Writing your business plan is critically important to validate your idea, but the process can be challenging. You have to consider dozens of factors to write a comprehensive business plan.
Here are four little known factors that impact your business plan, and a discussion about how total costs impact your sales prices and business profits.
Use this discussion to write a complete business plan that provides a realistic assessment of your business concept, and to accurately price your product or service.
Let’s use an example business to help you connect each of these concepts to a specific company. Assume, for example, that Bob owns Ridgeline Tree Service Company, a business that trims and removes trees.
Here is the sale price, costs, and profit for removing a 30-feet oak tree from the Smith’s backyard:
|Ridgeline Tree Service: Profit and Loss/ Smith Project|
|Materials (rope, netting, tree stakes)||$50|
|Labor (three workers)||$300|
|* Depreciation: vehicles, equipment||$30|
|* Home office costs
(Office manager, insurance, rent, marketing)
|Profit (20% of sale price)||$120|
This level of detail indicates that Bob knows what he’s doing in his business. He can identify each type of cost, and compute a sale price for the job that generates a specific level of profit.
How did he get there?
We’re going to reverse engineer the profit and loss summary above, so that you can use this same level of detail to make informed decisions in your business.
1. Profit Does Not Equal Cash Flow
Generating a profit does not mean that the dollars are collected from each sale immediately. There are many reasons why a client may be delayed in making payment here are a few of the more common you may encounter
- Not all customers pay immediately in cash.
- If you send a customer an invoice, they may not pay it for weeks, or more. The time it takes to collect a receivable balance varies by industry.
- Clients may go out of business or declare bankruptcy, and you may not receive payment at all.
These issues cause problems for many companies, including profitable firms.
Assume, for example, that Bob is putting together a business plan for Ridgeline Tree Service.
Bob’s experience has given him connections to roofers, insurance companies, and homebuilders who can refer business to his new company.
Bob’s initial business plan forecasts sales of $200,000 in year one, and a profit of $30,000, or 15% of sales. This forecast means Bob will incur $170,000 in costs in year one($200,000 sales – $30,000 profit), or costs of $14,167 per month.
Based on his experience, Bob expects the average customer to pay his or her invoice within 20 days.
Bob starts his business on March 1st, and incurs $2,000 in tree service costs in the first week. Some costs must be paid immediately in cash, and others can be paid later, after receiving an invoice from a vendor.
Keep in mind that customers may not pay for 20 days or longer, and this means that the company needs a cash balance to operate.
Bob can access cash by contributing his own money into the business, by securing a line of credit (LOC) at a bank, or applying for QuickBooks Capital. If Bob raises cash through an LOC or some other type of loan, he needs to pay off the balance as soon as possible to reduce the interest cost on the debt.
Bob’s business plan includes a $20,000 beginning balance in cash, which he estimates will be sufficient to start company operations. Here are some factors Bob should use to compute the required beginning cash balance for each month:
- Required operating expenses each month
- Sales collected in cash for the current month, and expenses for the current month that must be paid in cash
- Expenses from prior months that must be paid in cash
- Sales from prior months that will be collected in cash
To use this in your business plan, estimate what your monthly costs will be, and the average time it will take to collect payments from customers. Use this information to determine the amount of cash you’ll need to start your business.
2. Creating a Plan to Replace Assets
Assets are defined as a resource that is used to generate revenue, and no business can operate without them.
However, many business owners don’t plan for the need to replace assets over time, and this oversight leads to major issues over time.
Bob, for example, uses two stump grinders for removing tree stumps. Each stump grinder has a cost of $4,000 and is useful for roughly five years.
Bob’s business plan must include a plan for securing $8,000 to purchase two new assets in five years.
Thinking more broadly, Bob must know the useful life and replacement cost for vehicles, trailers, and other tree service equipment used in his business.
Ideally, Bob should put this information on a spreadsheet, and set aside business profits each year to pay for new assets, as they are needed. In the long term, this process is vital for Ridgeline Tree Service to stay in business.
To use this in your business plan, create a spreadsheet with the useful life and replacement cost for each asset you own, and use that information to plan for asset purchases in future years.
3. Document How You’ll Raise Capital
Many owners start their businesses using their personal assets, such as savings or a second mortgage on a home. At some point, however, you may need to raise additional dollars (capital) to operate and/or grow your business.
When you reach that stage, understand the difference between debt and equity because it impacts how you operate your business.
Since a new business does not have a track record of generating profits, it’s likely that you’ll sell equity to raise capital in the early years of operation.
Equity means ownership, when you sell equity to raise capital you are selling a portion of your company.
An equity owner may expect to have a voice in company decisions, even if they do not own a majority interest in the business.
After one year of operating Ridgeline, Bob raises $50,000 so he can purchase more equipment and hire a second crew of employees.
Sally, a business associate of Bob’s, pays $50,000 in exchange for a 20% ownership interest in Ridgeline.
Because this transaction is a private investment, Bob and Sally have to decide on Sally’s rights as a shareholder before the investment is made.
Sally may also expect to be paid a dividend, which is a share of company profits, and she’ll want to know how she can sell her ownership interest. These issues should be negotiated before the investment is made.
Shares trading on an exchange – such as The New York Stock Exchange – aretraded publicly, meaning that registration is required before the shares are initially sold to the public.
If you purchase common stock on a stock exchange, your rights as a shareholder are outlined in documentation that the issuer files with the Securities and Exchange Commission (SEC). This process is referred to as securities registration.
Most small business equity sales are private transactions.
You can also raise capital by borrowing money, and you’ll have to repay creditors both the principal amount borrowed and interest on the debt. Again, it’s difficult to borrow money if you don’t have a track record of generating profits, because profits are your source of debt repayment.
While you may not borrow money initially, many firms to borrow large sums as they grow and generate consistent profits.
As Bob’s company grows over time, he may raise capital through a combination of equity and debt. If you look at the capital structure of any large company, you’ll see that most firms issue both equity and debt.
To use this in your business plan, decide if you’re willing to accept the trade off of giving up total control and profits before you sell equity in your business. Research your available sources of debt, and what ability you may have to raise capital.
4. Know When to Hire Experts
Important business decisions require an expert, so your business plan should consider the cost of hiring experts. To make informed business decisions, you may need to budget for a CPA and an attorney.,.
Bob finds a CPA through one of his business contacts and agrees to pay the CPA to review his monthly accounting transactions and prepare the annual tax return. He also locates an attorney to help with his client agreements and with any legal disputes that may arise.
To use this in your business plan, ask your business contacts for referrals, and how much they pay for these services, and include the costs in your business plan.
We have discussed four key elements you must consider when writing a business plan. But perhaps the most often neglected idea that leads new business owners into trouble is not understanding total cost which an expert can help you with.
What Are Your Total Costs?
Costs, profit margins, and sale prices are closely linked, and many business owners set sale prices without accounting for all of their costs.
This discussion can help you account for all of your costs, and calculate your true profit.
Now, you may think that your business costs are obvious, and that calculating total cost is simple. But new business owners often neglect some cost when making their calculation.
The cost of your product or service must include all of your costs, including overhead. If not, you can’t determine a sale price to generate the profit level that you’re expecting.
Over time, underestimating these costs can creep up, catch you off-guard and eat away at your business. Here are some examples:
- Insurance premiums: Insurance costs tend to go up each year for most forms of coverage, and that’s particularly true with business insurance. If one of Bob’s employees is injured, for example, his workmen’s compensation insurance to cover this risk will increase. Will Bob increase his prices to offset this higher expense? He should.
- Labor costs: Bob may have to pay a higher rate for good employees, if fewer qualified workers are available.
- Mileage costs: If Ridgeline starts doing business with clients who are farther away from the office, on average, total fuel costs will increase.
Before you know it, Bob maybe pricing some jobs at a level that doesn’t generate a profit at all. It’s critically important to stay on top of changes in your costs.
Assume that Bob is bidding on a job to remove two 30-foot oak trees from a yard. He can easily estimate his labor costs, based on his years of industry experience. Bob also knows all of the equipment he’ll need to take down the trees, and the vehicles he’ll use.
However, that’s not all of the costs Bob incurs in the business. For example, Bob pays $30,000 a year for a person in the office who schedules work, answers phone calls and emails, and who handles billing.
In order to calculate his total costs, a portion of that $30,000 salary must be allocated to each job. If, for example, Bob does 300 jobs in a year, he might allocate ($30,000 / 300 jobs), or $100 to each customer job for salary overhead.
Bob needs to look at each overhead cost, and come up with a reasonable method to allocate costs to each job. To allocate depreciation costs on his vehicles, for example, Bob may allocate a dollar amount for each mile driven for a job.
Once Bob reviews and assigns every costs, he’ll know that true cost of each job. At that point, he can price the job to generate a specific profit margin.
Profit margin is defined as (profit) / (sales). If, Bob earns a $250 profit on a $2,000 job, his profit margin is ($250 / $2,000), or 12.5%.
This example assumes that Bob’s total costs are ($2,000 – $250), or $1,750, and that total must include an allocation of all overhead costs.
List every cost your business incurs, and make sure that you’re assigning those costs to each product or service that you sell.
Do Your Homework
Writing a comprehensive business plan and analyzing your total costs takes effort, but the work will pay off for you.
The time you put in will help you resolve weaknesses in your business plan and price your product or service correctly.
Simply put, you’ll know a great deal more about your business after this process so you can move forward with confidence.