or budget before you even start in business. I have met many small business owners who do not have any idea of how much they need to sell before they can draw a salary. By making a plan before you start, you will discover whether your idea is even viable – and this will inform everything, from your pricing to your marketing strategy. It will also give you a sense of timescale – as it is unlikely to be the case that you can pay yourself a salary straight away. If you’re happy to work full-time, and have a small business as a hobby, then it may not be that important – but if you are desperate to quit your job and want to know when that will be, it’s really important to make a plan.
If you can use Excel, it should be possible to do most of these projections yourself. If not, ask someone to help you, but it will be useful and important for you to have thought through the assumptions surrounding your business yourself. Most of this article will be about projecting a profit and loss account – which will tell you if, in theory, you will be able to pay yourself a salary.
How to plan a budget
A budget is worked out for one year at a time. Split each month out individually.
A profit and loss account is basically sales less all the costs of running your business. If this does not add up to a positive figure, you will be making a loss, and your business may not be viable (unless an early loss is strategic and it will still make a profit in future years.)
How to make assumptions
It is much easier to set a budget if you have sales history. This does not mean that there are not some ways of gathering information.
If you plan to sell on Etsy, for example, you could look at the ‘sold’ section of a competitor’s shop, to get an idea of how many they sell.
If there is someone in the same line of business who is a limited company (in the UK) or incorporated as an LLC in the US, their accounts should be publicly available. In the UK, you can get the accounts of any limited company from Companies House. Before I started my business, I researched several mail order companies which I knew sold items of a similar value to mine, to give me an indication of whether they made a profit.
Networking – if you make friends with other small business owners, they may give you some useful tips. It’s unlikely that they will tell you their sales figures, but they might reveal something useful. For example, many designers have told me that they do not always cover the cost of selling at craft fairs – so you might not want to budget for huge sales at each craft fair you attend. Another retailer told me how press reliant her business is, which has challenged my assumption of planning for growth each month.
Sales will be the amount you get in, less any returns, or Paypal, Etsy and other fees (for example, my store uses Shopify, which also charges a % on top of my Paypal fees, as well as a monthly flat rate amount.)
You should split these lines out separately so you can track them individually, and use a % where applicable, eg your Paypal fees will be an average % of your gross sale. Using %s instead of absolute amounts will make it easier to update your figures when you change certain variables.
It will be difficult to project sales for the first year, so I would estimate a conservative amount, unless your best friend is editor at Vogue and you are guaranteed instant press coverage.
You could also budget per item you are selling, as long as you aren’t selling 1,000 different lines – when I worked in publishing, we budgeted all of the new titles each year by title.
If you have different lines of business you should also budget for these separately. For example, if you are selling direct to customers, but also have a wholesale line, you should budget for these separately as your sales and margin will be very different on each.
If you have any large events in the year which might increase sales, you could budget for them specifically, too. If, for example, if you have a large trade fair coming up, you may want to budget for an uplift in sales in the months after the fair (which may be continuing if they become regular customers.)
You should take into account that you may have some sales tax to pay. I’m not sure about US taxes, but in the UK, you have to be VAT (value added tax) registered after your sales have reached £70,000. So, if your prices remain standard and VAT inclusive, you will have less sales revenue, as you have to pay the government 17.5% on each sale. For example, if at the minute I sell something for £10, my business makes £10 (ignoring Paypal fees for now.) When I am VAT registered, if my same item is still £10 and is VAT inclusive, I have to pay the government £1.48 and my business only gets £8.51 (I can also reclaim the VAT on my purchases, but it might affect my margin overall.)
For Papermash, I estimated my sales on a daily order level. So, for example, if I estimated I would have 1 customer a day, I multiply this by an average order value (which was just an estimate), by the number of days in a month.
For the subsequent months, I estimated my sales would grow a little, so I applied a % growth to the previous month’s customers (for example, if I multiplied my 1 customer by 1.1 (an increase of 10%), I would have 1.1 customers in the next month – and so on. It is good to keep assumptions separate in Excel if you can. If, for example, I keep 10% in a separate cell in Excel, for example cell A1, and make my growth formula 1+A1, instead of 1.1, I can easily change that one cell and it will update all of my sales figures.
Cost of sales: This will be the direct costs of making your items. If you are making something, this will include the cost of your materials, plus any direct costs which relate specifically to making your item. If you are a retailer it will include the wholesale price you paid for them plus the shipping charge and any other fees such as an import processing fee.
The easiest way to budget this is probably to use a standard %, unless your goods are exactly the same cost, as again it will update if you change your sales variable. So, if the goods retail for $1 and sell for 50 cents, then I just apply a standard % of 50%.
Gross profit is Sales less Cost of sales. Your gross margin % is Gross Profit divided by Sales.
Shipping: include the cost of posting plus the cost of packaging (it is useful to work this out on a per order basis too, as it will give you an indication of how to price your shipping fees.) You can use a % of sales for this if possible. For example, if your average order is $10 and your shipping cost is $2.50, you could make the postage 25% of sales. As I budget on a per order basis, I do not use a %, but base my shipping cost on my average shipping cost multiplied by the number of orders.
Promotional costs: costs of trade show stands, advertising, any samples you send you (which you’ll recognise at the unit cost, not the retail price), any promotional brochures, outsourcing PR. Large retail business often spend around 10% of their turnover on marketing – for an online business, and especially a new business, this may need be more to raise awareness of your site.
Other costs: think very hard about what other costs you may have, as there will be more than you can imagine. Put every cost specific to your business through your business account. These can include toner cartridges, professional fees, photography, licenses, business stationery, bank fees, accounting fees etc. If you are starting off, it will be useful to include an amount for miscellaneous expenses – as there will definitely be costs you haven’t thought of! An accountant will also include costs such as depreciation (for example, if you’ve bought an expensive piece of equipment with a lifespan of 10 years, the cost of that will usually be spread over 10 years in your accounts.)
Gross profit – all other expenses = operating profit. Remember, ‘sales are vanity, profit is sanity.’ If you have a huge level of sales but no operating profit, your business can not succeed (a loss may be strategic in the early years of your business, but if there’s no prospect of making a profit, your business will fail.)
Your operating margin % is operating profit/sales.
The break even formula for calculating how much you need to sell to make a profit of 0 is No. of units to sell = Fixed costs/(Selling price – unit variable cost.)
Complicated? Luckily, there is a brilliant tool in Excel called Goal Seek, which means you do not have to work out these formula yourself. Goal Seek is your friend! I use it all the time. You can find it in Tools/Goal Seek in Excel 2003 or Data/Data Tools/What if/Goal Seek in Excel 2007, and you ‘set cell’ to your desired outcome.
As long as you have formulas in your calculation, it will be able to help you calculate your break even sales for you.
You could try these examples, and there is a simple tutorial here
Q. My average order value is $100. My unit cost is 50% of my sales. I’m paying a PR agent $500 per month (which is a fixed rate.) How many orders per month do I need to have to break even?
Q. Same as above, but I’d like to pay myself (before taxes) $1000 per month as well. How many orders would I need per month?
In these example, you would ‘set cell’ to $0 and then to $1000. The answer is at the bottom.
It is really important to calculate I how much you need to sell to make your desired salary (or a salary you can live on). For example, if you make cards and you need to sell 20,000 cards a year to have a salary, you may need to think about whether you can do that by yourself and in your spare bedroom, or if you will need a) staff (and pay employer’s tax), b) premises, c) some professional marketing help, in which case you will have to include their costs in a new scenario if you haven’t built that in already. This may also inform whether, for example, you need to take on wholesale clients, as even though they may be less profitable, the volume of sales is likely to be significantly higher.
Revising your forecast
It is very unlikely that your budget will be completely accurate.
Most companies revise their budget three or four times a year (forecasting). Usually a forecast will change key variables, but does not mean redoing the whole budget from scratch. You should understand why your forecast is different to your budget.
As I mentioned before, it can be difficult to make accurate assumptions when you are starting out. Some examples of assumptions which could be wrong:
- My average order price could be higher than I thought
- My average number of orders per day could be lower than I thought
- Applying a growth % each month might not be the best way to project sales. I have found that in my first year of business, sales are very press reliant. For example, I expected December to be a busy month, and had increased my sales for December based on what I thought November would be – in reality, November was very busy due to some press coverage, but December was not.
- I could decide to outsource my PR (which might not lead to an immediate uplift in sales, due to press lead times.)
- If I budgeted by item (I don’t) and if I was having supplier issues, I may not be able to sell that item until August, instead of June, which I initially planned.
These are the kinds of changes that I could put through a revised forecast without changing everything. For example, some of my assumptions may stay the same, for example:
- I have a fixed contract with a photographer, so her costs won’t change
- I have a standard monthly fee for my mailing list, which won’t change
- My cost of sales % assumption was accurate so this won’t change
Reviewing your finances on a monthly basis, and comparing them to what was in your budget is very important – and most importantly, understanding why they are different. For example, recently my international customers have been ordering bulky items, which have cost a lot to post, so while usually the postage cost I charge should equal the cost of posting it (or close enough) I may notice that I am losing money on postage.
Things I could consider are:
a) my international postage charge is too low and I should increase it
b) whether I want to subsidise this a little while my business is growing
c) if it’s still worth having these orders if I lose a little on postage, if, for example, I have a lot of stock which isn’t selling and which they might be buying. If they are buying items which are in demand in the UK, which I’m expecting press for, and which are difficult to get hold of, then I may just want to increase my international charge.
If I did not review my accounts on a monthly basis I would not catch this issue until much later when I may have lost quite a lot of money.
Five year plans
Most large organisations will have a three to five year business plan, and it will be worth doing something similar. This tends not to be calculated with such a high level of detail (usually by year rather than month) but reflects key initiatives, or large items of planned expense. Things to consider in future years could include:
- An employee (and any tax you need to pay for them, advertising fees etc) – this can include yourself, if you hope to work full-time.
- A new line of products. For example, I’m hoping to start selling prints soon, which may increase my average order value.
- Moving to premises.
You can also make high level assumptions. If I look at the main lines on the P&L, you could consider the following:
Sales – increase by a %, unless there is a new initiative (eg a wholesale line.) If your sales are expecting to increase dramatically, this will impact other costs such as Paypal fees (which reduce as a % once your sales are over a certain threshold) but for a high level approach, you may not want to take this into account.
Cost of sales – as a % of sales, but this % may increase. For example, when I worked in publishing, the cost of paper was increasing year on year. However, if your business is really taking off, and you can buy your stock/materials in higher quantities, your cost of sales % may decrease.
Promotional costs – as a % sales, plus any specific outlay (for example if you have some trade fairs planned, or you are outsourcing your PR, these may increase your costs – although you should also then build in an increase in sales, as you’d expect an increase from those activities.)
Other costs – specific items, such as planned travel (for example, there might be an increase if you’ve signed up to a trade fair), or lease costs if you are moving to premises, otherwise a standard % for inflation.
Profit v. cash
Profit is an accounting term which does not relate to how much cash you have in the bank. For example, if I sell $1,000 of stock, and my net margin % is 50%, so my profit is $500, does that mean I can pay myself $500?
Profit and loss accounts generally recognise sales on despatch, and uses the unit cost of each of the items you have sold. For example, if I sell wholesale, I may have despatched my items, but if I have given my customer 30 days credit terms, they may not have paid me yet. So, in accounting terms, I have made a sale ($1,000) but I do not have the cash yet.
If I sell 100 items of stock, which cost me $5 each, then my unit cost for the month in my P&L is $500. However, if in that month I actually bought 200 of these (100 are in stock, not sold yet) then my cash outlay was actually $1,000.
So, in the above scenario, my accounting profit is $500, but my cash position is actually minus $1,000 (as I haven’t received my sales, and I spent $1,000 on stock.)
It is important to understand the difference and to also prepare a cash flow forecast – which may be especially important if you have to pay an employee monthly, for example, or have monthly lease commitments. This is also why it is important to try and negotiate credit terms with suppliers – if you end up paying for everything up front it may be harder and longer before you can actually pay yourself a salary (even if your profit and loss account says you can, you may not have the cash to do so.)
In very simple terms, you could just estimate how much cash you expect to get in and out each month. When you are starting off, it’s likely that cash flow will need to be very tightly controlled. For example, if you are starting off small, companies may not want to give you credit until they have a sales history with you, and you are unlikely to be able to negotiate beneficial terms if you are only spending $100 with them each time. You may also need to reinvest most of your cash in new stock/supplies until you have a significant base of customers built up.
There’s a reason why people train for several years to become an accountant – it’s tricky, and the above is just an overview of some basic principles. So, it is definitely worth seeking professional advice but hopefully you can at least come up with a basic financial plan and worked out if the business is worth trying! Once your business is up and running, reviewing your accounts monthly, even if you don’t prepare them yourself, will be key in the success of your business, as everything will still be new to you, and it’s easy to make financial mistakes.
There are lots of business support groups around which can help you. Two that I am aware of are www.score.org (in the US) which has Excel templates, and http://www.businesslink.gov.uk (in the UK) both of which run workshops for new businesses.
And for the Goal Seek challenge, the answers to the questions are 1) 10 and 2) 30.