As I’m winding up my series of posts on standard business plan financials  – this is the 20th since last month – I want to focus on why? Why bother to project your business plan financials ahead of time? Aren’t they going to be wrong anyhow? Aren’t they going to change? Some people will suggest that you don’t both with this part of planning. And that’s terrible advice.

For your own business, whether you have to show anybody else a business plan, or not, simple financial projections, done right, are a powerful tool for managing your business better. They give you a way to lay out in an orderly manner how you expect your sales, cash, spending, and capital to go, based on the meaningful assumptions for your business, whatever they are. Obviously what drives your business numbers depends on the exact nature of your business. For some it’s web traffic, downloads, or subscriptions; for others it’s store traffic, or leads, or pipeline, or unique visitors; you know what it is for your business. And furthermore, if you’re one one of those businesses that is using a business plan to show investors for due diligence, or as part of a bank loan application. I like nowy Martin Zwillig explains the use of business plan financials in a post for the gust.com blog:

Why? For you to make decisions and manage the business – because we are all mere mortals and can’t possibly keep all these numbers and calculations in our head – to decide whether and when the business is going to be profitable given rational projections of costs and income (these assumptions are referred to as your business model). Secondarily, it will be required by potential investors to validate how much money you need to get started, and how much return they can expect on their investment.

And for me, in my experience, it all comes alive with the plan-vs.-actual analysis. I say often business plans are always wrong, but also vital, and extremely necessary. Of course they’re wrong because we’re human so we can’t predict the future. But they’re vital because you track the direction and the details of what went differently, and you manage that as steering. When sales are better than projected, you figure out why, what’s working, and put more resources into it. When sales are worse than planned, you have your assumptions laid out so you can identify what went wrong and adjust. Did marketing programs not work, or did you not execute? Tracking the money will help you know. How do I have to cut to stay solvent? Having projections is vital.

I also advocate – strongly – taking the extra time to learn what a business owner needs to know about financials to make those projections match standard practices. I insist that the basic standard definitions are not that hard to learn (it’s all in this post), and keeping your projections in line with standards makes them instantly recognizable to people who expect standard financials. Fine points like timing, working capital absorbed in inventory and accounts receivable, and funding assets re critical to actual real cash flow in the real world. So you don’t just guess at standards, you follow them.

And here – in that illustration above – is a cool and intriguing benefit of doing the business plan financials right. When you have proper financial projections, you work in a delightfully closed system that helps you pull it all together. If you have the right conceptual linkages between sales, costs, expenses, profits, assets, liabilities, and capital, then your projected balance will balance and you will be both financially and mathematically correct. And that’s makes the whole projection effort easier and more interesting. Just as one example, for more than 20 years now, at Palo Alto Software we’ve used collection days (how many days, on average, you wait to get paid by your business customers) as an input variable to help solve the math for cash in the bank, which is a number we derive from the inputs. And it has to be right, because we’re using algebra in the background (of course it’s only as right as your assumptions, but that’s where plan vs. actual comes in; and the balance will always balance.)

It’s really important to have an idea of what you need before you start. Continuing with my series on standard business plan financials, startups need to project starting costs. Starting costs set up a starting balance, which is necessary to plan cash flow. And the starting costs are critical to determining whether a startup can bootstrap or needs outside funding. For existing companies that already have financial results, projections start with the expected ending balance of the previous period. But for startups, it’s about starting costs.

Starting costs are essentially the sum of two kinds of spending. You can estimate them both in two simple lists:

• Startup expenses: These are expenses that happen before the beginning of the plan, before the first month of operations. For example, many new companies incur expenses for legal work, logo design, brochures, site selection and improvements, and signage. If there is a business location, then normally the startup pays rent for a month or more before opening. And if employees start receiving compensation before the opening, then those disbursements are also startup expenses.
• Startup assets: Typical startup assets are cash (the money in the bank when the company starts), business or plant equipment, office furniture, vehicles, and starting inventory for stores or manufacturers.

A Simple Starting Costs Example

I’ve used a bicycle store as an example in several posts that are part of this series of standard business plan financials. Here’s a visual in spreadsheet form, of sample starting costs for a hypothetical bicycle store.

Notice that the lists for estimating starting costs, on the left in the illustration above, are matched to another list of starting funding, on the right side of the illustration. Books have to balance, so the initial estimates need to include not just the money you spend, but also where it comes from. In the case above, Garrett had to find $124,500, and you can see that he financed it with Accounts Payable, debt, and investment in various categories.

Another Simple Starting Costs Example

Here is another simple example: the starting costs worksheet that Magda developed for the restaurant I used for a sample sales forecast. Magda’s list includes rent and payroll, the same as in her monthly spending, but here they are included in starting costs because these expenses happen before the launch.

I included rent and payroll because they point out the importance in timing. The difference between these as startup expenses and running expenses is timing, and nothing else. Magda could have chosen to plan startup expenses as a running worksheet on expenses, starting a few months before launch, as in the illustration below. The launch in this case is early January, so the expenses for October through December are startup expenses. I prefer the separate lists, because I like the way the two lists create an estimate of starting costs. But that’s an option.

The LivePlan Alternative

If you’re a LivePlan user, the LivePlan interface assumes this method and has a more intuitive interface than the spreadsheet version I’m showing in this post. For LivePlan, you start your plan when you start spending, regardless of launch date. So the spending you do for rent and salaries and such, before launch, is part of the flow, as above. Also, LivePlan has its own guided way of helping you figure out what assets you need, how much they cost, and how you are going to finance starting costs, to set up your balance. And the LivePlan cash flow estimator will help you decide how much cash you need, so you don’t have to follow the spreadsheet method here (below).

How to Estimate Your Starting Costs

Obviously the goal with starting costs isn’t just to track them, but to estimate them ahead of time so you have a better idea, before you start a new business, of what the financial costs might be. Breaking the items down into a practical list makes the educated guess a lot easier. Ideally, you know the business you want to start, you are already familiar with the industry, so you can do a useful estimate for most of the startup costs from your own experience. If you don’t have enough firsthand knowledge, then you should be talking to people who do. For others, such as insurance, legal costs, or graphic design for logos, call some providers or brokers, and talk to partners; educate those guesses.

Starting Cash is the Hardest and Most Important

How much cash do you need in the bank, as you launch? That’s usually the toughest starting cost question. It’s also prone to misinformation, such as those alleged rules of thumb you can find everywhere, saying you need to have a year’s worth of expenses, or six months’ worth, before you start. It’s not that simple. For most businesses, the startup cash isn’t a matter of what’s ideal, or what some expert says is the rule of thumb – it’s how much money you have, can get, and are willing to risk.

The best way is to do a Projected Cash Flow while leaving the supposed starting cash balance at zero, which shows how much (at least in theory, according to assumptions) the startup really needs in cash to support the business as it grows, before it reaches a monthly cash flow break-even point. Magda did that to determine the $12,000 needed as starting cash for her restaurant. Note how, in the illustration here, the lowest point in cash is slightly less than $12,000:

That low point comes, theoretically, in the third month of the business, March. The low point is $11,609. Obviously that’s just an educated guess, but it’s based on assumptions for sales forecast, expense budget, and important cash flow factors including sales on account and purchasing inventory. So it’s better than a stab in the dark, or some rule of thumb. Just as an example, the total spending with the estimates shown here, the theoretical “year’s worth of spending,” is $182,000 (which you don’t see on the illustration, by the way, but take my word for it). The total for the first six months is $93,000. If Magda sticks to those old formulas, she can’t start the business. She is able to raise enough money, between loans and her savings, to put $12,000 into the starting cash balance. So that’s what she does. Then she launches and continues to have her monthly reviews, and watch the performance of all key indicators very carefully.

Continuing with my series on standard business plan financials, you can’t run a business, or start a new business, without a sales forecast. Whether you have a full business plan, or a lean business plan, or just a collection of spreadsheets, a proper sales forecast ought to become like a dashboard, meaning it’s a tool you use to check plan vs. actual results, see problems developing, and correct your day-to-day with the progress of your sales. Sales of some number mean nothing without the context the sales forecast gives you. For example, $100 isn’t good or bad on it’s own; but it’s bad if you expected $150, and good if you expected $50. The expectations make it real.

Real Goals of Sales Forecast

Your sales forecast won’t accurately predict the future. We know that from the start. What you want is to understand the sales drivers and interdependencies, to connect the dots, so that as you review plan vs. actual results every month, you can easily make course corrections.

Sure, people shy from doing forecasts, because it can feel like real numbers and you can think only the numbers people can do it. Don’t believe that. You don’t have to have an MBA degree or be a CPA. You don’t need sophisticated financial models or spreadsheets. I was a vice president of a market research firm for several years, doing expensive forecasts, and I saw many times that there’s nothing better than the educated guess of somebody who knows the business well. All those sophisticated techniques depend on data from the past. And the past, by itself, isn’t the best predictor of the future. You are. So let’s look at how to forecast sales, step by step.

If you think sales forecasting is hard, try running a business without a forecast. That’s much harder.
Your sales forecast is also 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, even if you do no other numbers.

If nothing else, just forecast your sales, track plan vs. actual results, and make corrections; that’s already business planning.

Match Your Forecast to Your Accounting

It should be obvious: Make sure the way you organize the sales forecast in rows or items or groups matches the way your accounting (or bookkeeping) tracks them.

Match your chart of accounts, which is what accountants call your list of items that show up in your financial statements.

If the accounting divides sales into meals, drinks, and other, then the business plan should divide sales into meals, drinks, and other. So if your chart of accounts divides sales by product or service groups, keep those groups intact in your sales forecast. If bookkeeping tracks sales by product, don’t forecast your sales by channel instead.

If you’re planning for a startup business, coordinate the bookkeeping categories with the forecasting categories.

Get your last Income Statement (also called Profit & Loss) and keep it in view while you develop your future projections.

If you don’t have more than 20 or so each rows of sales, costs, and expenses, then make the rows in the projected statement match the rows in the accounting.

If your accounting summarizes categories for you – most systems do – consider using the summary categories in your business plan. Accounting needs detail, while planning needs a summary.

If your categories in the projections don’t match the accounting output, you’re not going to be able to track plan vs. actual well. It will take retyping and recalculating. And you’ll lose the most valuable business benefit of business planning: management, steering your company.

The math is simple

Normally your sales forecast will group sales into a few manageable rows of sales and show projected units, prices, and sales monthly for the next 12 months and annually for the second and third years in the future. Here’s a quick example from a bicycle retailer named Garrett (with columns for April-November hidden on purpose, to make viewing easier):

If you’re a LivePlan customer, don’t worry about this spreadsheet view, which is generic. LivePlan will guide you through the sales forecast assumptions and do the calculations automatically. For the generic spreadsheet option, shown here, you multiply units times prices to calculate sales. For example, unit sales of 36 new bicycles in March multiplied by $500 average revenue per bicycle means an estimated $18,000 of sales for new bicycles for that month.

Total Unit Sales is the sum of the projected units for each of the five categories of sales.

Total Sales is the sum of the projected sales for each of the five categories of sales.

Calculate Year 1 totals from the 12 month columns. Units and sales are sums of the 12 columns, and price is the average, calculated by dividing sales by units.

The numbers for Year 2 and Year 3 are just single columns; unless you have a special case, projecting monthly results for two and three years hence is overkill. It’s a problem of diminishing returns; you don’t get enough value to justify the time it takes. Other experts will disagree, by the way; and there may be special cases in which extended monthly projections are worth the effort.

Estimate Direct Costs

A normal sales forecast includes units, price per unit, sales, direct cost per unit, and direct costs. Direct costs are also called COGS, cost of goods sold, and unit costs.

COGS stands for Cost of Goods Sold, and applies to businesses that sell goods. COGS for a manufacturer include raw materials and labor costs to manufacture or assemble finished goods. COGS for a bookstore include what the storeowner pays to buy books. COGS for Garrett are what he paid for the bicycles, accessories, and clothing he sold during the month. Direct costs are the same thing for a service business, the direct cost of delivering the service. So, for example, it’s the gasoline and maintenance costs of a taxi ride.

Direct costs are specific to the business. The direct costs of a bookstore are its COGS, what it pays to buy books from a distributor. The distributor’s direct costs are COGS, what it paid to get the books from the publishers. The direct costs of the book publisher include the cost of printing, binding, shipping, and author royalties. The direct costs of the author are very small, probably just printer paper and photocopying; unless the author is paying an editor, in which case what the editor was paid is part of the author’s direct costs.

The costs of manufacturing and assembly labor are always supposed to be included in COGS. And some professional service businesses will include the salaries of their professionals as direct costs. In that case, the accounting firm, law office, or consulting company records the salaries of some of their associates as direct costs.

The illustration below shows how Garrett uses estimated margins to project the direct costs for his bicycle store. For the highlighted estimates, the direct entry for bicycles unit cost is the product of multiplying the price by 68 percent. The total direct costs for bicycles in January are the result of multiplying 30 units by $340 per unit. And here again, LivePlan users don’t need to do these calculations; your software does it automatically.

Some Quick Notes About Standards

Timing Matters

Standard accounting and financial analysis have rules about sales and direct costs and timing. A sale is when the ownership of the goods changes hands, or the service is performed. That seems simple enough but what happens sometimes is people confuse promises with sales. In the bike store example, if a customer tells Garrett in May that he is definitely going to buy 5 bicycles in July, that transaction should not be part of sales for May. Garrett should put those 5 bicycles into his July forecast and then they will actually be recorded as sales in the bookkeeping actual sales in July when the transaction takes place. In a service business, when a client promises in November to start a monthly service in January, that is not a November sale.

Direct costs also happen when the goods change hands. Technically, according to accounting standards (called accrual accounting), when Garrett the bike storeowner buys a bicycle he wants to sell, the money he spent on it remains in inventory until he sells it. It goes from inventory to direct costs for the income statement in the month in which it was sold. If it is never sold, it never affects profit or loss, and remains an asset until some day when the accountants write off old never-sold obsolete inventory, at which time its lowered value becomes an expense. In that case it was never a direct cost.

Most of this has to do with proper accounting. My standard business plan financials series includes What’s Accrual Accounting and Why Do You Care, which is directly related. When in doubt, please read that one.

Gross Margin

Once you have sales forecast and direct costs, you can calculate your estimated gross margin. Gross Margin is sales less direct costs. Gross Margin is a useful basis of comparison between different industries and between companies within the same industry. You can find guidelines and rules of thumb for different industries that give you an industry profile or average gross margin for different industries. For example, industry profiles will tell you that the average gross margin for retail sporting goods is 43%. Every business is different, but knowing the standards and averages gives you some useful comparisons.

The distinction isn’t always obvious. For example, manufacturing and assembly labor are supposed to be included in direct costs, but factory workers are paid sometimes when there is no job to work on. And some professional firms put lawyers’ accountants’ or consultants’ salaries into direct costs. These are judgment calls. When I was a young associate in a brand-name management consulting firm, I had to assign all of my 40 hour work week to specific consulting jobs for cost accounting.

Garrett can easily calculate the gross margin he’s projecting with his sales forecast. The illustration below shows his simple calculation of gross margin using his sales and direct costs.

How do I know what numbers to use?

But how do you know what numbers to put into your sales forecast? The math may be simple, yes, but this is predicting the future; and humans don’t do that well. Don’t try to guess the future accurately for months in advance. Instead, aim for making clear assumptions and understanding what drives sales, such as web traffic and conversions, in one example, or the direct sales pipeline and leads, in another. And you review results every month, and revise your forecast. Your educated guesses become more accurate over time.

Use experience and past results

1. Experience in the field is a huge advantage. In the example above, Garrett the bike storeowner has ample experience with past sales. He doesn’t know accounting or technical forecasting, but he knows his bicycle store and the bicycle business. He’s aware of changes in the market, and his own store’s promotions, and other factors that business owners know. He’s comfortable making educated guesses. In another example that follows, the café startup entrepreneur makes guesses based on her experience as an employee.
2. Use past results as a guide. Use results from the recent past if your business has them. Start a forecast by putting last year’s numbers into next year’s forecast, and then focus on what might be different this year from next. Do you have new opportunities that will make sales grow? New marketing activities, promotions? Then increase the forecast. New competition, and new problems? Nobody wants to forecast decreasing sales, but if that’s likely, you need to deal with it by cutting costs or changing your focus.
3. Start with your best guess, and follow up. Update your forecast each month. Compare the actual results to the forecast. You will get better at forecasting. Your business will teach you.

How to Forecast a New Business or New Product

What? You say you can’t forecast because your business or product is new? 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 forecast the future.

Think of the weather experts doing a 10-day forecast. Of course they don’t know the future, but they have some relevant information and they have some experience in the field. They look at weather drivers such as high and low pressure areas, wind directions, cloud formations, storms gathering elsewhere. They consider past experience, so they know how these same factors have generally behaved in the past. And they make educated guesses. When they project a high of 85 and low of 55 tomorrow, those are educated guesses.

You do the same thing with your new business or new product forecast that the experts do with the weather. You can get what data is available on factors that drive your sales, equivalent to air pressure and wind speeds and cloud formations. For example:

• To forecast sales for a new restaurant first draw a map of tables and chairs and then estimate how many meals per mealtime at capacity, and in the beginning. It’s not a random number; it’s a matter of how many people come in. So a restaurant that seats 36 people at a time might assume it can sell a maximum of 50 lunches when it is absolutely jammed, with some people eating early and some late for their lunch hours. And maybe that’s just 20 lunches per day the first month, then 25 the second month, and so on. Apply some reasonable assumption to a month, and you have some idea.
• To forecast sales for a new mobile app, you might get data from the Apple and Android mobile app stores about average downloads for different apps. And a good web search might reveal some anecdotal evidence, blog posts and news stories perhaps, about the ramp-up of existing apps that were successful. Get those numbers and think about how your case might be different. And maybe you drive downloads with a website, so you can predict traffic on your website from past experience and then assume a percentage of web visitors who will download the app.
• So you take the information related to what I’m calling sales drivers, 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 – 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 lean planning process.

Sales forecast depends on product/service and marketing

Never think of your sales forecast in a vacuum. It flows from the strategic action plans with their assumptions, milestones and metrics. Your marketing milestones affect your sales. Your business offering milestones affect your sales. When you change milestones — and you will, because all business plans change — you should change your sales forecast to match