Third of three parts
Part 1: Top 5 ways small businesses can survive an economic downturn
Part 2: Top 5 balance sheet assets small businesses can turn into cash
With a full understanding of your financial situation, the next step in how to survive a recession or economic downturn is to create a revised sales budget and forecast. Focus on creating a short-term sales forecast, determine variable costs and manage fixed expenses.
This will help you create a realistic future revenue picture, and it will lead to the next critical step: cutting costs.
1. Identify what should not be cut
Cutting costs across the board may seem to be the most logical approach. However, business owners too frequently make decisions based solely on the bottom line. There are core costs and business strengths that should not be cut if they can make the business income. Marketing plans and sales development plans are good examples.
2. Focus on areas that you can control
When you review monthly expenses, do you feel burdened with line-item expenses that you don’t know how to influence? Do you know what these numbers should mean to you?
One way to “weed through” financial data is to identify costs as either controllable or uncontrollable.
Controllable expenses are those that you can directly manage month to month. Of course, all costs are theoretically controllable, but generally, uncontrollable costs can be defined as those that cannot be easily changed. For example, building rent is a fixed cost that you have little control over on a monthly basis.
Isolating and highlighting the controllable costs provides you with the ability to focus on the little changes that have an overall influence on your company’s profit and loss.
3. Recognize that all costs are not created equal
Activities that provide value in excess of their cost are termed value-added activities. Conversely, activities whose costs exceed their benefits are considered non-value-added activities.
Non-value-added activities should become candidates for elimination or transformation into activities that do add value. Your business performs activities to support the creation of value for your customers. In order to evaluate activities, two types of information are needed: the actual value the activity creates and how much it costs.
One way you create value is by transforming inputs into outputs. Inputs include materials, workers and equipment. Outputs are the tangible goods or intangible services that have value to the customer.
There are four basic methods for creating value:
- Altering an item
- Storing an item
- Inspecting an item
- Transporting an item
It’s important to note that value is determined solely by customer perception. As an example, adding elaborate design characteristics or options to the product without considering the needs of the customer does not add value. Thus, while there are four ways of creating value, simply performing a value-creating activity does not ensure that value was created. For value to exist in the product, the customer must perceive that it exists.
Further, non-value-added costs can be classified as necessary and unnecessary. Necessary non-value-added costs are activities that do not add value but must be performed as part of being in business, such as making collection calls or preparing financial statements. But unnecessary non-value activities do not create value to the customer and are not a necessary part of being in business. Therefore, they should be eliminated.
4. Measure actual results against the revised forecast
After performing steps 1-3, the most efficient way to determine whether you’re meeting your new objectives is to measure the results. If you are veering off course, you’ll need to make a correction sooner rather than later.
Forecasting can be used as an indicator of things to come. The most comprehensive way to forecast is to develop a series of pro forma, or projected, financial statements. It involves:
- Constructing a pro forma income statement based on sales projections and the production plan
- Translating this information into a cash budget
- Assimilating all previously developed information into a pro forma balance sheet
There are generally two types of financial forecasts, pro forma financial statements and cash flow forecasts.
Pro forma financial statements are simply a prediction of what your company’s financial statements will look like at the end of the forecast period. One way to accomplish this is to tie many of the income statement and balance sheet figures to future sales, since all variable costs and most current assets and current liabilities vary directly with sales. The final step is to determine the amount of external funding that may be required.
Cash flow forecasts are simply a listing of all anticipated sources and uses of cash by the company over the forecast period.
For most planning purposes and credit analyses, pro forma statements work best because they present the information in a form suitable for additional financial analysis. For short-term forecasting and management of cash, the cash flow forecast is appropriate.
Throughout the year, compare actual performance with the operating budget to determine if your business is on track with expectations. This is the true value of the budgeting process — a control device that can provide much-needed information, identify variances and help you make faster, more proactive decisions.