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The Income Forecast: Cloudy with a Chance of Profits

Posted on March 10, 2014 at 5:24 PM
Tags: small businesses

Forecast $$$$.jpgMeaningful financial projections are essential to business success. How much revenue will you take in? How much will be profit? Will the profit be enough to sustain the business?

No one should ever start or buy a business without a clear plan of profit and a realistic understanding of the sales volume needed to achieve it.

Easily said, not so easily done. Revenue forecasting with ballpark accuracy can be a daunting task even for seasoned entrepreneurs who have a keen understanding of their industries, their markets, their competitors and the relationship between demand and price.

Where does someone inexperienced in the ways of forecasting begin? First, this caveat: Every assumption you make must be firmly grounded in fact, not fancy. You have to see things the way they are, not the way you hope they’ll be. It’s all too common that new business owners start with unrealistic expectations for sales, revenue and profit.

The Desired Income Approach

Start by asking yourself these questions: How much money do you need the business to generate? What’s the minimum level of profit you can accept? Remember, you’ll need money to live, to repay loans, to pay creditors and suppliers, and possibly to plow back in your business (though reinvestment may not be necessary immediately).

Living expenses vary from person to person. Maybe you have substantial savings or income from other sources and don’t need the business to cut you a regular paycheck until things really take off. Maybe you need the business to meet all of your personal expenses from day one. Only you know the answer here. Just remember, your planning must be thorough and realistic.

If you had to borrow money for your startup, the bank (or investors) will be expecting a regular check, too. Here’s how to calculate how much income you’ll need to repay lenders.

Let’s say you borrow $30,000 for five years at an annual interest rate of 15 percent. Here’s how to calculate the annual payment:

  • $30,000 / .023790 = $713.70/month (.023790 comes from loan amortization tables.)
  • $713.70 x 12 months = $8,564.40/year

This $8,564.40 represents the total interest and principal repaid on the loan the first year of operation. We’ll round up to $8,600 and estimate personal living expenses at $15,000 for the year (yes, you’re living like a monk). That means the business must generate a total of $23,600 to meet your personal needs and keep current with the lender.

Now Calculate Sales

What kind of sales will you need to earn the $23,600? It’s helpful to get some average performance data for your industry. Many companies use the annual statement studies, published by the Risk Management Association, to get their data.

Be sure that the industry standard being applied includes the owner’s draw as a part of profit. So, let’s assume that industry sources show that the average profit for your business, including your draw or salary, is 11 percent of sales.

Here’s the formula to determine your required annual sales volume:

  • $23,600 is 11 percent of X
  • X = minimum required annual sales
  • .11 X = $23,600
  • X = $214,500

Assuming your business is average, you’ll need to sell $214,500 of products or services to cover expenses, keep your loan current through the first year and withdraw the desired $15,000. That’s the minimum sales target.

Is the number realistic? For some businesses, it will be readily apparent that it’s not. What then? Rethink your position. Alter your plan to make things more realistic. Or walk away and look for a better business opportunity.

For others, careful market research will be necessary before any reliable conclusions can be drawn.

Market Analysis

There’s a lot of raw data out there, but before it will be of use, you need to develop some basic definitions for your business.

Start by describing your business in detail and the industry it will operate within. Your business image is very important. It must address a perceived market need and must be designed to appeal to customers in your industry – not just to you.

Now, you need to understand your competitors and major historical trends in the industry. You should also examine and define significant outside influences on your business such as government regulation, energy concerns, inflation and other economic factors. Many of these forces will be beyond your control, but they must be recognized and planned for.

Production Analysis

Likewise, you need a full and complete analysis of your production capabilities. Your ability to satisfy market demand will be directly limited by your ability to produce, finance, sell and service. The market may indeed be able to meet or exceed your target minimum sales volume, but that’s meaningless if your production can’t meet demand.

In the same way, sales revenues are limited by the availability of working capital and by your ability to negotiate sufficient sales transactions. Indeed, you may determine that a substantial market potential exists, but you will need to consider the restricting impact of these internal factors.

Defining Your Customers

Next, you need to define your target market. Describe in detail the customers most likely to be interested in your product or service. Define them by relevant demographic factors -- income level, home ownership, gender, marital status, age, occupation, education or any of a host of market-related characteristics. Researching and creating a target customer profile can take a lot of time, but it’s critical to further market analysis.

Locating Your Customers

Now that you've defined your customers, you can start finding them. Basic demographic data outlining population size, density, distribution and other vital statistics is readily available from a variety of sources.

Develop a trade area based on geographic considerations. Defining your trade area involves determining how far you can reasonably and profitably take your product or service out into the marketplace or how far you can expect to draw customers to your place of business. Depending on your type of business, the trade area can range from a segment of a community to entire countries.

You need to understand competitors within and adjacent to your trade area. Attempt to describe who your competitors are and compare strengths and weaknesses with the business you want to operate. Become familiar with your competitors’ pricing policies and overall method of operation. You will be competing head-on for the limited number of opportunities within your selected trade area, and you must have as much knowledge of your competition as possible. Do not neglect to analyze future competition. Market dynamics are not static; they freely allow others to enter your market and to change and improve on products or services you will be offering.

Keep Your Eye on the Goal

Remember, the goal of your research is to verify whether your target minimum sales are feasible. Ask basic questions about your business. How much does the average customer spend in a typical sales transaction? How many sales transactions are required to meet your target minimum sales? Is there a sufficient customer base to generate the needed sales revenue?

Income forecasting is an inexact process, as much art as science. But starting with a desired income as your target and using an orderly approach to gathering data will keep you in the ballpark.

Learn More

Consultants at our Small Business Assistance Office can help you understand more about income forecasting techniques. And our network of Small Business Development Centers has experts located in nine main regional offices and several satellite centers statewide.

For a deeper look into income forecasting, see our Guide to Starting a Business in Minnesota. Available for download in PDF, formatted for e-readers, or available in print (all free of charge), the book covers the major issues, questions and concerns about business startups.

Nothing we cover in this blog should be taken as legal advice. It’s not. And it’s no substitute for the professional guidance of a lawyer or accountant.

The Last Word

Understanding pricing is key to income forecasting. If a business wants to generate more revenue, should it raise or lower the price of its product? Understanding an important concept called "Price Elasticity of Demand" will help you decide.

[http://youtu.be/4oj_lnj6pXA]


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