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More businesses should make business plans priority

Denver Business JournalOn the Money
From the February 14, 2003 print edition

The Wall Street Journal reports that 70% of the firms in America do not have a formalized business plan for the upcoming fiscal year. Many companies – in spite of having no plan in place – have high hopes for 2003. In order to achieve that increase, companies need a plan; specifically, a financial plan.

A common reason for this financial roadmap void is the belief that the personal charisma and memory of the owner, coupled with enforced compliance of a hastily prepared line item budget will be enough.

However, simply taking last year’s line items and adding 10 or 15 percent will not reveal the essential issues necessary to engineer authentic progress.

The old term is “zero-based budgeting,” or tabula rasa- starting with a clean slate and building the plan with as much current objectiveness as possible.

The Following are two critical elements in the construction of a budget for the New Year: activity based sales budgeting and breakeven analysis.

Sales don’t just happen by enchantment; although there are some confused sales executives that might disagree. Sales are the direct result of activities.

Common progressions of selling activities are: cold-call, warm-call, phone meeting, face-to-face introductory meeting, a formal presentation, refinement of the presentation, one last negotiation, and finally closed sale.

For each event the in preceding example, a ratio of success should be applied to calculate the ultimate “closing ratio.” This closing ratio can be applied to each step in the process; thereby providing a dynamic performance monitoring tool as well. It is critical to describe and budget not only the end result (closed sales), but each action within the process.

Turning to the expense side of company operations, the most important ingredient is a thorough grasp of the breakeven point. This implies a thorough understanding of the firm’s costs.           In order to calculate breakeven, the following elements must be clearly understood.

Bear in mind – these items are deceptively simple to understand – yet profound in their implications.

Variable unit cost – The cost associated with producing the next additional unit, $4 per unit for example.

Total variable costs – The product of units produced and variable unit cost (example 10 units at $4 variable cost produces a total variable cost of $40).

Contribution margin per unit – The sales price per Unit minus variable costs per Unit ($10 – $4 = $6 per unit).

Fixed cost -The sum of all costs required to produce any product whether you produce them or not. This amount does not change as production increases or decreases.

Total costs – Sum of fixed costs and variable costs.

Expected unit sales – The number of units expected to be sold.

Price – Price you will be able to receive per unit (example $10).

Total revenue – Product of price and expected unit sales (example 10 units at $10 equals $100 total revenue).

Profit – The total revenue minus total costs.

Breakeven – Number of units required to sell to make a profit of zero.

Breakeven point can be determined by using the following formulas: Sales price per unit minus variable costs per unit equals contribution margin per unit ($10 minus $4 = $6).           Breakeven sales volume equals fixed costs divided by contribution margin per unit ($1,000 in fixed costs divided by $6 = 166.6 units).

Deceptively simple in concept, but difficult in practice is the two-sided analysis of breakeven – The analysis is two-sided because of cash vs. accrual methods of expense. A deep understanding of costs is vital to success.

Furthermore, a very clear understanding of the difference between a cash cost and non-cash cost is essential. For example, depreciation is a fixed cost; however, it is not cash. Another difficulty that complicates the analysis is that variable costs may decline as volumes increase reflecting quantity discounts for components used in manufacturing.

Nevertheless, useful breakeven analysis shows two things: What level of total revenue covers fixed costs and, more importantly, how many units must be sold to breakeven.

It is a large mistake to simply calculate the necessary level of revenue without tying it to the preceding sales activities. It is also a blunder to calculate breakeven only on a net income basis. A cash basis breakeven point must be established as well.

Digging deeply into these two basic parts of a budget will construct a plan that is realistic and manageable. Monitoring not only the result, but the internal components will give the firm an early opportunity to correct and respond to changing market conditions.

To paraphrase Col. Sherman Potter, “Here’s to the new year. May she be a damn sight better than the old one, and may we all be profitable when she’s gone.”

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.