ComplianceFinanceApril 11, 2019

Establishing reasonable planning assumptions

When you draft a business plan, you have to make many different types of assumptions. These include the general business environment, business-specific factors, and issues outside your control.

Some of these are so basic that they remain unstated. Realistically, there is no point in worrying about cataclysmic or other events that can render all your planning moot. You have to start with the assumption that everything will work as planned. For example, retailers assume that consumers will continue to make most of their purchases during the holiday season.

Beyond that, there are several broad types of assumptions that you're going to have to make. These assumptions are what support and quantify the projections that you'll make in the plan.

  • First, you're going to have to make some assumptions about the general business environment. By and large, these assumptions tend to focus on issues such as interest rates, demographics, and other factors that all businesses face.
  • Second, you're going to have to make some assumptions that are specific to your business. These assumptions focus on specific capabilities that your business must develop or maintain.
  • Third, you can model alternate assumptions to explain how you will shift gears, if necessary, in response to events outside your control.

Assessing the general business environment

As you draft your business plan, you may feel somewhat overwhelmed by the sheer number of external factors that can dramatically impact your business. Most of these factors are simply beyond your control.

For example, if your business is dependent on loans or a line of credit, the interest rate on that debt is crucial. If you obtain a loan at 2 percent over the prime rate, there is no guarantee that the prime rate won't fluctuate, perhaps wildly, in the first few months of your planning period.

It is up to you to decide not only what assumption to make regarding the rate, but how likely it is that your assumption is correct. If you assume that rates won't change by more than 1 percent one way or the other, how comfortable can you be with that assumption?

You'll also have to make assumptions about factors that are not easy to quantify. While you may know exactly how many people are physically located in your geographic market, assumptions regarding how many are potential customers for your product or service aren't as easy to make. But such assumptions are necessary when it comes time to project sales.

Despite the difficulty ensuring that your assumptions are reasonable, there is a lot of help available. There are many sources that provide objective information that may be helpful. For example, a bank can provide you with historical information regarding rate changes. Vendors can tell you about product availability issues.

Get as much information as you need to feel comfortable that you are making reasonable assumptions. Remember, however, that no one is likely to be right all the time. If the assumptions on which you base your planning are generally "in the ballpark," you have done a good job.

Assume you're considering opening up a store to sell auto racing collectibles. The auto racing industry provides a good example about making assumptions. It experienced dramatic growth in broadcast viewers and race attendance for a number of years beginning in the 1990s. Expecting a 10 percent annual growth in the audience was pretty reasonable, at least for a while.

The economic slump of the early 2000s made that growth assumption unreasonable for almost a decade. However, sponsors are returning to auto racing as a marketing tool because it is still an effective medium for reaching a targeted audience.

Making assumptions regarding your business for planning purposes

As you work your way through the planning process, you will be called on to take your best guess regarding the key operational issues facing your business. You'll have to make estimates regarding productivity, capacity, cash flow, costs, and many other interrelated factors. For example, if you are considering a manufacturing business, how many units of product can you expect a particular piece of equipment to produce? What assumptions can you make about its reliability and potential down time?

From a practical standpoint, there are two potential sources for the information you need to make reasonable assumptions. If you have an existing business, you have your personal experiences on which to rely. You know how much to expect from an employee and if your production equipment is reliable. Even if you're taking on a new product or trying to enter a new market, your experience in the industry in general will serve you well.

The same holds true if you have experience in your industry, but not as a business owner. Many new businesses are started by people who have experience as an employee in the same or a related field. If that applies to you, what you learned will serve you well as you strike out on your own.

But what about the business owner who has relatively little experience in a particular field? The best bet is to tap into existing sources of information. One excellent source is industry groups or associations. These organizations exist to help business owners within a specific industry or field of endeavor. They can provide information regarding a wide variety of topics. Another good source of information are local chambers of commerce and other civic organizations. These groups can provide valuable demographic information regarding the specific geographic market in which you will compete.

Banks are an obvious source of information regarding financial matters. You're going to have to make numerous assumptions that relate to money, cash flow, interest rates, expenses, etc. Much of what you need to know to make reasonable assumptions can be obtained from lenders. This also provides you with an opportunity to screen potential lenders by experiencing the quality of customer service they provide. Potential vendors and suppliers can also be consulted to get information regarding costs, product availability, timing requirements, etc.

While there is no substitute for personal experience, you can derive a large benefit by drawing on the experiences of those around you. Unless you're starting a completely new type of business, there will be someone around with experience at what you're planning to do. You'd be surprised how willing even potential competitors are to share information, if asked in the right way. This is particularly true if your business will serve a limited geographic market and won't directly compete with a similar business located some distance away.

Finally, don't forget about the management aspects of running your own business. In addition to whatever product or service you'll provide, you will also have to perform a broad range of managerial activities. The most important assumption you can make about these back office duties is that they'll take more time than you'd like. But the same sources who can provide the data you need to make reasonable financial and operational assumptions can also advise you regarding tasks that fall on you as a business owner.

Dealing with unexpected changes in external factors

Economic and weather conditions immediately come to mind when you think of factors outside your control. If a particular geographic area experiences an economic decline, there isn't much you can do about it. If your business is dependent on fair weather, and unusual conditions prevent you from working, even short-term business plans will quickly go out the window. A house painter faced with nearly constant rain just won't be able to do the planned work. If the profitability of a business that relies heavily on borrowed funds is affected by interest rates, changes in lending rates can be a huge factor.

In short, every business must deal with an environment in which key assumptions can change without much warning. A plan based on those assumptions is at risk. A good business plan can include contingency plans that help you establish how to react when the real world doesn't conform to your plan. One way to do this is to look at how a change in one or more variables might affect your plan. Here's how you might want to do that.

First, identify "environmental" conditions that would have the most direct impact on your business. There may be several. Make an effort to examine each of the environmental factors in turn so that you can develop a range of planning scenarios. Try to realistically estimate the number of days you won't be able to work. Recent weather notwithstanding, it isn't likely that it will never rain on days you would otherwise work, nor is it likely that it will always rain.

Second, try to quantify how changing conditions would impact your business and what the likelihood is that those changes will occur. Quantifying the result of a change in conditions is the easier of the two.

For example, if your business is heavily reliant on utilizing a line of credit to finance operations, a change in interest rate would directly affect the profitability of your business. If you assumed that you were going to pay $10,000 a year in interest, and an increasing interest rate pushes that to $15,000, your profit potential just went down by $5,000. If nothing else but the interest rate changes, at what level will you start losing money? In contrast, fluctuating interest rates wouldn't present the same challenge to a business that rarely used its line of credit.

A little more difficult is the question of how likely is it that conditions will change? By definition, the factors are outside your control, but you can look at historical trends (e.g., the interest rate over the last two years) for some indication of the likelihood of changing conditions. If interest rates are a factor, consider a broad range of rates to determine what is the highest rate your business could tolerate.

A third step completes the analysis. First, you identified environmental factors that could impact your plan. Second, you assessed the likelihood that conditions would change, and you quantified the effect that each of these changes would have on your plan. Now, consider what would happen if, for example, interest rates go up and mid-way through your season, it's already rained 11 days. Will you be able to meet your net income targets under these new conditions? Look at the factors with the potential for substantial impact on your plan and combine them in various ways.

Try to build reasonable "what if" scenarios that reflect your best estimates of what could happen. For example, if a salesman quits, you lose the ability to reach part of your customer base. But if the loss of the salesman results in reduced sales, and production and wage costs also go down, the temporary loss of a salesman might hurt growth potential more than current net income. Knowing that you can survive for awhile without him gives you a better chance to hire a high-quality replacement. Try to limit your modeling to situations that might realistically occur. Remember that some potential factors are just too remote to concern you.

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