It’s important that we have a good idea as to where our money comes from, since we’re relying on a certain level of income in order to keep the business afloat.

To be able to visualise how money moves through a business, we need to see the “skeleton”:
Revenues – Variable Costs – Fixed Costs = Profit (or Loss)

In this article, we’re going to look at how revenue is calculated, and see a few ways you can make better guesses when trying to forecast next year’s sales.

The Basics
We need to have an informed opinion on two things; how many customers we have, and how much they usually spend.
But these are deceptively simple.
Maybe if you’re selling peanuts at a sports stadium you can make easy projections, since you only have one product and one type of customer.
For the rest of us, we’ll need to dig deeper.

Customers and Baskets
What makes this easier is if we split our customers into smaller groups, and give them each their own “basket” – the collection of purchases that person typically makes.

Customer #1 might be casual shoppers who buy one item, once.
Customer #2 might be be a frequent shopper, who could buy frequent small purchases, or periodic large purchases.
Customer #3 might be a business, who only buy one type of item but do so in bulk.

Example: Cafes
The café in my building has an interesting revenue model.
Essentially, you can group their customers into three segments:
People buying coffee, who spend $4 each
People buying lunch, who spend $20 each
People ordering event catering, who spend $200 each

You’re probably thinking “Well clearly some of those are more lucrative than others!”
Sort of.
What this doesn’t show you is how frequently they visit.
If my friend and I have coffee for 45 minutes, we take up a table and spend $8.
If my friend and I have lunch for 45 minutes, we take up a table and spend $40.
Lunch customers are bringing in 5x more revenue than the regular coffee drinkers.

However, lunch customers might come in once every few months, whereas regulars come in for coffee twice a day.
In that regard, the regulars make up the backbone of the business.
Interestingly, it’s probably these regulars who later decide to use their catering service – when they need to run an event, who springs to mind?

Example: Car Dealerships
Some people think that the aim of a dealership is to charge as much as they can.
Only the short-sighted operators try that approach.
Car dealers have one main type of customer, but multiple products to sell them.
If they play their cards right, they can keep the customer on the hook for many years, which is where they become really valuable.

You might buy a car for $22,000.
Each year, you’ll need to get the car serviced – where will you go?
If you had a good experience at the dealership, you’ll probably go back.
If you do this for ten years and then need a new car, where are you likely to look first?
Or what if your partner needs a new car next year?

A dealership has three opportunities to sell you something:
1. Selling a car, with negotiable prices
2. Servicing cars, ranging from $250 to $3,000 per visit
3. Selling a second car, with negotiable prices

This is why a dealership will be nice to you, taking less on that first car in order to keep you as a happy (and lucrative) customer.
They’ll drop the price to $21,500 if it wins a customers’ trust – and their ongoing services.
It also means that they need to be good at guessing how many customers will come back for servicing, and what percentage go on to buy multiple cars over the next ten years.

Market Sizing
Now we have to guess how many customers will walk in the door, and how many will buy something.
There are two main ways of reaching a rough number: Top Down and Bottom Up.
Top Down is where you take the size of the entire market, then determine what proportion of this market you can take for yourself.

It’s very satisfying, but you run into the “Chinese Refrigerator Problem”.
This is where people learn that China sells 100 million fridges per year, and think
“If we can just get 1% of that market…we’ll sell a million fridges!”
As Peter Thiel points out, this misses the fact that you’ll have either 99 other companies competing against you for 1% each, or you have a few major players compete all of the profits out of the market.
For this reason, Top Down claims are exciting but often misleading.
It also might be that your business is very niche, and only appeals to a small number of specialised customers.
That’s ok, we just need to keep in mind that our audience won’t ramp up even if we are suddenly able to increase our production.

Bottom Up forecasting is based on the capacity of your team.
This is where you determine that one sales person can make 8 visits a day, and convert 75% of those meetings, which is 6 sales per day.
This allows you to forecast 30 sales per team member per week, and extrapolate from there.
No matter how large your market share, your team won’t magically start doing twice as many visits – they’ll each keep knocking out eight per day.
Or in the case of a café, you can only fit a certain number of seats in the premises, even if your competitor down the road goes out of business.

It’s worth using both approaches in tandem to check your guesses.
This avoids the trap of over-estimating your ability to attract customers, but also keeps in mind how many potential customers are out there.
There’s no magic formula – the secret is in listing your thought process.
That way other people can come in and see how you reached your assumptions, and they can help refine your guesses.

Pricing – Willing and Able
When determining prices, it’s easy to pull round numbers out of thin air.
A better approach is to look at your customer’s willingness to pay and their ability to pay.
You need both.
If they’re willing to pay but not able to pay, you have fans but no sales.
If they’re able to pay but not willing to pay, you have grumpy spectators clutching their money on the sidelines.

It’s also worth looking at what the customer expects to pay.
This might be based on how much it costs to produce a service, how much your competitors charge, or how much it’s worth to them.
By having an opinion on all three of those numbers, you’ll be well placed to choose appropriate price points.

Length of Engagement
In order to estimate how much a customer will spend in a month or year, we need to have an understanding of how long the relationship will last.
How long does it take for your customer to experience your Value Proposition?
Is it a quick standalone purchase?
Or is it a gradual process that contains multiple transactions?

·      Platforms like Uber and Airbnb delight their customers, and happy customers use their platforms frequently throughout the year.
·      Subscription services like Spotify and Netflix bill their customers each month, with most paying somewhere between $100-$200 per year.
·      Companies like Sennheiser sell headphones with two-year warranties, so they don’t expect to see a repeat purchase for a while (unless it’s for a separate product)
·      Stores in airports never expect to see customers again, so their transactions are all quick and at premium prices.

You might not like making these estimates, but they’re inevitably going to be factored in.
By listing and tracking our assumptions, we can see how customers behave and change our forecasts accordingly.
It also allows you to identify what triggers a re-order, so that you can design more effective marketing and prompts.

So there we have it; the three levers you can pull to grow your revenue.
You can add more customers, create longer relationships with each customer, or raise the price of each item/service.
There’s no perfect rule for which one you should do – instead you’ll need to see it all laid out in front of you, and observe which numbers have the potential to change.

Grab a whiteboard or some blank paper, and try writing up your revenue formulas.
Your business isn’t so complicated that revenues can’t be drawn out in a few lines.
Later we’ll be looking at strategies for boost your revenues, but for now we just need to visualise where our money comes from.

Next we’re looking at the second part of the skeleton: Variable Costs…