Expense Planning: Understanding the Sensibility of Cash

Recently, I presented the webinar, “Expense Planning: Understanding the Sensibility of Cash.” We covered a variety of topics, including expense characteristics, where expenses are found, expense types for planning and planning methodologies.

Expense Characteristics
While all companies strive to minimize expenses wherever possible, business can operate within varying cost structures. Yet regardless of the cost structure, all expenses have the following characteristics:

  • Fixed Costs remain the same regardless of use or sales volumes. Examples of fixed costs are salaries and rent.
  • Variable Costs will fluctuate based on the amount of revenue produced in each period. Examples of variable costs are raw materials used in production, utilities, etc.
  • Mixed Costs have some element of fixed and variable costs to them. Most wireless phone plans have a monthly fixed charge and variable costs for overage on usage.
  • Economies of Scale are cost advantages that businesses enjoy as production or output increases; for example, volume discounts on materials.
  • Economies of Scope are cost advantages that businesses enjoy as the scope of operations increases; for example, channel distribution sharing across business lines.

Company Expenses
Expenses are found within the income statement or balance sheet. Cost of goods sold are expenses recorded on the income statement that represent the expenses required in the delivery of services or products that result in revenue. Operating expenses are costs incurred in the normal course of business that are not directly related to the recognition of revenue, which includes salaries, advertising, office rent, etc. Non-operating expenses are found outside the course of normal business and are not linked to daily operations, which typically includes taxes, non-operating losses, etc. Capital expenses are not recorded on the income statement but instead on the balance sheet; these are typically investments in equipment, land, buildings, etc. that have lives longer than a year. Their values are depreciated or amortized over the life of that asset.

Types of Expenses
For planning purposes, expenses fall into two categories: cash and accrual. Cash expenses are real dollars that will be paid out at some future period, either as cash within the reporting period or in a future reporting period through accounts payable. Accruals, on the other hand, are expenses recorded for GAAP purposes that are not associated with any cash payments. These items may represent reserves for bad debt, inventory or depreciation/amortization of capitalized assets.

Both expense types are important for planning purposes because cash expenses represent costs of the business that need cash flow to support, while accrued expenses show true accounting profits that feed balance sheet items for lenders to calculate spreads from. The use of accrued expenses in your budgeting process is a byproduct of what the intended use of the projections are. Management should understand the cash impact of plans as well as the accounting impact on earnings and ratios.

Planning Methodologies
After identifying what your expenses are, most companies start planning with revenue. Revenue planning is a function of costs, and there are two primary methods for planning revenue: resource-based projecting and market-based projecting. Leverage both models in parallel and use the lower of the two forecasts to generate the most effective revenue targets. Revenue likely won’t exceed the level justified by your resources or the level justified by your market potential.

The first step in preparing a resource-based projection for expense planning is to identify key resource factors that will produce or limit revenue for your business. This means that you are effectively setting your revenue targets by first setting the capacity constraints of your expense levels. These expenses may include labor costs (production driven model), facilities rent/costs and sales costs (quota driven model). These costs are usually predicated on historical and current levels. For example, your company adds a salesperson who has a quota of $X, and by adding that resource and expense, you drive additional sales volume. Or, your company adds a production line in the form of capital expenditures which adds the ability to double or triple production capacity, hence driving revenue upward.