financial modeling expenses

(This article is co-written with Evan Kimbrell and will introduce you to a basic marketing concept that you can use as a handy lens for understanding your financial models. )

It’s always easy to daydream about revenue and how we can chart your inevitable hockey stick growth for your business.

But allow me to be the Debbie Downer in the crowd and tell you that we are now going to focus on the other side of the equation – the expenses.

I’m bold. I would go so far as to say:

Understanding your expenses and the relationship they have with your expansion is more important than understanding your revenue model and potential growth rate.

A lot of modeling revenue is just pure guesswork – we assume that we’ll get this many customers now and this many later.

But with expenses, we can very quickly get real numbers and figure out… is this even feasible?

Expenses are… expensive.

You can quote me on that. But one distinction we need to understand about our “expensifications” is that there are two types of costs: first is what we call startup costs, and second is what we call operating expenses.

You can also think of startup costs as one-time costs, and operating expenses as ongoing costs

The best way to think about startup costs is that they’re the costs you incurred to get up and running whereas your operating expenses are the expenses you need to KEEP your business running on a day to day basis.

What would it look like for a lemonade stand?

Ok, let’s start with the lemonade example. If we were to start a stand for selling lemonade on the side of a busy street, what would the two types of expenses look like?

Well, we’d need all the things associated with first selling some lemonade, and we might need the big ticket items that allow us even to operate. In general, you can think of startup costs as being split between two things: things you need to get to get started, and the things you need to handle the early parts of your growth.

Do you need a table to get started? Yes, absolutely. That falls into the first category. And if we’re anticipating 100 sales the first day, well we might need to buy 100 cups upfront as well. Those count as expenses for your first couple days of growth.

In modeling these, we will need to separate the two sets of expenses into what’s associated with the prep station and those that are used to get the stand setup.

If I add in all the items we covered previously and add a total, we’ll have a very rudimentary estimate of our startup costs.

Ok, but what about all the things you need for your for your first set of sales? You need ingredients and cups, right?

So let’s add these things in line with the other costs. Let’s assume we order all our ingredients and cups/napkins in small batches just to be safe in case this business flops day one.

Because we want to make sure these costs fall squarely into the realm of startup costs, let’s just add the costs for what we would need for two days of sales. If you go past that well… good luck explaining that to the IRS.

Ok, so now we have a more complete look at what we would need in our bank account to get this started on Day One. If you have the cash, then you could probably pull this off.

But of course, there’s always more to think about and take into consideration.

How do you account for unexpected expenses?

Do you believe planning to float yourself for 2 days is enough?

That seems a little aggressive, right? Well, you could get even more aggressive and do just one day but of course, there will be pros and cons.

Pro: You need less money upfront

Con: You might have to get money from a loan shark to cover payroll.

In fact… let’s try to be realistic with this. Two days is fine ONLY if we get these exact expenses. What happens if we get a fine for where we put our table? What happens if a pitcher breaks and we have to replace it?

Well, we need to add the age-old concept of contingency.

Generally, I like to do contingency one of 2 ways:

  • FIRST, try to think of all the worst case issues that could happen for expense items and then double it, or
  • SECOND, make it a percentage of your costs (e.g. add 20% to total expense estimates).

Of course, these contingency numbers will vary massively depending on your risk tolerance and industry.

One last thing I think we might want to throw in. Let’s say you hire your “sales associates” or lemonistas and they’re just not cutting it on the first day. Or let’s say they accidentally overheard a Bernie Sanders rally and are now unionizing to demand higher wages. Or maybe sales are just slower than you expected.

To ensure there will be enough funds should any of these scenarios play out, we could increase our initial labor expense estimates by 100%, for example. That could cover a lot of different labor-related issues because when you first start a business, you have no idea what you’ll need. It might turn out you need 2x the employees or simply just higher caliber salespeople that cost more to hire and retain.

These are things worth taking into consideration.

If you’re interested in learning how to build robust financial models for your startup business, join over 43,000 fellow students in my Financial Modeling for Startups & Small Business course, complete with fully built financial models for seven completely different types of businesses.

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