When will I make profit? Budgeting Basics I

A straight to the point guide to financial planning for startups

2 | When Will I Make Profit? – Budgeting Basics I

Content

Introduction ..................................................................................................................... 3

The Key Measures ............................................................................................................ 4

Startup investment ....................................................................................................... 4

Why? .......................................................................................................................... 5

How? .......................................................................................................................... 5

Wanted profit ................................................................................................................ 6

Why? .......................................................................................................................... 7

How? .......................................................................................................................... 7

Contribution margin ratio (or gross profit) .................................................................. 7

About variable/direct costs ....................................................................................... 8

Operating costs ............................................................................................................. 9

Necessary turnover .................................................................................................... 10

Sensibility .................................................................................................................... 10

Operating budget – turn it upside down ....................................................................... 11

Reality check on your necessary turnover ..................................................................... 12

3 | When Will I Make Profit? – Budgeting Basics I

Introduction

Financial planning is usually not a favoured discipline by entrepreneurs. Maybe because it is difficult to see how it brings your project forward and maybe because it forces you to leave the room of opportunities and visions and enter the room of limitations and reality.

Another thing is, that we tend to avoid things that we don’t know much about, and financial planning is often a big black-box for entrepreneurs. And I have met many entrepreneurs whose biggest fear was the bookkeeping.

Therefore I have made this guide to give you a simple and straight to the point introduction to financial planning.

My approach is not to teach you how to make fantasy budgets about the potential of your fantastic idea. It is rather to give you an idea about when you will be able to make enough money on your business.

This is the main question for most startups and also a main question from your bank in the startup phase.

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The Key Measures

Making budgets is the main activity of financial planning, but the purpose of financial planning is not making budgets. The purpose is identifying the key measures.

The simplest way to start working on your budgets starts with identifying four key measures:

• Startup investment • Wanted profit • Contribution margin ratio (or gross profit) • Operating costs

If you can identify those four numbers, you will be able to identify how much you need to sell to generate the profit you want and need.

I will tell you how a little later, but first an introduction to four key measures, and why we need them.

Startup investment

If you start a restaurant, you will need to buy furniture, tableware, staff uniforms, marketing material, food for the first day(s) etc. and you will have to pay rent in advance just to get started. This is your startup investment.

In an innovative project the startup investment may also include product development, testing, patenting, building the prototype etc.

The startup investment is more or less a one-time-investment, where the operating costs are the recurring costs of your business estimated on a yearly – and often monthly – basis.

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Why? We want to know our startup investment so we know how much it will cost us just to get started and to start selling.

And the banks will want to know too, if we want money from them. They want to know how much we need and what we will spend the money on.

Especially if our startup requires a large investment, we will want to raise our requirements for annual profits. The more you invest in the beginning, the more profit you need to pay back yourself – and the bank. If fx you want to develop an electric car, you will have to spend millions before you have something ready to sell.

How? We calculate our startup investment by making an establishing budget (sometimes called investment budget). Basically it is a shopping lift if the things and services you need to buy and the people you have to pay before you start.

You can find a template for establishing budgets on http://www.dynamicbusinessplan.com/shop.asp

But remember, that a template is just an example. You might want to add other investments and leave others out.

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Wanted profit The next key measure is quite a bit easier to determine – or at least less time consuming. It is a simple question you have to ask yourself:

How much profit do I want my business to generate per year?

That is, what profit will make it worth the risk and effort?

If you think like an employee, you will ask yourself:

• How many hours am I going to spend on this project per year? • What will be a reasonable hourly wage?

If you think like an investor, you will ask yourself:

• How much have I invested in this business? • What will be a satisfying return on my investment?

When professional investors invest in startup ventures they will often expect an annual return on investment of 30-40 percent of their investment. They want a high return because it is a risky investment compared to investing in bonds or stocks in solid and established companies.

You will have to find your own mix of the two approaches:

• What will my total effort be? Remember to count your unpaid hours in the preparation phase too.

• What will my total investment bee? Focus on your full personal investment, not just the bank loan and your personal cash.

If you expect to work full time on the business and have to put 100.000€ into the business as startup investment, you may want fx

50.000€ for you work pr. year.

30.000€ as return on your investment (30% of the startup investment).

This means that you will want at least 80.000€ in annual profit to consider the business worth the risk and effort.

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Why? By determining the wanted profit you shift you mindset from passenger to pilot. You shift your mindset from what is possible to what is necessary. And you start looking at your business as something outside yourself that is supposed to create something for you – or for itself.

How? Determining you wanted profit is a subjective matter, but as mentioned above you may want to consider:

• How much profit do I want for my own effort on a yearly basis? • How much do I want as return on my startup investment?

This is why we started by estimating the startup investment.

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Contribution margin ratio (or gross profit) Now that we know what profit we want, we want to know how to create it. We want to know how profitable our products or services are.

The simple question is:

• When I sell a product or a service, how much do I earn?

Let’s take a restaurant as an example:

Steak Dessert Wine Sales price ex VAT in € 18 8 22 Variable/direct costs 6 2 6 Contribution margin/gross profit 12 6 16 Contribution margin ratio - % 67 75 73

The table shows, that when we sell a steak, we earn 12€ or 67 pct. of the sales price and that selling dessert and wine seems even more profitable.

If we sold only one product, it would be simple to determine the contribution margin. It is a bit more complicated, when we have more products.

To calculate the necessary turnover, we will have to make assumptions about the average contribution margin. In the example above, we may assume that most customers buy a steak and a bottle of wine, and maybe half of them will buy dessert as well.

This will give us an average contribution margin of a bit more than 70 pct.

About variable/direct costs Variable costs or direct costs are the costs that are a direct result of the sale. If you sell a bottle of wine you will have a cost on the wine you bought. But if you don’t sell it tonight, you can sell it to another customer tomorrow, so you will have had no cost yet on the wine.

The waiter on the other hand is more of a fixed cost if he gets his salary no matter how much he sells. However, if the waiter’s salary is directly dependent on how much he sells, you might consider it a variable cost.

The distinction between variable/direct and fixed costs can be a bit blurry sometimes, so you have to make your own reasonable distinction.

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Operating costs Now we are almost there and ready to calculate our necessary turnover. We “just” have to estimate operating costs, for the first year.

When we calculated our contribution margin, we only subtracted variable costs from the sales price. The operating costs are simply the rest.

Operating costs can typically be divided in the following categories:

• Premises (rent, heating, electricity etc.) • Staff (salaries and other costs of staff) • Marketing and sales • Administration (office supplies, IT, phone etc.)

These are the traditional costs of things and services you buy. And then there are a couple of other costs you might have to consider:

• Depreciation – typically on buildings, cars, interior, machines etc.

If you buy a car for your business – fx for kr. 200.000 you may want to spread the cost over several years, since the car is probably something you use over several years. By the principle of depreciation, you can spread the cost over f.eks. 5 years if you expect to keep your car that long.

2011 2012 2013 2014 2015 Investment in car 20.000 Depreciation 4.000 4.000 4.000 4.000 4.000 Value of car 16.000 12.000 8.000 4.000 0

• Interest

If you have to borrow money in the bank, you will also have to consider interests as part of your costs. For a rough budget you can check your startup investment and estimate how much you will need to borrow from the bank and how much you will have to pay

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Necessary turnover By using the following measures we can now calculate the turnover necessary to make the wanted profit:

• Contribution margin ratio • Wanted profit • Operating costs

The formula goes like this:

Necessary turnover =

(Operating costs + Wanted profit) * 100 Contribution margin ratio

If you can make a turnover of this amount or more, you will get the profit than you want. That is of course if you can hold your contribution margin ratio and don’t overspend on your operating costs.

Sensitivity analysis To get a feeling about how your business works, you might want to put in some alternative measures:

• How much more will you need to sell if your contribution margin is 5 pct. smaller?

• And what will happen if you can improve it by 5 pct.? • How much turnover would it be acceptable to lose if we raised our prices by

10 pct.?

• How much more will you have to sell if you exceed you budgets for operating costs by 10 pct.?

• How much more will you need to sell to pay an extra full time employee?

This is a simple sensibility analysis, that you can easily perform if you want to check the consequences of different decisions or incidents.

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Operating budget – turn it upside down

When you have got the numbers in the formula above, it is actually quite simple to make your operating budget. Just line up the numbers in reverse order. The simple version goes like this:

€ Turnover - Variable costs = Contribution margin - Operating costs - Depreciation - Interest Net profit

How you calculate the variable costs and contribution margin? If your contribution margin ratio is fx 70% like in the restaurant example, it means that your variable costs are 30% of the sales price – and therefore also 30% of the turnover.

This is the basic structure of an operating budget. It will often be in much more detail, but the basic principle is like above.

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Reality check on your necessary turnover

The formula for necessary profit is a relatively simple way of making your sales budgets. However, there is one major weak point. There are no thoughts behind you sales measures, so we have no idea, whether they are realistic.

And actually it is not really a sales budget, more a kind of minimum sales goal.

If you go to a bank or an investor, the will want to know how you estimated your sales, and they will not want to hear, that you just put some numbers into a formula. So there is still a bit of work to do.

I suggest that you look at you necessary turnover and ask yourself a lot of critical questions:

• How will the sales figures be for the first year month by month? Some months are probably busier than others, and some may be completely dead.

• How much will a new customer buy? • How soon and how frequently do they come back? • How many customers will I have to get month by month? • How many sales visits will I have to make to get those customers? • How fast will customers make decisions and place an order? • How much time will I spend on sales pr. week to reach my goals? • How many selling hours go into a new order? • How much time will I have to spend on producing and delivering customers

orders pr. week? • How many potential and realistic customers actually exist? • How big a share of them will have to buy from me before I reach my goals?

These questions will help you find out how much work you have to put into it before you are profitable and it will give you a better idea about how easy or difficult it will be to be profitable.