Sustainable Business/Can you afford to start up?
Once you’re satisfied that you have a good chance of gaining an adequate market share, the next step is to determine if you can afford to start up your business. This chapter will help you to:
- calculate how much money you need to start your business
- determine what other resources you need
- set a realistic price for your product or service
- create systems for managing your finances competently.
Assessing how much money you need to raiseEdit
One of the biggest causes of business failure is underestimating the start-up costs plus the amount of cash needed to sustain the business until it breaks even.
Working through the financials at this feasibility stage will help you to assess how much money you’ll realistically need to raise beforehand. It also makes sense to work out if your investment is going to bring you a good rate of return.
For example, if you’re planning to take out a loan or mortgage or use your savings to set up your business:
- how long can you afford to support yourself until the business turns a profit?
- will all the time, trouble and risk involved in setting up your business be worth it, or would you be better off investing your money elsewhere and working for someone else?
Calculating set-up costs and working capitalEdit
To avoid underestimating your set-up costs, try to be as accurate as you can with your forecasts and calculations. Realistic forecasts can boost your confidence in your ability to meet regular and ongoing commitments, and give you a more accurate idea of when you can expect to reach key financial milestones.
- Get your figures checked
Give your figures to an accountant to check. As they deal with many businesses, they can help you to make your forecasts realistic.
- Calculate your initial set-up costs
You may already have an idea of some of the costs involved in setting up your business, but getting those figures down on paper and doing some fundamental calculations give you the facts in black and white.
Calculating these costs also gives you a chance to consider what’s necessary (elements you must have to get your business operational) and what’s desirable (elements that you’d like but may have to discard or revise in the early stages).
Initial set-up costs might include:
- locating suitable premises
- buying plant and machinery
- buying furniture and fittings
- buying general office equipment
- buying technology.
As you research and record each item of expenditure, try to source credible estimates and prices, but be aware that costs sometimes come in higher than you expect, so budget accordingly.
Also, try to be resourceful. Consider how often you’ll use a particular asset and look at possible alternatives. For example, do you have to buy a new or top-of-the-line item or could you lease, hire or buy second-hand equipment instead?
See Template 10 (Calculate set-up costs)
- Buy at auction
Online auctions and auction yards can be great sources of cheap second-hand equipment. Keep your eye on the local paper, register on sites like Trade Me or ask your local business contacts to let you know of any upcoming sales and auctions.
- Hidden costs
Remember to factor in the ‘hidden’ costs of setting up a business too; the ‘little things’ that may not be quite as obvious as a building, plant or machinery. These costs may be comparatively small, but they all add up and could significantly impact on your ability to set up.
- Deposits or advance rent/lease payments.
- Connection charges such as electricity, phone and internet.
- Any insurance premiums payable in advance.
- Distribution costs.
- Travel costs.
- Website-development costs.
- Stationery, promotional material and signage.
- Wages/PAYE/KiwiSaver if you intend employing staff .
- Professional fees (accountant, lawyer or business consultants).
- Avoid over-investing in fixed assets
Unlike day-to-day business expenses, assets are depreciated in value over a period of time and you can’t claim the full amount spent immediately. If you’re unsure how depreciation works, talk to an accountant.
To find a suitable accountant in your area, ask your associates for a recommendation or visit the New Zealand Institute of Chartered Accountants’ website.
- For a few dollars more
Remember that quotes and estimates can differ from actual costs. To avoid any nasty surprises, allow a few dollars more and build in a percentage on top of your estimates to meet additional ‘hidden’ costs that can take you over budget.
Working capital is the amount of money needed to keep your business running until you break even. Raising your set-up costs is the first challenge, but for your business to be feasible you must have enough working capital to cover the ongoing costs.
You need to factor in both fixed and variable costs to calculate how much working capital you’ll need.
- Fixed costs
Fixed costs are the regular expenses such as phone, power, rent and stationery. They are costs that remain reasonably constant, regardless of your sales activity.
- Be energy efficient
Investigate ways to minimise costs by using energy-efficient equipment and processes. Use the Energy Efficiency and Conservation Authority’s small business planning tool to see how you can maximise your energy efficiency and minimise costs.
- Variable costs
Variable costs are the costs related to the delivery of your product or service (for example, your stock purchases) and relate directly to your sales volume. For instance, if your sales increase you’ll need further supplies to meet demand, so your costs will increase. Likewise, if sales decrease, there’s no need to buy in further supplies, so your variable costs go down.
Costing and pricingEdit
If your business is to succeed, your prices must cover the cost of producing your goods or services, plus generate a profit. This may seem obvious, but it’s easy to get it wrong. Too many new businesses neglect to crunch the numbers and discover too late that they’re either not making money or, even worse, losing money.
Your earlier market research will have given you an indication of what prospective customers are prepared to pay, so now it’s time to work out if you can feasibly deliver on their expectations and get a return on your investment.
- What’s the cost to you?
Before you set your prices, look at the overall cost of producing your product or service.
On top of the variable costs involved (such as material, labour and compliance costs) you need to factor in your fixed costs such as rent and power, then consider the amount of profit you want to make over and above these costs.
Prepare prices using different methods to help you determine the best costing and pricing method for your business, and be sure to talk to your accountant before finalising your pricing structure.
See Template 11 (Calculate working capital requirements)
See Template 12 a, b & c (Calculate pricing)
As you work through the different costing and pricing methods, you may discover that your idea is just not cost effective. Even though this is disappointing, it is better to discover this now than further on down the track.
- Only buy what you need
Specials and bulk-buying discounts may be tempting, but can be a false economy if those goods are going to lie idle for some time and you desperately need that tied-up cash. Calculate your costs based on what you need to get your business up and running.
Calculate overheads by requesting quotes from suppliers, adding in your own actual costs and estimating monthly expenses such as phone and power. You should be able to assess your overhead level reasonably accurately by investigating carefully. Most suppliers will tell you their costs.
- Markups and margins
Most industries have standard markups or hourly rates (retailers often have set margins, or services can tend to price at a similar level). However always decide your own price based on the calculations in this guide first, and then compare to the market second.
Common pricing methodsEdit
- 1. Cost-plus pricing
This method involves calculating all production costs and adding a required margin to meet a preset price point. Often used for specific projects, this method excludes any fixed costs, which are instead absorbed into the overall profit margin, based on projects ongoing over the year. For example, if you were selling books the cost-plus might be: Raw materials per book (paper, ink, plates) $5.00 Freight $1.50 Packaging $0.20 Labour $3.00 Other – design work ($1000/1000 copies) $1.00 Total Cost $10.70
Required margin $15.00 Sell price is $25.70 excl GST Or $28.90 incl GST
- 2. Job cost – materials plus labour
Job costing involves creating a ‘job card’ for each transaction, using it to record all materials used plus any labour time involved, then adding a profit margin or ‘mark-up’.
Example – Job card for bench seats:
Direct materials Timber $40.50 Glue $1.10 Screws $1.50 Sandpaper $0.80 Stain $6.70 $50.60
Direct labour 15 hrs @ $10.00 per hour $150.00
Overheads $2.50 per direct labour unit $37.50
Total cost $238.10 Mark-up (50% of cost) $119.05 Selling price $357.15 excl GST Or $401.79 incl GST
- 3. Hourly charge-out rate
This is the method to use in a service-based business if you’re charging for your time.
- Decide on the level of income you want from your business.
- Work out (realistically) how many hours you can charge out per year.
- Calculate how much you’ll need to charge per hour to achieve your desired income.
- Add an additional hourly rate to cover the cost of your general overheads.
- Finally, add a profit margin to allow for ongoing business and professional development costs.
For example, you want an annual income of $80,000 and consider 1350 chargeable hours realistic (30 hours a week for 45 weeks of the year, taking into account holidays and time off sick).
$80,000 divided by 1350 = $59.26.
If overheads are $40,000, divide that by 1350 to give the amount you need to charge to recover in a year ($29.63).
Now add in a margin for the risk of being in business of say $20,000 (again, divide by 1350 hours, which equals $14.81).
So to cover your $80,000 income, $40,000 overheads and $20,000 profit you’ll need to charge $103.70 plus GST an hour ($59.26 + $29.63 + $14.81).
Still feasible? Compare this with your direct competition.
Once you’re satisfied that you can set prices that meet market expectations and give you a return on your investment, calculate if you can realistically meet ongoing financial obligations and commitments to ensure that everything runs smoothly. The way to assess this is to prepare a cash flow forecast.
- Offering a service? Take a reality check
As a service-based business, even though people might be paying you for your ideas, expertise or specialist knowledge, essentially you’re selling your time.
Given that you (and any staff) will need to take holidays and spend time on administration, business planning and other non-chargeable tasks, avoid basing your calculations on 40 hours of chargeable time every week for 52 weeks every year. This is both unrealistic and unsustainable. Be realistic about how many hours worked each week will actually be chargeable.
- What does the competition charge?
Competitor prices can give you an idea of market rates, but it’s still important to work out your own prices to ensure you can make a reasonable profit.
- Why prepare a cash flow forecast?
Imagine how helpful it would be to managing your new business if you could glimpse your bank statements for the next year right now. A cash flow forecast is essentially an attempt to predict exactly what those future bank statements will look like. The closer you can get to the reality of those future statements, the better your financial management.
Preparing a cash flow forecast helps you to manage the cash coming in and going out of your business. You can compare the income you expect to receive every month with the costs and expenses you expect to meet.
As most start-up businesses experience cash flow ‘crunches’ at some stage, this is an important exercise. If you spot a shortfall, the forecast gives you time to approach the bank or other lender about a loan or bridging finance. Lenders will often be more open to helping you if you approach them well before a cash flow crisis than if you contact them in the middle of a crisis.
Without a previous trading history on which to base your figures, you’ll have to estimate or predict sales based on your market research findings. The figures you use for your costs can be more precise, such as actual quotes from intended or potential suppliers.
Prepare a forecast for at least the first 12 months and, given that you’re dealing with the unknown, we recommend you prepare three versions: ‘pessimistic, ‘realistic’ and ‘optimistic’ forecasts.
- Talk to your bank manager
Build a good relationship with your bank manager. They dislike sudden surprises, so be sure to keep them well informed of your plans and your progress.
- Professional advice from industry experts
If possible choose an accountant or financial advisor with experience of your industry, they may be able to provide useful benchmark figures for your industry type when you are calculating overheads and your product or service margin.
See Template 13 (Prepare a cash flow forecast)
If you decide to proceed with your business idea, you can update the estimated information in your cash flow forecast with ‘actual’ figures, using these to prepare more accurate forecasts in the future.
- Identify your cash cycle
As you put your figures together, consider your business cash cycle. This is the length of time it takes to turn your product or service around – from lead time into a completed (and paid-for) sale.
Each business has its unique cycle. For example it may take:
- a hairdresser 30 minutes to complete a job and get paid in cash
- a mechanic one to five days to complete a job, then 30 days to get settlement
- a wedding photographer three months from the wedding to receive a cheque
- a software developer two years to get any return on development work.
How long is your business cash cycle? If you sell on credit, build a delayed cash flow factor into your forecast since it may be a while before you see any money coming in.
- Be aware of seasonal purchase cycles
Many large organisations only make purchases at specified times in the year (often at the start of a new financial year). If you’re planning to sell to a business or government department, you need to find out who makes the buying decisions and at what time of year they place their orders.
- Plan according to your cycle
The longer your cash cycle, the more working capital you‘re likely to need from the outset.
If your intended business follows a seasonal pattern (for example, holidays like Easter or Christmas), factor this also into your cash flow.
Be sure to make provision for ongoing costs, equipment, staff and other resources that align with your plans for development and growth. Also remember to consider how much and how frequently you’ll need to draw money from the business.
Then ask your accountant and your potential suppliers for their opinions of your estimated sales targets. They may be able to give you a good indication of expected volume based on their dealings with customers in a similar situation or industry.
- Identify potential cash flow risks
You may hope for ‘plain sailing’, but try to identify any potential risks that might derail your cash flow predictions and impact on your business. Take this opportunity to review your weaknesses and possible threats to your business.
- Is your product tried and tested or could there be some potential ‘blips’ once it’s out in the marketplace?
- Will your competitors respond with a special deal after you launch?
- Does your product have a limited shelf life or use-by date?
- Do you have a debt-collection system ready to limit any bad debts?
- Take a balanced approach
Try to take a balanced approach. Too much pessimism or optimism can be damaging to your business. Revisit your figures and timeframes. Have you been realistic? If not, revise at this stage before advancing your plan.
- Calculate breakeven
Often viewed as a key milestone, your business is at breakeven point when your income is meeting expenses (but you have yet to start making a profit).
When you know what your breakeven point is, you can work out how much more revenue you need to produce the profit you want. If necessary, review your costing and pricing plan.
If it takes you too long to break even, your business may not be feasible or may need more longer-term investment.
See Template 14 (Potential cash flow risks)
See Template 15 a & b (Breakeven calculation)
- Seek professional advice
Complete as much of the forecasting as you can using your research and the templates. Then, unless you’re an accountant, get professional advice from your bank manager or accountant on the realism of your forecasts.
- Free financial advice
Most major banks have a range of useful business information, tools and resources to help you with your financial forecasting and decision-making.
ANZ offers a Breakeven Analysis calculator.
BNZ offers online training modules.
The National Bank offers a Customer Business Resource Centre, with solution guides and a free start-up download.
Westpac offers a business toolkit.
- Review your figures
Take time to review your calculations thoroughly before you move on to the next stage of your feasibility study.
- If your business isn’t looking viable, revisit your figures to see if there’s any way you can reduce your costs or overheads sufficiently to get you started.
- If the figures still make no financial sense, you may need to accept that your business is not feasible at present, but you’ve saved yourself money in the long term.
- If your business looks feasible, re-check your calculations to ensure that you’ve accounted for all foreseeable costs and have allowed a percentage on top to account for any surprise costs.
- If you plan to attract outside investment, you may need to prepare some more detailed financial forecasts.
- Looking for investors?
If you need to raise additional funds to get started, contact NZTE’s Escalator service.
Escalator helps qualifying New Zealand businesses to get investment ready. Services include assessment and advice on your ‘investment readiness’, plus investment-specific workshops. For more information freephone 0800 822 748 or visit the Escalator website.
Ensure that you work through all these steps to prepare realistic financial forecasts and assess if you can feasibly afford to get your business up and running.
- Financial feasibility checklist
:Calculate set-up costs and working capital requirements.
:Work through costing and pricing your products or services.
:Identify your business cycle and the implications for cash flow.
:Prepare a cash flow forecast.
:Calculate the breakeven point.
:Review your figures.
:Get expert input and advice.
If you’re still confident that you’re looking at a viable business proposition, the next step is to investigate the additional regulatory or external factors you need to take into account.