When preparing financial projections a business needs to use expense forecasting to establish its expenses for inclusion in the income statement.
When forecasting expenses, we could simply enter a fixed amount for each expense. However, this takes no account of the fact that some of the expenses do not remain fixed and vary with the scale of the business activity. In addition, entering fixed amounts for every expense makes the financial projections time consuming to adjust as the scale of the business changed.
To simplify the process of expense forecasting there are various techniques which can be employed. For example expenses can be linked to other variables (cost drivers), such as revenue or headcount. Of course there will always be expenses which are fixed in nature. Fixed expenses cannot be linked to other variables and need to be estimated in absolute monetary terms.
Expense Forecasting Using Revenue
Expense forecasting using the revenue forecast simply involves establishing a percentage relationship between the revenue and the expense. This percentage is then applied to the forecast revenue used in the financial projections to estimate the expense.
Cost of Sales
The best example of this type of expense is the cost of sales. Cost of sales is the total of the expenses associated with producing and manufacturing the products sold during the year. If there are no sales during the year, then there will be no cost of sales. By its nature, cost of sales includes variable expenses which vary in direct proportion to the level of sales activity.
Examples of cost of sales expenses include direct materials, direct labor involved in production, freight, shipping and carriage inwards expenses. In a service business, the cost of sales is more likely to include wages for staff delivering the service.
Cost of sales (COS) is best estimated by taking a percentage of the sales revenue, as there is a direct link between the two. If you double the revenue, then the cost of sales will double. To illustrate, if revenue is 100,000 and the COS% is 40%, then the COS is 100,000 x 40% = 40,000. If the revenue doubles to 200,000, then the cost of sales will also double to 200,000 x 40% = 80,000. This relationship will hold true so long as the cost of sales percentage remains the same.
Cost of Sales and the Financial Projections Template
In the financial projections template the COS% is included by applying a gross margin percentage (GM%) to the revenue. Cost of sales and gross margin are linked by the following formula.
To illustrate, if the COS% was 40%, then the gross margin percentage has to be 1-40% = 60%.
To establish the COS% and therefore the gross margin percentage, we have provided various gross margin calculator templates. These templates allow a business to enter details of the expenses relating to the product or service, and for the GM% and COS% to be calculated.
Forecasting Sales Commission Expense
There are of course other expenses which can be linked to revenue. The trick is to establish a percentage link between the two and apply that percentage to the revenue forecast. For example, sales commissions might be established as a percentage of revenue used in the financial projections. To illustrate suppose the sales commission expense was 2% of revenue, and the revenue forecast is 150,000. In this case the sales commission expense would be calculated as 2% x 150,000 = 3,000. As the revenue forecast is changed the sales commissions are changed.
Be careful to make sure that there is an actual link between the revenue and the expense. Looking at historical information might show that for last year rent was 10% of revenue. This does not necessarily mean that there is a link between the two for future years. If rent is a fixed amount of 10,000 and revenue was 100,000 last year, rent is indeed 10% of revenue. However, when the revenue is forecast to be 200,000, the rent remains fixed at 10,000. The rent is now 5% of revenue. In this case there is no percentage link between revenue and rent, and this expense forecasting technique should not be used.
Expense Forecasting Using Headcount
Headcount refers to the number of people employed by the business. With the headcount forecast in place, expense forecasting techniques can be used to estimate a large number of individual expenses.
A major expense for any business is the payroll expense, the cost of wages and salaries for employees. Using the headcount forecast and the estimated average wage for the type of employee, the wage expense can be forecast. To illustrate suppose the headcount forecast shows the requirement for four sales employees. If the average wage of a sales employee is 25,000, the estimated payroll expense is 4 x 25,000 = 100,000.
Having established the total wage and salary expense using the headcount forecast, other payroll related costs such as bonuses, recruitment fees and payroll benefits and taxes can be forecast by applying a percentage to the wage and salary expense. For example, if the headcount forecast shows five people with an average wage of 20,000, then the wage expense estimate is 5 x 20,000 = 100,000. If bonuses are 5% of wages and payroll benefits are 15% of wages, then the financial projections can use the wages expense estimate to calculate expense estimates of 5% x 100,000 = 5,000 for bonuses, and 15% x 100,000 = 15,000 for payroll benefits.
The level of detail to which this is carried out depends on the business and the level of detail required in the financial projections. A small business might simply say there are five employees with an average wage of 20,000. In contrast a larger business requiring more detail, might forecast headcount by department, e.g sales and marketing, research and development, general and administration, and estimate an average wage and total wage expense for each department. Our headcount and staff costs calculator can be used to simplify the process of forecasting headcount and staff costs.
Other Expenses Related to Headcount
While payroll is the major expense, numerous other expenses can also be linked to the headcount forecast. In this case, the expense forecasting technique is to estimate a cost per headcount and apply the headcount forecast to this cost to arrive at a total expense forecast. For example, the telephone expense might be established at 500 per sales employee. If the headcount forecast shows 20 sales employees, then the telephone expense can be forecast as 500 x 20 = 10,000.
This expense forecasting method can be applied to a number of expenses such as travel expenses, mobile phones, office expenses and conferences.
As a side note, while not an expense to be included in the income statement, this same headcount expense forecasting method, can also be applied to estimate the capital costs need to equip each employee with items such as computers, desks and chairs etc.
Expense Forecasting Using Other Cost Drivers
Of course not all variable costs can be linked to revenue or headcount. However, depending on the type of business, there are other variables referred to as cost drivers which can be established to allow expenses to be forecast. For example, the number of website visitors can be used to forecast hosting costs or credit card transaction fees. Additionally average monthly searches can be used to estimate advertising expenses based on an average cost per click (CPC).
Fixed Expense Forecast
Finally there is the category of fixed expenses. Fixed expenses are expenses which will happen whether or not a business has any production or sales activity. Fixed expenses are a function of the passage of time. For this reason they are sometimes referred to as periodic expenses.
As there is no link to establish, expense forecasting for fixed expenses involves setting an absolute monetary amount in the financial projections. This fixed amount can be based on historical information for established businesses. In the case of a startup business comparisons with similar businesses can be used.
For example, rent on a building is normally a fixed expense. Consequently if the level of sales or production activity changes, the rent for the building will remain the same. By looking at rental prices in the area and the size and type of property required, a best estimate can be obtained.
Stepped Fixed Expenses
Fixed expenses are entered in the financial projections as an absolute monetary amount. Therefore care must be taken to review the financial projections for any major changes in the scale of activity of the business to see whether adjustments need to be made. In the case of rent for example, at some point the business will become too large for its current premises. In this case the rent may increase as larger premises are taken on. This type of increase is referred to as a stepped expense, as the expense will step up to a new level. It is important to realize that a stepped expense is not the same as being a variable expense.
Whichever expense forecasting technique is employed, initially it can be a time consuming process to determine the links to revenue, headcount or other cost driver. However, once the cost drivers have been established the process of forecasting and in particular that of updating the financial projections as the size of the business changes, becomes a much simpler task.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.