When planning a new business venture, costs are always difficult. Why? For one, there are so many of them. Most people try to get a handle on the chaos by creating a fifty-two line Excel spreadsheet.
- That’s their first mistake – they try to capture everything. Which is pretty much impossible.
- Their second mistake? They use traditional accounting categories like “Cost of Goods Sold” and “FF&E.” Most of which mean nothing to most people.
- Third mistake. They try to forecast it out for three to five years by guessing at some growth rates.
The end result? They think they’ve got the business cost forecast under control. It looks nice on paper. Then someone asks a basic question like, “Why is your profit twice the industry average?” Their deer-in-the-headlights look says it all.
If any of that sounds familiar, good news awaits . . .
The trick to forecasting costs is to eliminate the irrelevant. That means.
1. Focus deeply on the big stuff
I’ve bagged on the 80/20 rule in another post. But, here is one place where it makes sense to use it. There will be a few cost items that are big, “margin-eaters.” They consume 10 and 20% chunks of profit in a single bite.
Make sure you nail those. Research them in depth. An error in forecasting one of those can swing your profit dramatically. In contrast, smaller items can be wrong with little consequence to the final answer.
2. Use intuitive expense classes
When creating a cost forecast, throw away the accounting mumbo-jumbo. Using it causes two problems.
One, you add costs that you really don’t have. Like having a line item for “Entertainment” even though you have no idea who you would entertain or how it would grow your business.
Two, you lose the intuition behind why these costs are incurred in the first place. Really, what does “overhead” mean?
I recommend three cost buckets: Production, Sales and Fulfillment.
- Production captures everything required to build your product.
- Sales is everything required to generate leads and close sales.
- Fulfillment is the costs incurred to deliver the product and any post-sale follow up (like customer service).
3. Forecast only what you have to
Look for ways to eliminate excess work.
If you have no profit after costing out the raw materials needed to build your product, stop forecasting! You will only be more in the red.
Don’t even think about back-office costs such as accounts and lawyers until you have a nice profit coming off you production line.
Why forecast five years?
Forecast one good year. If that doesn’t look great, it probably won’t get much better in the future. Most businesses fail to reach that nirvana known as scale economics.
Don’t fall into the trap of making a bad business look good by manipulating the revenue and expense growth rates until you get the answer you want. Come on. Don’t pretend you don’t do that!
Conclusion
The bottom line of cost forecasting is this:
- Always look for ways to eliminate work.
- Don’t get caught up in minute details.
- Prioritize your focus on the important stuff.
- Keep it real – don’t play with growth rates to make your business work.
If you want to learn more, check out my ebook – Foundational Transactions. In it I walk through exercises that help you do this step by step.
