Most everybody does. One of the more powerful drags on business planning in general is what I call fear of forecasting. Lots of people have it.

“How could I possibly know?” is one of the more popular complaints. After all, who can predict the future? How can you know what’s going to happen in the market, competition, or new technologies. Isn’t it just wasting your time?

No, it isn’t just wasting your time, because one thing harder to do than forecasting is running a company without a forecast. The real question isn’t how could you possibly know what’s going to happen, but, rather, how could you possibly know whether what actually did happen is good or bad or better than you thought if you don’t know what you thought would happen?

Confusing? Think of it this way: although you forecast for at least a year, you actually only go out on a limb for the next month. In a month, you’re going to review that forecast. You’re going to see what is different from the forecast, and revise the forecast. Your year doesn’t stay static after the first month if results of the first month cast doubt on the whole year.

So don’t worry so much, get started with your forecast, and you’ll be revising.

Remember, there is no single way to forecast any business. It’s often very creative.

Magda was looking at forecasting sales for a small restaurant. She hadn’t locked in the location at that point, but she had a pretty good idea of the small size she wanted. She decided she would be able to seat six tables of four people each as a starting point. She knew of course that things might change when she actually decided on the space to rent; but she had to start somewhere, so six tables of four it was.

Then she did some simple math: six tables of four means at capacity she would be serving 24 meals. Meals take about an hour at lunch, and about two hours at dinner. She figured she’d have one servicing of lunch and two of dinner, roughly calculating the 5-5:30 crowd as the first serving, and the 7:30-8:00 crowd as the second serving. So an absolutely full lunch service in a day would be 24 lunches. An absolutely full dinner service in a day would be 48 dinners.

She decided that an average lunch would be $10 of food and $2 of beverage. And that an average dinner would be $20 food and $4 beverage.

And now I stop for a second, and we consider this. Magda isn’t turning to some magic information source to find out what her sales will be. She isn’t using quadratic equations and she doesn’t need an advanced degree in calculus. She does need to have some sense of the estimated guess. Ideally she’s worked in a restaurant or knows somebody who has, so she gets a sense of reasonableness.

So, end of digression. She can do some numbers. At capacity she sells 24 lunch and 48 dinners in a day, with matching beverages. She can do a simple calculation to figure a good day’s sales:

1. Lunches are 24 times 10 plus 24 times 2, which comes to 240 plus 48, or 288, when she’s at full capacity.
2. Dinners are 48 times 20 plus 48 times 4, which comes to 960 plus 188, or 1148, when she’s at full capacity.

These numbers are not magic. The point of this example is simply that Magda finds ways to make sense of her forecast. As you work with yours, don’t look for some answer out there in the world, like a right answer to a puzzle; look for ways to break your assumptions down into the logic you need to work with them.

Magda should get on a computer and put that in a spreadsheet. Make it four rows labeled lunches, dinners, lunch beverage, and dinner beverage. And then add a row for other, because there is always other. Spread these assumptions out with the simple math so you can see the assumptions.

There’s an example in the illustration here. All the math is simple. If you don’t know how to work a spreadsheet, using formulas for rows and columns, go to spreadsheet logic for some resources. Don’t get fear of math, or fear of finance. The math is simple.

Having figured out what sales might be in a maximum day, then she looks at how sales might vary for the days of the week. The provides a weekly base line. It isn’t just four weeks per month; multiply an average week times 52, then divide that product by 12 to get an average month. In the example, you can see how Magda estimated conservatively, with less for example on Sunday lunch, and closing at lunch on Saturday and Sunday. She knows she’s not going to get a full capacity day that often. So she’s calculated a base line month as show, with around 350 lunches and 1044 dinners. But she’s also just starting up, so she comes up with an educated guess for a lot lower than that, around half the capacity.

By the way, she can do that kind of a forecast graphically, with the right tools. Draw the line to help yourself visualize the way the numbers flow. Here’s an example of how a simple line drawing can forecast the lunch number for the first year.

Remember, please,these are not scientific numbers. They are based on assumptions. What’s going to happen with the plan-as-you-go business plan is that you’ll review these numbers every month, and tune them against reality. So therefore you don’t have to guess right for long stretches into the future; you have to start with a reasonable guess and then start tracking.

Furthermore, you don’t have to be right from the beginning because as your business goes on, you constantly improve your forecast. After the first month, as you look at the second months and all the rest of the forecast, you have the results from the first month to work with. Always review, and revise as the review indicates.

So with Magda and her restaurant, she starts the forecast and the first month results come in. Oh-oh, lunch sales are much less than she thought, but then dinner sales are slightly more.

So here’s the difference between what was planned and what happened:

And from there, Magda revises her sales forecast. Why wait? She had a logical first guess based on some simple numbers, but then she already has real-world results. So revise. Here’s a revision:

And now her sales forecast is up and running. Plan as you go.

Although we probably agree that the best way to forecast sales is by looking at past experience, I know that you can’t always count on having that kind of information available to you. So let’s suggest other examples. It’s never as exact as it sounds. There’s a lot of creative guessing. Here are just a few examples. These are ways you might forecast sales of a new business. The point isn’t listing acceptable methods, but rather to suggest that anything logical might work. So here we go:

• You want to sell products over your website? Ok find a way to predict traffic. Maybe you can buy search terms. For example, with Google advertising, Google Ad Words can help you estimate how many will see the link you buy on the search terms. Then you estimate how many of those people actually click your link. Estimate a very low percentage, less than 1%, unless you have the world’s most compelling link. Then estimate how many of those actually buy what you’re selling. That’s a low percentage too. At least with this you’ve got some mathematical basis for unit sales. And if you’re estimating more than 1 per thousand, be careful, it’s probably too high.
• Doing retail business? Find some estimates of sales per square foot for your type of business. You can do a web search for that, and you might find something. I found annual sales per square for for Best Buy, Apple, Neiman Marcus, and Tiffany, and learned that Apple does $4,000 per square foot, compared to $2,600 for Tiffany and less than $1,000 for those other two.
• Let’s say you’ve published a book you wrote, in a self-publishing mode, you paid to have the book printed. Forecast your sales through different channels: amazon.com and competing websites first, then perhaps through distributors to physical bookstores. But can you get that book into distribution? Will they accept you? Use the reverse tree method and call other authors from the same publishing house to see how they did. Do a web search on self publishing. Start a blog and use search terms advertising to generate readers. Estimate how many people who visit your blog will click a link on it to buy your book. Build your sales forecast according to the places where people can buy the book: online at your site, online at other sites, and physically in stores. Be realistic about how long it takes to get into stores.
• You are opening up a bicycle store in a summer tourist destination. Find an estimate of tourists, then estimate what percent end up renting a bike, then how many units that means, and go from there. Or count bike rentals per day, and build up a forecast from there.
• Selling products through channels of distribution? Maybe unit sales by channels.
• Professional consulting? Do it by the job, or the day, or by the hour. Make assumptions based on leads.
• Lots of companies use pipeline analysis: how many leads per marketing effort, how many presentations per lead, how many closes per presentation.

Whatever it is, find some numbers and logic for it. Break your assumptions down into units, and price per unit, and have some way you can check on the logic and revise and track as the numbers flow in. The key to this is watching the actual results.

Business charts are an excellent tool for understanding and estimating numbers. Use them to evaluate the projected numbers. When you view your forecast on a business chart, does it look real? Does it make sense? It turns out that most humans sense the relative size of shapes better than they sense numbers, so we see a sales forecast differently when it shows up in a chart. Use the power of the computer to help you visualize your numbers.

For example, consider the monthly sales chart below. You can look at this chart and immediately see the ebbs and flows of sales during the year. Sales go up from January into April, then down from Spring into Summer, then up again beginning in September. When you look at a chart like that, you should ask yourself whether that pattern is correct. Is that the way your sales go?

Monthly Sales Chart

The next chart shows a comparison of three years of annual sales. Here again you can sense the relative size of the numbers in the chart. If you knew the company involved, you’d be able to evaluate and discuss this sales forecast just by looking at the chart. Of course you’d probably want to know more detail about the assumptions behind the forecast, but you’d have a very good initial sense of the numbers.

Annual Sales Chart

When we did the sample restaurant sales forecast, we used a line chart to estimate the seasonality for the restaurant.

Yes, that’s right. If you can, whenever you can, start this year’s forecast by putting last year’s numbers onto this year’s spreadsheet. Then revise as needed. One of the real luxuries of the existing and ongoing company, compared to the startup, is that there is data. You have experience.

As soon as you have a forecast with last year’s numbers in it, then you starting thinking about what’s going to be different.

• What’s new and different this year compared to last year? New products? New business relationships, new channels, new locations maybe?
• What about bad news. Sometimes things are cooling, some new problems develop. Maybe new competition shows up.
• Will pricing change?

You can look at costs and expenses too. Normally we assume costs and expenses rising gradually. That’s just a general matter of inflation. Is it going to apply for your business in the next year?

Why? Or why not?

Costs are among the financial and accounting terms that have specific meanings. You can’t just decide to think of them as what makes sense to you, because the accountants and analysts won’t understand you. They’ll say you are wrong. Ouch. Not pleasant.

So….

Cost of Sales

No, that’s not expenses related to making a sale. It isn’t that lunch with the customer, and not the trip to go visit the customer and make a pitch. Costs of sales mean what it costs you to make or deliver whatever it is you sell. If you don’t sell, you don’t have any costs. They are variable by definition.

• Costs are supposed to be directly related to sales. Costs are about what it costs you to have or build or deliver what you’re selling.
  • Costs of a manufactured product include materials and labor. So for example the computer costs $200 to build, including $150 in parts and $50 in labor. Its costs are $200.
  • If you just buy the computer built, then sell it, the cost is what you paid to buy it.
  • If you deliver a service, you still have costs. The taxi or airline has fuel, maintenance, and personnel costs. The law firm has what it pays the lawyers, plus legal assistants, and photocopying and research.
• Costs depend on who and when. For example.
  • When you buy a book for $19.95 at the local bookstore, the store’s cost of goods sold are whatever it paid to buy that book from the distributor. Let’s say it paid $10.50 plus shipping. The store’s sales are $19.95 and it’s cost of goods sold is $10.50 plus shipping.
  • If the distributor bought the book from the publisher for $6.25, then it’s sales for the book is $10.50, and its cost of goods sold is $6.25.
  • Let’s say the publisher had the book printed for $2.00 per copy and it pays the author a royalty of 10%. It’s sales for the book is $6.25 and its cost of goods sold is the $2.00 plus $0.652 for royalty. And the publisher probably paid to ship the book to the distributor, which would had another small amount, maybe $0.25 to the cost of goods sold.
• Understand inventory. This comes up again as a cash flow trap.
  • Stuff that’s going to become cost of goods sold when it sells starts out as inventory, which is an asset. It sits there in inventory until it sells.
  • Think about this in terms of timing, and cash flow. The publisher buys the books from the printer and pays for them, which makes them inventory. They sit there for months until the distributor buys them, at which point they become cost of sales. The distributor has them as inventory until it sells them to the store. Then they become cost of sales. The store has the book for as long as it takes, from when it receives it — and puts it on the shelf — until you buy it.
  • The cash flow trap is that the whole inventory asset doesn’t show up on your income statement until you sell the stuff. In the meantime, whether you’ve paid for it or not, the income statement doesn’t care. The money is gone, but the sale hasn’t been made. This is a classic cash flow trap. You won’t see it on the income statements. It is completely outside of the realm of profit and loss. But you have spent the money.
• Services have costs of sales too. They may not be costs of goods sold because service businesses aren’t selling goods, but they are direct costs.
  • As per that example above, the taxi has fuel and maintenance.

Here’s where you rate yourself. If this is obvious, go on, don’t worry about it. If you’re uncomfortable with these terms, vaguely worried you don’t know what they mean, then read on, in about five minutes you will.

Fixed vs. Variable Costs

Part One: The Real Case; Manufacturing Costs

Sometimes this matters, many times it doesn’t. Technically, fixed costs are costs that you pay regardless of whether or not you sell anything, or how much you sell. For example, the monthly rental of an installation used exclusively to build stuff would be a fixed cost. It gets technical and surprisingly creative as cost accountants figure out how to allocate fixed costs to the related sales. That was a special course in business school. I found it fascinating, but for business planning purposes, let it go.

It’s planning, not accounting. Remember?

Part Two Fixed vs. Variable and Risk

And then there’s the division between fixed and variable costs that are really fixed and variable expenses, or variable costs and fixed expenses. It gets very detailed. Basically what this is about is trying to figure out how much risk you have in the business.

The big picture is relatively straightforward. The underlying assumption is that your spending has two parts: the fixed part, that you spend no matter what; and the variable part, that you spend only if you make the sales, and for which the level of spending depends (hence the term variable) entirely on the level of sales.

For an example of that, a true story, back in the formative years of Palo Alto Software we chose to pay an outside sales representation company 6% of our retail sales, after the fact, rather than hire somebody as an employee to manage retail sales.

The tradeoff should be obvious. There’s a lot less risk with the variable cost. If I don’t get the sale, I pay nothing. If I do get the sale, then I have money from the sale that I can use to pay the variable cost.

Some of your spending is almost always fixed: rent, insurance, payroll, for example.

Some of your spending is almost always variable: direct cost of sales, for example.

And some of your spending is hard to classify. The plumber pays the yellow page advertisement in the telephone book once a year, regardless of sales levels; but if sales go up because of the ad, she might be tempted to increase the ad size next year. Your web site seems like a fixed cost, but many of us in the web business pay affiliate commissions to affiliated sites that help us make the sale.

It’s fine tuning like this that has given us the term “burn rate.” That term became particularly popular during the first dot-com boom in the late 1990s, when Internet companies with fat bank accounts fed by investors would talk about how much money they were burning every month (hence the term burn rate) while they weren’t taking any money in. Burn Rate, by reftk, is a very entertaining book about it. You counted your future as how many months worth of burn rate you had in the bank, from the investors.

I like burn rate instead of fixed costs. Technically, fixed costs are costs that would stop if you didn’t sell. But the burn rate, on the other hand, is how much money you spend every month, without quibbling over whether it’s technically fixed costs or not.

All of this becomes more than just idle debate and definitions if you try to do a break-even analysis. I think of break-even as mostly optional, but still a good illustration of your basic financial picture. So you might find it worth the effort (reftk).

Your Burn Rate

The new term to watch is your “burn rate.”

Burn Rate: How I Survived the Gold Rush Years on the Internet by Michael WolffMichael Wolf was by no means the first or the only one to popularize the term “burn rate,” but his book cemented the term into the post-Internet dot-com boom business vocabulary. Read more about this book…

Your burn rate is how m
uch you have to spend on an average month to keep your company up and running. That normally includes rent, payroll, and — unlike the concepts of fixed vs. variable costs — whatever else you spend in a normal month that isn’t directly tied to your sales, which means it isn’t automatically paid for by sales, whether it’s fixed or variable or not. So it includes your standard marketing expenses, which would technically be called variable expenses.

The burn rate became popular during the dot-com boom. Some Internet companies that had no sales or revenue had lots of money from investors. So they would divide the money they had in the bank by their monthly burn rate to calculate how many months of life they had. Without sales or revenue, burn rate became very important. They’d use it to know when to look for more investment, or, in some cases, when to look for a new job.

I think you should always know your burn rate. I hope you have sales and revenue as well. If your plan calls for burning more money than you’re bringing in, then you know you need to be borrowing or finding investment.

I also like the burn rate instead of fixed costs as a good number to use in a break-even analysis. In classic financial projections, the kind they still teach in financial analysis courses in business school, you’d use your fixed costs to calculate your break-even point. Burn rate is a newer idea, and better.

Usually these costs go directly along with the sales forecast, because these are costs that you don’t incur unless you make the sale. If you haven’t already, you might want to read the understanding costs, fixed vs. variable, and burn rate section, with some important definitions. The sidebar here about that will help too.

So I assume you already have your sales forecast. One of the first things you do with spending budget is figure out how much it costs you to deliver what you’re selling. As I explained in that previous section, this is Cost of sales, sometimes called Cost of Goods Sold (COGS) or direct costs, is traditionally the costs of materials and production of the goods a business sells. Cost of Sales or COGS belongs in accounting in the month in which the goods or services are actually sold, regardless of when they were purchased.

For a manufacturing company this is materials, labor, and factory overhead. For a retail shop it would be what it pays to buy the goods that it sells to its customers. For service businesses, that don’t sell goods, the same concept is normally called “cost of sales,” which shouldn’t be confused with “sales and marketing expenses.” The cost of sales in this case is directly analogous to cost of goods sold. For a consulting company, for example, the cost of sales would be the remuneration paid to the consultants plus costs of research, photocopying, and production of reports and presentations.

If you projected sales in units, for your sales forecast, then it isn’t too much harder (for most businesses) to figure out what each unit costs you. Then you can multiply that per-unit amount times the units to estimate the costs associated with exactly that month’s worth of sales, which is the point.

If you just project sales by the amount, then try to estimate the related costs and — at least as much as you can — keep the costs in these cases as much as you can in the same month as the related sales. Don’t go crazy with it, but try.

Sample Cost of Sales

In this sample, there is a unit cost for each of the items the store sells, so you multiply the units from the sales forecast times the per-unit cost to automatically calculate the direct costs of sales.

OK maybe my example here is a bit much, but planning is for everybody, all companies, not just the startups, so what the heck. It’s a not-so-small company, but the math is till pretty obvious. Let the numbers be higher, it helps me use the same company for some other examples.

The point is that budgeting expenses is a matter of simple math, common sense, and reasonable guesses, without statistical analysis, mathematical techniques, or any past data. The mathematics are simple; sums of the rows and columns. You’ve seen it before.

And, as with the sales forecast, you really need to have some idea of this. Either you get it from past data, or you get it from your experience in the industry, or form a partner or team member with experience, or you do some shoe-leather research. Try the telephone tree technique. Look for standard industry data.

Also, remember that you only have to go one month without having any idea, because by the second month, with plan-as-you-go planning, you have the first month’s results to help review and revise.

Here’s a simple example:

Match the depth and detail of your budget to the control and accountability you have on your team. Make it so that the rows are useful for following up later, looking at what was different from plan (and it will always end up different) and why.

Does your spending match your priorities? Remember the strategy pyramid, intended to help you keep your activities aligned with your strategy? This is where you begin to see it in action.

Aim for the right level of detail for following up. Too much detail makes it very hard to manage and track, and too much aggregation makes it hard to develop accountability. Do you know, in your business, who is responsible for each row in the budget? Does everybody else on the team know?

Before I go too much further, I’d like you to consider how important payroll is as part of you budget. Let’s see where those numbers came from. I recommend it be another separate table, whose totals flow into this one.

Payroll is really the most important of your expenses, right? Unless you’re

working all alone, when things get fuzzier, the worst thing that can happen is missing payroll. So that’s a number that should really be in your plan, among the simple basic numbers. I hope you agree.

Here too the math, the spreadsheet elements, are pretty simple. It doesn’t take advanced analysis or specialized equations. If you have past data and history, it becomes very easy (which is not to say that projecting future pay increases is an easy part of business, but the math and estimation is relatively simple).

Here’s a spreadsheet example.

This is just one easy way to do it. Lots of people add sophistication to it, like dividing the payroll up into departments, or estimating how many people in each functional area, then the average pay per person, then multiplying. For now, though, I want to keep things simple as we go.

It’s funny how the words come together. Few people do projections, but lots of people do budgeting. They are not that much different. Lots of people hate to forecast. Lots of people hate budgets.

Even the word “budget” sounds like disapproving accountants and denied requests: “It’s not in the budget” is one of the world’s more familiar negatives. “No,” by any other name, would smell as sour.

But, despite their bad reputation, budgets are always useful tools and are almost essential to the proper running of a business. Budgets are used for planning and for tracking performance against plans. Your plan-as-you-go business plan should always include your spending budget, and that, by the way, when you rename it, is one of your building blocks for your projected income.

Some people think of budgets as normal, not scary. Some people think of forecasts as scary. They are basically the same thing. Take it however it seems easier for you. It shouldn’t be that hard to do.

The best way, and easiest way, to do a useful expense budget is to take last year’s expenses and run them forward.

Start with an empty spreadsheet, the columns set up to show the months you’re running for your plan, presumably 12 months. Then use the row labels on the leftmost column to assign categories. Start with something simple, like rent. Estimate your rent and get it into a standard format. Don’t say you don’t know, or you have no idea