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Wednesday, November 4, 2015

Preparing a Cash Flow Forecast - Forecasting Variable Expenses Part 1

As stated in my previous post, almost all expenses over time are variable. There are thus those expenses that are fixed over short periods of time, but which over the longer term are variable. The most important ones generally are:

1. Financing expenses on monies borrowed for expansion.
2. Salaries and benefits
3. Premises rent.

The second major category of variable expense is that which is a constant function of some driver and for which the mathematical relationship does not change over time, or changes very infrequently as the business expands. Examples include:

1. Income taxes on the first $500,000 of business profits in Canada, which stands at about 15%.

2. Office supplies which is a function of the number of employees currently working for the business.

3. Hydro and gas expenses which are a function of the amounts of power and gas consumed for heating the business premises.

4. Cellular telephone costs which are a function of the number of minutes used by the employee pool. This, in turn is a function of the number of employees working for the business.

5. Payroll taxes such as CPP and EI contributions, which are a function of both the number of employees and the level of salaries being paid by the business.

6. Employee Health Tax (in Ontario), which is a function of salaries paid.

7, Inventory cost of sales, which is determined using either a specific identification of items sold, or some kind of averaging method. Usually for forecasting purposes, you will have determined an average profit margin for the business and conversely an average cost of sales percentage, so all you really need to know to estimate cost of sales is the volume of sales itself.

8. Vehicle expenses, which are a function of the number of employees working for the business mostly. The actual expense per employee will vary according to the number of KM each employee drives for business, but a large component of automobile expenses are fixed in nature, and so the overall level of expense depends more on the number of employees than it does on distance travelled.

10. Travel and trade show expense which varies according to the number of shows or conferences attended and the number of employees who attend.

As you can see, there are very few of the above expenses that you can estimate based on sales alone. Most all of the expenses require you to know how many employees will be working for the business in the period you are forecasting.

Even something fixed like premises rent is tricky because each employee requires a certain amount of space to work productively - something like 50 square feet. Plus they have to have a lunch room, places to hang their coats, washrooms, meeting rooms etc. So as your business expands, you are going to find that you will need to expand the size of your office. The difficulty with that of course is that most commercial leases are for 5 years or more and you cannot simply acquire an extra 5,000 square feet in the period that your forecast says you need it. So what you will find yourself having to do is forecast the growth of the business over the period that a lease would cover and then acquire a space large enough to accommodate the number of employees your business will eventually hire. In the meantime you would have to configure the space so that you can sublet the space you don't need to other tenants to recover some of the rent paid.

So clearly in order to produce a meaningful forecast of most variable expenses, you are going to need to know how many employees the business will require in each period. Determining that with reasonable accuracy will require you to know:

  • what positions you will need to hire for;
  • what the target level of productivity is for each position;
  • what the job description is for each position
I'll illustrate this with an example from my own business plan to show you some of the considerations that you will need to take into account. 

I stated earlier that my sales are constrained by two things:

  • How much inventory I have running on E-bay
  • How much marketing effort is expended to drive traffic to my listings.
In addition, though my sales will also be constrained on the supply side: how many orders can be processed in a reasonable amount of time. My marketing effort can be measured in the number of blog posts I produce and how long it takes me to produce a blog post. Right now, I'm doing everything required to run my business, which includes:

  • Opening my mail and sorting inventory purchases into the right place
  • Listing new items on E-bay
  • Picking orders, preparing them to be sent and actually mailing them
  • Recording sales in the books of account
As my business expands, I will find that I cannot do all these tasks without finding that I have little to no time to list new items or buy and process new inventory. It is at this point that I will need to hire. Each of the above tasks takes a certain amount of time on average, and the amount of time taken tends to be fairly constant. So you can estimate how much work an employee can get done in a day, a week, a month and a year if you have the average productivity figures for each task. A word of caution though: as the entrepreneur you are motivated differently from an employee. So you cannot use your productivity figures to estimate how long your employees are going to take to complete their tasks. A good rule of thumb is to increase the amount of time allowed for your employees by 25-50%. A superstar employee will work at the same speed as you, an average employee will be about 25-50% slower though. 

So in my example, I said in an earlier post that it takes me an average of 8 minutes to list an item on E-bay. So in estimating how long it will take an employee, I would set the time at 12-15 minutes per item. 

Your sales forecast will allow you to figure out how many orders you are going to process in the period that you are forecasting and this divided by your target productivity will tell you how many employees you will need for each job function. 

Once you know how many employees you need, you can research employment agencies online to determine how much you will likely have to pay your employees, and that in turn will enable you to calculate the salary expense. 

Once you have salary expense, you can use mathematical formulas to calculate the related benefit costs such as health insurance, CPP, EI and Employee Health Tax. 

That covers the first part of my post about variable expenses. Tomorrow I will do a quick wrap up post to bring everything I've talked about together and explain how you can complete the forecast of your cash outflows.

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