I’m sure you’ve heard that when you ASSUME it makes an ASS out of U and ME. Here’s a way to make assumptions that work.

Investors all know that business plans are fiction, or rather fairy tales (fiction sometimes has an unhappy ending business plans never do.) And many successful companies thrive without business plans. Even those who promote business plans as a management tool usually say it’s the planning not the plan that’s of value. So what’s better?

A business Model
As I’ve long said, a model is better than a plan. The key difference is that a plan is based on time – what you’ll do in this month, that quarter, the next year. Hint: the vast majority of business plans have a huge sales jump in year three. Why year three? it’s so far in the future that it doesn’t have to be based on reality, yet it gives you the numbers you need to make your return look good. A model, on the other hand, has all the parts of the business based on each other (and ultimately sales) not based on time. So as reality happens differently than you’d like, you can adjust. Quickly.
How to Assume
This article gives a good example of the kind of assumptions that underly a business model. The two key points are Dollars per … and Levels of demand.
Dollars per …
You only spend money in a business because you want to gain something. Usually it’s to gain capacity. Every single one of your costs should have an assumption tied to it that links dollars to some non-financial thing. And no cheating. You can’t assume rent by saying dollars per square feet. That’s the same thing. You need to say dollars per employee (if you’re renting office space) dollars per SKU (if you’re renting retail space) or dollars per widget produced (if you’re renting manufacturing space).

You must tie each dollar you spend to something else – it makes you think long and hard about why you’re spending it. In some cases you need to break down a single line item on your P&L into multiple assumptions. Take the example of rent I gave above. Suppose you rent a building that you use as an office, a warehouse, and a manufacturing space. Your P&L probably just says RENT. But to build a good model, your assumptions have to state why you need so much of each type of space. That way the parts of your model are tied together. If you double your business, you won’t just double your rent because the ratio of office to warehouse to manufacturing won’t stay the same. Likewise if your business falters and you have to downsize.

So having an assumption of Dollars per for each reason you spend money gives you a model you can use.

Levels of Demand
Hidden in this paragraph of the article I linked to is a gem. (emphasis mine)

Admit that revenues are a mystery. If you don’t have any revenues yet, you can’t say what they’ll be. The point of a model is to prove you can make money if people buy your product, not to insist that they will. By developing different scenarios based on different levels of demand, you can later calibrate hiring and spending according to which scenario fits reality best.

This was written for a start-up but it applies to any business that is growing (or shrinking) or attempting a new initiative. Since you don’t know how the customers will react, or how fast, you need to develop scenarios based on different levels of demand. This is possible to do if you’ve made your assumptions with dollars per. Because what you’re buying with those dollars is capacity – the capacity to support a certain level of sales. (And by support I mean everything in the whole company life cycle – market, sell, produce, deliver, invoice, collect etc. Everything.)

So pick three levels of demand and work your model of what your costs need to be to fully support each level. That way as your initiative goes forward, you know what you should be spending.

If you’re a start-up one of those levels needs to be break-even: the level sales need to be so pay for all the support in a self-sustaining manner.

Takeaways:

• A model is better than a plan.
• You spend money to gain capacity – your assumptions should reflect this.
• Develop scenarios for different levels of demand.
• Building a business model is a CEO skill

[tags] business model, small business, entrepreneur, start-up business plan[/tags]