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PocketWatch On February - 18 - 2011

This is the seventh in a series of articles that will hopefully educate readers and illuminate the process of doing business in a simple to understand, nuts-and-bolts way.

To read all the articles in this series, click on any of the following:

In the previous articles, we have covered motivation and are in the process of getting organized. 

In this article, I will continue to discuss the preparations necessary for building a Financial Plan based in reality.

More on Understanding the Past…

Last time, we looked at total sales using a method called “Weighted Averaging” as a way to make the recent past more important than years farther back in time.  We gathered all sales information, categorized it by sales stream, year and month and created a little database that looked like this:

We can now look at individual sales streams using the same methods as we did for the totals.  I’m not going to go through the process again here.  You can refer to Part 6 for the details.  The reason you want to do that seperately will become clear below.

What you should end up with, in the end, is a chart that shows a Weighted Average for each sales stream and the total sales.  Set that aside for a moment.

Costs of Goods Sold (COGS) as it relates to sales…

We should all be pretty familiar by now with COGS as direct costs of producing the product or service your business provides.  If not, go back through the series and get an understanding regarding this, because this is the next step.

Go back to your records of the same time period you used for your sales analysis and pull out all COGS expenses for those years.  Segregate them for years only.  You don’t have to go through mathematical analysis regarding COGS as you did for sales.  We are looking for a total of COGS expenses only for each fiscal year for which you have data in your chart.  There is a reason for this.

Sales, COGS and the time shift…

Unless you keep more detailed and accurate records than any business ever seen, there is no way you can relate each job, project, or service in your sales records to the expenses associated with them.  Let me repeat that.  It is nearly impossible to relate COGS to sales in great detail!

Why is that, you may ask?  Seems you should be able to.  Well, if you follow this series to the end, you will be able to come pretty close, but in some things, you can only estimate.  Let me explain.

Think about this… a business may spend money days, weeks or months on materials and labor before the sales of a product or service renders a sale.  The COGS for that sale may have even happened in a previous fiscal year!  It is very difficult to accurately associate direct costs to a specific sale in most case without a rational and reasonable Chart of Accounts that has categories for COGS that are segregated by Sales Streams!  That is why we set it up that way in the previous articles.  But we are talking about a Financial Plan, a very different thing, but that is based on that same Chart of Accounts we built.

We have to make an assumption now.  It’s a pretty safe assumption.  The assumption is this:

Assuming that the direct costs of sales is fairly stable (it generally costs about the same to produce similar products/services), we can take the total costs of those products/services and create a ratio between the costs and the sales.

It works like this… Let’s say the total sales in 2008 for Sales1 is $54,285.  Let’s further say that the total COGS for Sales1 (after you have pulled all your records and totalled them all up) is $34,200.  That is about 63% of those sales.  Doing the same for 2009 yields, let’s say a 65% ratio.  It would be safe to assume that the COGS for Sales1 is likely to be a fairly stable 64% of sales in the future.

Working through that process for all sales streams and COGS for those streams now gets you to a conclusion.  You can begin to see which sales streams are more costly by percentage than others.  Doing the same thing allows you to project COGS for the whole business.

Do the calculations, and put it all into a chart similar to above, adding lines for Sales1 COGS , Sales2 COGS, etc. as well as for total COGS.

What you will end up with is the basis for Projected Base Sales for the next fiscal year (Weighted Average Sales) and the COGS for those sales by applying the percentages you produced for each sales line and the total sales.  We are going to use this BASE information to project Gross Profit for the coming fiscal year, but there a few more things to consider before we get there and to produce a true Financial Plan.

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Please contact me offline at [email protected] with anycomments, suggestions or ideas for future articles that you may not want to share here.

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Written by PocketWatch

I am a small town boy from northern Wisconsin, who grew up in the quintessential American family. Dad was a carpenter, mom stayed home, two brothers and a sister. Our politics, and we were political, was always Democrat. My dad always said all you had to do was to look at what each side was fighting for, and it was easy to see, even as a kid, that Republicans were all about big money and rich businessmen, whereas the Democrats were more about social solutions. I spent 6 years in the US Army in the VietNam era as an electronic instructor for NSA, worked as a Field Engineer for a computer firm based in Massachusetts, spent another few years building paper mills around the world for a firm from Washington state, drove long haul truck for a while, did 10 years of servitude in NYC for a large multinational market research company as the Business Manager, spent some more time on the road as a Business Consultant, and the last bit as the Business Manager for a manufacturing firm here north of Houston. I am trying to start up my own consulting firm using all my experience to help small and medium sized businesses stay out of trouble versus waiting until they get into trouble. No one teaches people how to properly run a business. Business schools and MBA programs really don't. There are very basic nuts and bolts that are either assumed or are ignored, and like the house built on sand, businessmen and entrepreneurs ignore these solid foundations at their peril. (Now retired and doing some substitute teaching at a couple of small K-12 schools here in northern Wisconsin. Living in a small hamlet of 340 people, quiet, peaceful, serene.)

12 Responses so far.

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  1. Truth says:

    Oh my, PW: you’re already at part 7! I managed to read up to part 3, and now I try to apply this on the project we’re planning to launch here (Invite for collaboration). Your work is greatly appreciated!

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    • PocketWatch says:

      Truth….

      I saw where you guys were trying to rope me into that one! LOL I’ll be glad to help once you decide what direction you want to go (the business plan) and how it is to be organized (functional org chart). See how that works?

      • Truth says:

        PW -- help! Again you take it just a few steps further… Let me first see how it works out. Basically the whole thing started very sponaneuously -- one poster said: someone should make an article about Huff, others said, ok, then write it yourself and then came deygirl who suggested we could do it together. An idea which we all liked. Along comes AdLib who explains about the collaborate thread. Next, the one who triggered all of that disappeared without a word. Then deygirl accepted to make the start. But then the next thing I knew, without any prior announcement her article was published… (and she basically disappeared too).
        And so I’m not even sure if she has the same goals in that as I have. So I’m waiting for her reply and in the meantime wrote down my vision and a basic outline about the project. Doing that is a good way to figure out how to tackle the thing. I did have this project in mind, but not exactly as the next thing I planned to do…..
        Well then, now I hope deygirl and I are on the same boat. If not, we can still make two projects out of it -- I’m just hoping to clarify this soon. Obviously everything is still pretty chaotic here… And anyway, not sure if I ever reach your standards…(they are pretty high) but am certainly grateful to have a red ribbon to lead me along the path. Thank you for listening…

        • deygirl says:

          Go for it. I am happy to follow your vision.

        • PocketWatch says:

          Truth…

          First, I know adey. She is a very good egg. And a real rabble rouser, someone good to have around. I have been following that thread a bit, waiting to see if there is a consensus on how to proceed. My suggestion is that SOMEONE start with a short “mission statement.” What, exactly, and in very few words, are the goals of the project?

          That will lead you to the steps necessary to complete the task. Just list them. THAT will lead to the functions required to get there.

          Next, a down-and-dirty org chart or plan… we have functions that need to be performed… who will do them? What resources are necessary?

          That’s what you need to get a project like this accomplished. All that planning might take all of a half hour… doesn’t need to be fancy. What it does is provide clarity of thought and a map to completion.

          I’m not sure what the goal is, yet, in clear detail. Until that happens, the rest is ephemeral. That is why there is ‘confusion.’

          • Truth says:

            Thanks, PW -- and here she is. What you said to do is exactly what I’m working on. We couldn’t get the consensus yesterday -- after all it was Friday… -- but now that I have the ok to go ahead, it’s fine for now.

  2. KQuark says:

    Sorry I have not contributed that much to this important series. As a sciency type the business part always seemed too much like work to me. But alas even in R&D we had to factor in cost effectiveness of the raw materials we used to make our products.

    I just have one point. Business is terrible at assessing or most of the time just caring about the environmental costs of one material over another. Since I developed products for the paper industry I always tried to factor in the environmental costs and believe me that did not make me a favorite of the bean counters. If the total cost of a product is 10% more than the cost of something that you needed twice as much no mater how safe that chemical is is much better for the environment to use half. Sure there are some economies of scale that played in as well but it should be a no brainer. Of course I use to butt heads with the business folks most when there was a chemical where the safety of that chemical had come into question but it was the most cost effective product by a large factor. Talk about an ethical dilemma. Most of the time I simply would eliminate the chemical from testing to start. I figured a lie of omission at the beginning was better than suppressing data.

    By the end of my career I would simply use chemicals approved by other more environmentally countries mostly in Europe and Canada.

    • PocketWatch says:

      KQ… good point. Downstream costs are always very difficult to quantify. However, there are things that can be done, since most downstream costs ARE buried in overhead, many times intentionally, and many times through ignorance.

      Case in point … safety. If you look at the costs to a company down in overhead of increased Workman’s Compensation due to claims caused by accidents, and compare those costs to the costs of an effective safety program, you can see that one offsets the other.

      In the paper idustry, what are the insurance and legal costs associated with settled claims and increased insurances due to using dangerous chemicals versus safer ones?

      There is homework involved, and it has to do with thinking about what are the hidden costs of doing things this way versus that way. And we all know how everyne hates homework!

      • KQuark says:

        I think those cost would be available if you knew where to find them.

        I doubt you could even calculate the environmental costs to any degree of certainty. You’d almost have to use know factors like aquatic toxicity and bio degradation rates and make environmental impact calculations. The EPA actually does this quite well. But it seems like a no brainer that if you add twice as much chemical to a river where the chemical is twice as toxic and has one tenth the rate of bio-degradation it’s cost to the environment is much higher. But alas that only matters if the local populous cares about the environment which is why they put most paper mills in the south and rural areas.


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