The economy is hard to see. There is the local economy, the national economy and the world economy. When the economy is good, there are plenty of jobs. Wages go up as employers compete for a limited supply of workers. As wages go up, it is easier for families to pay the rent for their home or apartment. People are more confident and make more purchases which helps businesses succeed and hire even more workers. This is called an upward spiral or positive feedback loop.
However, when the economy is bad, the opposite happens. Businesses sell fewer products and have less money to pay workers. The business owner has to fire workers or reduce their hours or reduce their pay. Workers then have less money to buy goods and pay the rent. They shop less which puts more pressure on business owners to further reduce their number of employees. This is called a downward spiral or a negative feedback loop. If it goes on long enough, it is called a Recession or Depression.
The fact that employee wages and hours rise when the economy is good is an example of the Law of Supply and Demand. This law states that as the supply of a product (such as workers) goes down, the Price or Pay for those workers will go up. If there are too many workers in a given field, then the supply will go up and the pay will go down.
We can also look at the Demand for products or services. As the demand for products goes up, then the price for the product will also go up.
Therefore one key to having a successful business is to choose a product or service with a high demand or lots of buyers but also a low supply or few competitors. Another key to a successful business is to make sure your business generates more in sales and income that it spends in expenses and costs.
The Household Budget
Before we look at a business budget, let’s first look at a family budget. Just like businesses, families need to make sure that the money coming in each month is greater than the money being spent each month.
The household budget starts with the initial bank balance. It is important to keep some savings in the bank each month to allow for unexpected emergencies such as the car breaking down. To make things simple, we will use a family of three with an initial savings of $1,000 and a total monthly income, after taxes of $3,000.
Initial Bank Balance $1,000
Monthly Net Income $3,000
Total Income Available $4,000
Whether you are a business or a family, you have two kinds of expenses. Some expenses are required to be paid each month. These include the rent, utilities such as heat and water, car and health insurance and food. For this example, we will say or family has a rent of $1,500 per month, utilities of $100 per month, car insurance of $100 per month, health insurance of $400 per month and food cost of $100 per week or $400 per month. This brings the total mandatory expenses to $2,500 per month.
There are also Monthly Optional Expenses. These can include going out to dinner or going out to see a movie or a trip to the zoo or buying some new clothes. For our example, we will assume our family spends $100 per week or $400 per month on optional expenses.
Thus, the total monthly expenses are $2,900 per month. This leaves a monthly savings of $100. The Monthly Savings plus the Initial Bank Balance for this month equals the Initial Bank Balance for the next month – which will be $1,100.
While the family income is often determined by the wages paid per hour times 40 hours per week, the family expenses are more complex and are related to the Typical Cost of Living in the community where the family lives.
The Business Budget
Businesses also need a budget to make sure that their income each month is higher than their expenses. Business income is typically in the form of sales – with customers buying products or services from the business owner. Some business expenses such as rent and insurance are similar to expenses faced by families. But businesses have other expenses that families do not have. The three main business expenses are the Cost of Goods, the Cost of Employees and the cost of marketing.
Cost of Goods
The cost of goods is the cost that it takes to make a particular product. For example, when making a Gallon of Lemonade, you will need a six lemons and one cup of sugar. If the lemons cost one dollar each and the cup of sugar costs one dollar, then you might think that the cost of a gallon of lemonade is $7.00. But you also need to consider the cost of the cups. There are 16 cups in a gallon of lemonade. So you will need to buy 16 cups. If a package of 16 cups costs one dollar, then the total cost of a gallon of lemonade is $8. The Cost of Goods for one cup of lemonade is $8 divided by 16 or 50 cents. If you sell all 16 cups of lemonade for $1.00 each, your income will be $16 and your expense will be $8 for a profit of $8.00.
Cost of Employees
Even if you will only hire yourself, you should consider the cost of your time as your employee. If you sell 8 cups of lemonade per hour, it will take you 2 hours to sell 16 cups. If your profit is $8 for 16 cups, then you can pay yourself $4 per hour. But if you can attract a lot of customers and sell two gallons of lemonade or 32 cups of lemonade every hour (which is one cup every two minutes), then you can pay yourself $8 per hour.
Cost of Marketing
A lemonade business might not need much marketing. You can set up your lemonade stand on a busy street and hope cars driving by will stop to buy a cup. Thankfully, you can set up a website online for free and advertise your business through free places such as Facebook for free – if you know how to set up your own website.
Determining the Break Even Point
In addition to variable costs, many businesses also have fixed costs. For a lemonade stand, this can include the cost of the table and the cost of the lemonade jar. If your table costs $20 and the jar costs $4, then your initial startup fixed cost is $24. If you make a net profit of $1 per gallon after all of your fixed expenses and employee and marketing expenses, you will need to sell 24 gallons of lemonade just to break even on your initial fixed cost investment of $24.
Return on Investment (ROI)
Another obstacle faced by any new business is where the initial funds will come from to start the new business. For our lemonade stand, the initial investment is $20 for the table, $4 for the jar, $6 for first six lemons, $1 for our first cup of sugar and $1 for our first package of 16 cups. Therefore our total startup cost is $24 plus $8 equals $32. But if we only have one gallon of lemonade, we will not have any replacement lemonade to sell once the first gallon is gone. A more realistic plan is to buy enough supplies for two gallons of lemonade. This way, we can make the second gallon and have it ready to sell once the first gallon is gone. While we are selling our second gallon, we can send our parents to the store with the $16 we made from the first gallon to buy two more gallons of lemonade supplies.
As the fixed cost for each gallon is $8, the total initial investment for the table, jar and two gallons of lemonade supplies is $40. Who will give us this $40 we need to start our business?
The most reliable source for any business investment is you own personal savings. Maybe mow lawns for your neighbors for $4 per lawn. You will need to mow 8 lawns to save up $32. Other investors might include your parents, aunts, uncles and grandparents. To encourage them to give you the initial $32 you need, you will need to include some interest paid to your investors. This interest is called Return on Investment or ROI.
You will need to pay your investors more interest than they would get paid at a bank since starting a new business is much riskier than putting money in a bank. It is common to pay investors about 10 percent per year as a Return on their investment. 10% of $40 is $4. So our Lemonade Stand Business Plan should also include a Return on Investment of $4.
As our business expands, we should consider the return on investment for each gallon of lemonade we sell. What would our profit be if we sold 100 gallons of lemonade or 1000 gallons of lemonade?
This can be calculated precisely. But it is usually expressed as a Percent. If we make a net profit on each gallon of one dollar, then the long term return on investment is the net profit per gallon divided by the total cost per gallon. In our case, the net profit is one dollar and the total cost is $15 for a Return on Investment of 1/15 = 7%. Put another way, for every $100 we invest, we make a profit of about $7.
How can we increase our profit?
Besides simply selling more lemonade, one way to increase profit would be to cut the fixed cost for each gallon. Instead of putting six lemons in each gallon, we could put just three lemons in each gallon. Then instead of making one dollar per gallon sold, we could make four dollars per gallon sold. The total cost per gallon is now only $12 and our profit is $4 The Return on Investment is 4/12 or 33%. Another way to increase our profit is to increase the price of each cup of lemonade. If we doubled the price to two dollars per cup, instead of making $16 per gallon, we could make $32 per gallon. If the total cost was $16 per gallon, our Return on Investment would be 16/16 or 100%.
Market Research
But the problem with cutting the number of lemons in half or doubling the price is that customers may not like the diluted lemonade and may not buy a second cup. They also may not recommend the lemonade to their friends. They may even want their money back. One way to determine the best number of lemons is to make a test batch with six lemons and another batch with three lemons. Then see if you, your friends or parents can tell the difference. Another less expensive way to determine the ideal number of lemons is to do an online search of other lemonade stands or lemonade recipes to see how many lemons other people put in their lemonade.
Operating Margin
Another way to look at this return on investment is to look at the profit as a percentage of total sales. This ignores the initial startup costs and looks only at sales and profits from sales. It is called the Operating Margin. If the net profit is one dollar per gallon or $16 in sales, the operating margin is 6%. If the net margin is four dollars per gallon, the operating margin is 25%. This means that for every one hundred dollars in sales, you would make a profit of 25 dollars.
Business Plan Estimating Sales and Expenses… The Sales Forecast
Making a sales forecast is the most important part of your business plan. Business forecasting is like weather forecasting. But instead of guessing whether it will be rainy or sunny tomorrow, you are making an educated guess of how many units of products you will sell and what your expenses and profits will be if you sell those products.
Just as you should research how many lemons other lemonade stands use per gallon, you should also research how many cups of lemonade other lemonade stands sell each hour, each day, each week, each month and each year. Your Business Plan Sales Forecast will help you decide whether your business will be worth investing your time and money to start – whether you will make a reasonable profit - or whether you will lose money and be wasting your time.
Example Sales Forecast
Here is an Sales Forecast for our Lemonade Stand. Note that Sales Forecasts are often done in the form of a table to help you and your investors better see how many gallons you would need to sell to make a profit. We will make two different plans with two different assumptions. Our first plan will be based on using six lemons per gallon and our second plan will be based on using three lemons per gallon. Both plans will assume that we will sell lemonade for 5 hours on Saturday – from Noon to five pm and five hours on Sunday from Noon to five pm.
Sales Forecast 1 – six lemons per gallon, 10 sales hours
Sales Rate |
1 gallon per hour |
2 gallons per hour |
3 gallons per hour |
Total Gallons Sold |
10 |
20 |
30 |
Cost per Gallon |
$15 |
$15 |
$15 |
Profit per Gallon |
$1 |
$1 |
$1 |
Total Profit |
$10 |
$20 |
$30 |
Fixed Cost |
$24 |
$24 |
$24 |
Profit after paying fixed cost |
Loss of $14 |
Loss of $4 |
Profit of $6 |
Total Sales at $1 per cup |
$160 |
$320 |
$480 |
Return on Investment |
None |
None |
$6/$40 = 15% |
Operating Margin |
None |
None |
$6/$480 = 1 Percent |
Sales Forecast 2 – 3 lemons per gallon, 10 sales hours
Sales Rate |
1 gallon per hour |
2 gallons per hour |
3 gallons per hour |
Total Gallons Sold |
10 |
20 |
30 |
Cost per Gallon |
$12 |
$12 |
$12 |
Profit per Gallon |
$4 |
$4 |
$4 |
Total Profit |
$40 |
$80 |
$120 |
Fixed Cost |
$24 |
$24 |
$24 |
Profit after paying fixed cost |
$16 |
$56 |
$96 |
Total Sales at $1 per cup |
$160 |
$320 |
$480 |
Return on Investment |
$16/$40 = 40% |
$56/$40 = 140% |
$96/$40 = 240% |
Operating Margin |
$16/$160 = 10% |
$56/$320 = 18% |
$96/$480 = 20% |
Exercise:
You can see from the above tables that you will make very little profit if you use six lemons per gallon and you will make a lot of profit if you use three lemons per gallon. Write a sales forecast table using four lemons per gallon. Will you still make a profit using 4 lemons per gallon even if you only sell one gallon of lemonade per hour?
Benefits of a service business
Starting a service business can have a lot of advantages over starting a product business. The biggest advantage of a service business is that you do not need to worry about paying for the Cost of Goods. Put another way, you do not need to buy lemons, sugar or cups. The Unit of Sales is no longer the number of cups you sell per hour or per day, but the number of services you sell per hour or per day. Let’s say you want to start a hair cutting business and you can cut a person’s hair in 30 minutes. Then the number of haircuts you can give in an hour is two and the number you could do in an 10 hour work day would be 20.
But there are a lot of fixed costs with cutting hair. You need to pay for the hair cutting tools. Let’s call this a one time initial cost of $100.
You also need to pay for the chair your customers will sit in and another chair they will sit in while they are waiting. Let’s assume you could buy both used for $100. You also need to pay to rent space for cutting hair. Let’s call this $80 per day or $8 per hour or $4 per haircut. But the landlord requires a full month of rent in advance which is $3,000. So the total startup cost is $3200. Let’s also say that the minimum wage you can pay an employee in your community is $10 per hour (which is $5 per haircut) and that the going rate for haircuts at other similar businesses is $20 per hair cut.
Here is an example Sales Forecast for our Hair cutting business:
Sales Rate |
1 haircut per hour |
2 haircuts per hour |
3 haircuts per hour |
Total Sales Per Hour |
$20 |
$40 |
$60 |
Employee Cost per Hour |
$10 |
$10 |
$10 |
Rent Cost per hour |
$8 |
$8 |
$8 |
Total Cost Per hour |
$18 |
$18 |
$18 |
Profit per Hour |
$2 |
$22 |
$42 |
Total Profit per day |
$20 |
$220 |
$420 |
Fixed Startup Cost |
$3200 |
$3200 |
$3200 |
# Days to break even on startup cost |
160 days = not possible in 1 month |
15 days |
8 day |
Total Daily Profit x 30 days per month |
20 x 30 = $600 |
220 x 30 = $6600 |
420 x 30 = $12,600 |
Return on Investment |
Loss of $2600 |
$6600/$3200 = 200% |
$12,600/$3200 = 400% |
The above table indicates that if you only give one haircut an hour, you will go out of business very quickly. But if you can attract a lot of customers and give three haircuts per hour, you should be able to make a lot of money. Obviously, marketing will be important for your haircut business to succeed.
You should also be aware that a real hair cutting business will have many more expenses than what we have shown above. For example, you will likely need business licenses from your city, state and federal government. You will also likely have to pay taxes to your city, state and federal government. All of these hidden expenses will reduce your profit. It is therefore important to research all possible costs. You can do this online or by working for a local business before your start you own or by asking local business owners if they would be willing to share estimates of some of their costs with you. You can learn a great deal about how to start a business by talking with local small business owners about their products, services, sales and expenses.
Advantages of an Online Business
So far, we have seen that product related businesses have significant cost of goods and traditional service businesses have significant employee and rent costs. This leads us to a third model of business – the online Ecommerce business. The advantage of an online business that is also a service related business is that there is almost no cost of goods and no store front rental costs. At the beginning, there is also almost no employee cost. Because websites can be built for almost nothing, the startup cost of an online business can be almost nothing. Therefore there is no need to pay back investors. Here we will take a look at an online business my daughter started when she was in the Second Grade.
She built a website and posted pictures of her kitties on her Home page. She then passed out business cards to her classmates with the link to her website. Her friends would then look at the pictures and tell my daughter which pictures they wanted. My daughter then printed out the pictures and traded them to her friends for cookies they had in their school lunches. The exchange was one picture for one cookie. My daughter made a profit of at least thirty cookies in the Second Grade. Her cost was less than one dollar for thirty sheets of paper. This is the power of starting an online business. The only limit is your own imagination.
What’s Next?
Now that we understand some business basics, in the next section, we will build the framework for our new small business plan.