By Gary Drake and Michael Kerrigan, Beacon Consulting Group

According to the U.S. government, 50% of all small businesses fail within the first three years. Unfortunately for many business owners, by the time they recognize the critical nature of their problems, it's too late. Most business owners share an inherent sense of optimism and believe that they're close to success. Many of them also share a sense of disbelief when their expenses continually outrun their revenues.

If you're like many small-business owners, you might track the performance of your company informally and make business decisions based on intuition — which might be confirmed (or denied) when a monthly bank statement arrives. Even successful business owners struggle to determine accurately whether they're regularly operating at a profitable level. It's difficult for businesses to project profit levels based on target sales levels.

Develop a profit projection

A profit projection consists of identifying future income streams and expenses (outflows). The process enables small companies to identify tradeoffs inherent in any business. Although you probably recognize the immediate benefits of this type of planning, you might lack a structured approach and the appropriate tools to accomplish the task.

A profit projection weighs assumptions, projected revenues, and projected expenses. After you have established detailed sales and expense projections for a given period and have identified and noted key assumptions, you can use a simple formula to project profitability. It's essential to thoroughly review the results of this analysis.

Assumptions

Assumptions are at the heart of every financial projection and determine the usefulness of those projections. A considerable amount of time should go into developing these assumptions, and you need to review them thoroughly. In addition, assumptions should be clearly identified as such, and you shouldn't hesitate to modify them as needed to accommodate different business scenarios or to reflect real-world experience.

Projected revenues

When developing projections, it's wise not to be overly optimistic. For example, it doesn't pay to underestimate the impact of such factors as seasonality and the changing buying habits of your customers or to ignore the actions of your competition. If you do, you might overestimate attainable sales levels and develop unrealistic profit projections.

When developing revenue projections, start with these steps:

• Identify repeat or recurring revenue sources  Because your company has a history with these customers, you can develop assumptions based on historical purchasing patterns.
• Document potential new customers and markets  Identifying prospective customers along with the expected revenues and unique product requirements helps substantiate growth projections.

Projected expenses

Companies tend to spend more time analyzing revenue streams and less time evaluating the cost structure required to support those revenue streams. Thoroughly analyzing your company's existing expense structure is crucial in developing a good baseline that can be used to project future expense levels.

For many small businesses, two of the most significant categories of expenses are labor and overhead.

• Labor  When projecting labor costs, be sure to take into account the impact of such items as insurance and taxes, employee turnover, annual compensation adjustments, and overtime pay so that you're less likely to underestimate total costs. If you're projecting significant growth, it's a good idea to quantify the capacity of current staff levels and identify the incremental costs required to meet growth targets.
• Overhead  Overhead consists of expenses that are incurred but are not directly tied to a specific customer or sale. Overhead typically includes items such as rent, insurance, utilities, and administrative expenses. Expected increases in overhead expenses, such as a rent increase, need to be factored into the profit projection. Pay particular attention to these indirect expenses, because it's easy to underestimate the impact that these overhead costs have on the profitability of a product or service.

After you identify expense items, categorize the items as either "fixed" or "variable."

• Fixed expenses  These are costs that are incurred regardless of sales levels — for example, rent, electricity, and fixed wages.
• Variable expenses   These are costs that generally increase or decrease based on sales volumes, such as cost of goods sold and cost of direct labor.

Do a breakeven analysis

After you have created a profit projection, analyze sales and cost figures under different operating scenarios to determine breakeven levels. A breakeven level is the minimum sales level that is required to cover projected expenses. This analysis is useful for all firms, because it helps to determine revenue thresholds.

Often, breakeven analyses result in aggressive revenue requirements. In these cases, reevaluate pricing and expense assumptions to ensure that they're reasonable. For example, variable costs, such as direct labor, might be reduced over time as your company becomes more efficient at producing your particular product or service. Cost estimates need to reflect these savings.

Look at a variety of scenarios

Because of unpredictable and constantly changing economic conditions, it's a good idea to develop several different breakeven scenarios. The results of these various scenarios provide valuable data that can help you make more informed short-term and long-term decisions.

About the authors   Gary Drake is a managing associate and Michael Kerrigan is a principal with Beacon Consulting Group, Inc., in Boston, Massachusetts. Beacon specializes in providing operational and strategic consulting services to the investment management industry.