Working on your customer base potential is the first step to building reliable financial projections for startups. To start, we can analyse one of the most common types of revenue stream for businesses: the sale of physical products. How to calculate products sold correctly, prices, volumes, customer preferences, inventory and other direct costs.
After analysing, sizing the market and projecting customers, you should have the following figures for every month or year of your expansion: number of customers reached, number of new customers and number of active customers: which of these figures you will need depends on your business model.
How you plan to charge your customers defines your entire business model. This include deciding when to start charging customers, how much, how and whether you want to sell different products or services to different customer groups; it can also provide a competitive advantage and define the type of resources that you will need to implement the chosen revenue model.
Many startups first decide to focus on a fast-growth strategy involving technology development and/or customer acquisition and only later define their revenue model, but having a set strategy is becoming increasingly important for investors, because proving that you can generate revenue from your customer base becomes part of the validation process.
There are eight types of revenue streams that we can distinguish from for the purpose of our exercise:
- Sale of products
- Sale of services
- Subscription fees
- Transaction fees
- Licence fees
- Rent Fees
- Safekeeping fees
These revenue types are grouped based on the type of inputs that you need in order to calculate each of them, but each of these categories may have very different subcategories depending on the sector they refer to. For each of these revenue streams you should determine the portion % of your customers that applies, as well as whether you will charge the number of customers reached, number of new customers or number of active customers. Most revenue streams apply to active customers, who may buy products or services repeatedly, but not all, and some revenue streams may be better split into two. For example, you may have a sign up fee for new customers and a subscription fee for active customers. By analysing the type of product and the customer base, you should know whether you are selling something that will only be bought once, and therefore that you can model only based on new customers, or repeatedly, meaning that you should model the revenue stream on active customers. Most companies have some repeat customers: clearly, acquiring customers to sell only one product can make for an unsustainable business model and not likely investable.
The sale of products is quite straightforward, as it involves the sale of physical good that your company produces or distributes directly to the customer, but nevertheless many calculation mistakes are made. To plan this revenue correctly, there are a few factors and inputs to take into consideration:
- How many products do customers buy per month or year? Determining how often your customers buy a product and how many units they buy is not easy, but it is something that you are bound to measure during the typical business operations. You can also increase the frequency over time.
- Unit price of each product. The unit price that will flow into the projections should be consistent with any unit used to determine costs. In addition, inflation should be considered, as well as the point in time when you start charging the normal price after a fast customer acquisition during market entry. Some retail businesses use a fixed mark-up on the cost of goods sold. Just like you determined how often customers shop, you can also determine the basket size each time the customer shops, instead of an average price for each product. How you do this, depends on your type of business. If you sell a variety of different products, for example a retailer, you should use basket size or value, while in other cases selecting the number of products if you only sell few products (or including this figure in frequency) helps you determine direct costs more easily.
- % sales split each product. After working on your customers projections, you estimate the portion of customers buying your physical products, but if you have multiple products, you should estimate the % of your selected customers that will buy each product. The sum here can be more than 100% as some customers may buy multiple products of your product range.
New entrepreneurs make the largest errors with revenue projections, but costs projections are also rarely realistic. Most mistakes, however, originate with the calculation of fixed costs: direct costs are certainly more straightforward. Calculating costs for the sale of products, on the other hand, is quite complex for companies holding inventory, easier instead for drop-shipping companies.
One complication could be carrying out net revenue adjustments, with warranty returns, resales and discounts, when these items apply to your business model.
Direct costs for goods sold would then include:
- Cost of materials and labour, calculated on a per unit basis according to contracts with suppliers, taking inflation into account
- Product licence fees
- Product packaging or labelling
- Wholesale commission or third-party platform fees
- Credit card or transaction fees
The following costs are instead calculated based on the inventory, which may involve calculating units ordered, units on stock, value ordered and value of inventory on stock:
- Inventory write-off
- Freight-in and import costs, including, duties, freight, certificates of quality, product containers
- Postage & Packaging to customers and distribution centres
Cost of materials involves less mistakes, but other costs are usually forgotten or grossly understated. The complexity of this business model is related to inventory, which is seldom calculated correctly and linked to the correct inventory figure.
Another problem with startup projections lies in the timing of payments. The advantage of a dropshipping business model, where the inventory is held externally, is not only a much easier calculations of cash outflows, but also fewer advance payments. The inventory is typically paid in installments, and especially for new companies, in advance. Suppliers have stricter terms for startups in terms of advance payments than for established companies, as they are more risky. To ensure that the company does not to run out of inventory, inventory levels and corresponding pre-orders should be planned. Pre-payments of inventory also lead to higher liquidity needed, which should be included in the amount of funds raised: the failure to estimate inventory payments correctly can lead to unexpected low liquidity for the startup.
Compared to physical products, calculating the gross profit from the sale of services is much more straightforward, as there are fewer cost items to consider. In this category we can consider any service or digital product that is not sold as a subscription.
Just as in the calculation of physical products revenue, base on the market size calculated, which includes the number of customers reached, the number of new customers and number of active customers, you should decide the following: what is the proportion of your customers that will buy the services at any one time, in case you have other revenue streams, and whether your product if bought by customers once, which will apply to new customers, or at specific intervals, which applies to active customers.
The sale of services involves the following factors and inputs to take into consideration:
- How many services do customers buy per month or year? Determining how often your customers buy a product and how many units they buy is not easy, but it is something that you are bound to measure during the typical business operations. You can also increase the frequency over time. This would only apply to repeat customers.
- Unit price of each service. For services it’s sometimes hard to estimate, as you may have many different services and charge different prices to different clients, but you should try to estimate an average for each service category. In addition, inflation should be considered, which can also be understood as increase in average order value.
- % of customers buying each service. If you have multiple products or a pipeline, you should estimate the % of your selected customers that will buy each service. The sum here can be more than 100% as some customers may buy multiple products of your product range.
Direct costs for service are much more simple, as they can be easily calculated as a transaction fee (credit card fee, wholesale fee, other transaction fee) multiplied by the amount of services revenue that they apply to: this results in a the portion % of direct costs in relation to sales revenue.
Additionally, one of the major direct costs of services revenue is direct labour costs. If this an important revenue item, it would make sense to include this staff in direct costs, as often freelancers are hired to these tasks as well. The labour costs can be calculated as hours needed per product and cost of labour hour including inflation: this results in the cost of labour per product. If you need to calculate the number of staff that you need to hire to fill this task, you can select the number of monthly hours that 1 staff will take up, so that your financial plan can also be used for operational purposes.