Financial Projections: The Revenue Model (part 1 of several)
Oct 08
Preface for this series of posts: I thought it might be a good idea to walk through developing financial projections – starting with the revenue model. Sure, I want to show everyone how our tools make this process easier, but I also want to point out that garbage in = garbage out. There’s a lot that goes into business planning! But let’s take a look at some simple examples and see how it might all come together.
Developing solid financial projections is not an easy task for an entrepreneur. Doing so requires us to think really thoroughly about our business. We have to think about who our customers are, how we’re going to reach them, how many and which flavor products we can sell to them, how much advertising spend we need, how many sales and marketing resources will we bring aboard, etc. This is hardly the entire list, which can be overwhelming!
But that’s not all. It’s not as simple as running through a list of questions and providing answers. All your “answers” have to link together. For example, a huge sales team can be constrained by tiny advertising budgets that don’t generate enough leads. Conversely, a tiny sales team could be overwhelmed by response to advertising.
Now, while these examples are, intentionally, pretty simple, if we look at this from a higher level there are a few real important checks we must be sure we pass to have a successful business. We need products that add value to customers. We need customers. We need distribution to get our products to our customers. We need a marketing plan. We need an operational plan. This all has to link…
Once we’ve thought through all of this we need to show what will happen financially if we execute our plan as designed (conservative financial projections are usually best for internal use and strategic planning. Projections that yield hockey-stick growth charts tend (a) to be unrealistic and (b) only work when you’re pitching to a venture capitalist…in 2000).
Assumptions are the bridge between the strategies you’ve thought out and the numeric representation of your company you might be struggling to develop. Let’s walk through a simple example.
You manufacture and sell widgets. You make widgets, store them in inventory, your marketing plan generates leads, your sales staff closes as many leads as possible, and you ship the widgets. It’s a straightforward business model. Now let’s make up some assumptions around the revenue model:
- 5,000 leads in year 1
- 5% sales conversion rate (1 in 20 leads turns into a sale)
- You have 2 products, a “Basic” ($100) and “Premium” ($300) widget
- 80% of orders are for the “Basic” model and 20% are for the “Premium” model
Mathematically, for our basic widget this equates to: 5,000 x 5% x 80% x $100 = $20,000 for year 1. The premium widget is: 5,000 x 5% x 20% x $300 or $15,000. This might be a simple example but it illustrates how important assumptions and how much leverage an assumption might have on the result (try a 6% conversion rate…it yields a 20% increase in revenue). We could dive deeper and look at seasonality of sales, up-selling customers, new versus repeat customers, optimizing sales tactics, other distribution channels, etc. But that’s not the point of this article, so let’s continue.
We’ve established that assumptions are at the core of financial projections. They’re the input and foundation. Once they’re developed we need to (1) do the math to get the big financial picture on an annual basis and (2) explain these assumptions in the business plan.
Focusing back on the revenue model, let’s round out this first post by looking at how it’s structured. While it can also be called a Sales Forecast, in either case this statement produces your “top line” (revenue or sales). A consolidated statement will take a higher level perspective in the form of annual or quarterly figures, though you could easily look at your model monthly as needed. Consolidated or not, the statement is going to tell you 3 things about each of your products:
- How many units you sell
- The average price you sell each unit at (average because prices can change over time)
- Total revenue (or units sold times price)
A revenue model or sales forecast might look something like (click for larger):
You might notice that there aren’t very many assumptions (or inputs) that feed a revenue model. You’d be correct in this observation. The inputs and arithmetic behind this statement are simple. But don’t confuse simple for unimportant or trivial. After all, the golden formula for business is profit = revenue – costs. The revenue model gives you half of that equation!
In a series of posts to follow over the next couple weeks I’ll walk through the other financial statements (P&L, Income, Cash Flow) and look at how assumptions feed into them and how they relate to each other.
Matt