In the pursuit of multi-million dollar outsourcing contracts, the company I worked for required me to defend my financial projections. The auditor who usually ran these reviews was one of the kindest, yet toughest, auditors I’ve ever worked with. He’d always start with the same question, ‘What are the eaches?’ He wanted to know how many hours, square feet or cubic yards of something we had to sell to reach a specific revenue or profit goal. This experience taught me that looking at a business in terms of units made or sold provides critical clues about the viability of it.
Many projections and budgets lack any real precision. Typically, a desired revenue number is plucked from the air, or other suitable location, as a starting point. Some ‘standard’ percentage is applied to this number for cost of goods to arrive at gross profit, which then has some ‘standard’ expense number applied to it to determine at operating revenue and so on, all the way to the bottom line. If the profit number isn’t satisfying then lather, rinse, repeat.
This method has two basic problems. First, implies that there is a ‘standard’ anything. The smaller a business is, the more subject it is to variations in revenue, cost and expense. Its prices are constrained by and its costs are generally greater than, larger better capitalized companies. There can also be wide variation in prices paid for labor and materials depending on location, time of year and a company’s financial health.
Second, when using gross target numbers, you don’t deal with the idea of unit costs. Without estimating (or guessing) unit cost, you don’t know how many of a thing you have to make or sell to achieve the mystical revenue and profit numbers you seek. Knowing how many widgets you have to produce gets at the concept of capacity, which is one of the key limiting factors to how big your business can grow.
For example, if I say I want to make a million dollars selling a doodad for a dollar, then I have to make and sell a million doodads. This, in a good projection, is the first reality check: ‘Do I have the space, people and upfront money to produce a million doodads?’If I answer that question with any thought at all, I will have to estimate (or guess) how much material will cost and how long it will take to make a doodad. Having determined that, I can guess (estimate) the kinds of people I’ll need to hire and what to pay them. I will be able to estimate how big my staff will be and how much space I will need to house them.
It will become apparent quickly whether I can, or cannot, make a million doodads. Either I will have enough people and inventory inside of a reasonable space, or I won’t. This information may change my top line revenue number, but it will do so based on the capacity of my business instead of a whim. This process of estimating will also give me insight into the start up and fixed costs of a business idea.
Using the ‘eaches’, or unit pricing and costs to develop your projections may reveal that the business is not a good one to get into at all. Think about it. If you could have a good indication whether or not your business idea will make the profit you want it to before you spend money to open a new venture, that would be the most valuable piece of information you could get.