03/ 15/ 2007
by Kelle Campbell
A common problem when expanding a business is the underestimation of costs, which can lead to the discovery that you have insufficient funding. Below are five factors to consider when preparing to grow your business--and tips for managing them.
1. Building costs
Whether you're building or renovating a space, arrange to have several contractors bid on the project. Provide a blueprint or sketch so every contractor bids on identical specifications, and you can correctly judge their ability to do the work cost-effectively.
- Contracts
Under a lump sum contract, you have the security of paying a fixed sum. However, contractors may present you with time and materials (T&M) contracts, requiring you to reimburse them for labor, materials, subcontractors and other items, as well as pay a fee for overhead and profit. Obviously, T&M contracts can render costs unexpectedly high if the project runs into obstacles or delays, but they are beneficial if the contractor is fast, or if the scope and timeline require flexibility. - Bonds
If your contractor does shoddy work or fails to pay subcontractors and other parties, a performance or a payment bond protects you from additional cash outlays to amend the deficiencies or liens against your property. Specific bond requirements should be included in the original bid and contract documents, but you may not be able to obtain a bond for small jobs.
2. Equipment costs
If you cannot afford the initial cash outlay required by a purchase, leased equipment generally requires low down payments, and you can even opt for a lease-to-purchase plan. Leasing also makes sense when you have a short-term need, or when the equipment becomes outdated quickly. Look for a lease agreement in which the lessor is responsible for repairs, so your cash reserve is further protected.
- Taxes
Consult with your tax advisor about how leasing or buying will affect your particular situation. When you're financing a purchase, only the interest is deducted, but the lease amount you can deduct as an expense will depend on the type of lease. - Related equipment costs
Discuss your needs with several suppliers and make inquires about costs for delivery, connections to utilities, installation and so on.
3. Inventory costs
Many assume that a growing inventory will cause costs of storage, handling, insurance, taxes and obsolescence to decrease due to economies of scale. However, examine these costs closely to make sure that they actually will decrease.
- Inventory turnover ratio.
To ensure that you will not hold too much inventory (and tie up valuable capital), determine your inventory turnover ratio, which measures how many times you sell your inventory during the year. You can use both or either of the two formulas below. Repeat them for each category of inventory you have. The only difference between the two is that the first formula includes profit margins:Inventory turnover ratio = Annual sales / Average inventory value
Inventory turnover ratio = Cost of goods sold / Average inventory value
4. Accounts receivable
If a portion of your cash flow is typically tied up in accounts receivable (money that your customers or clients owe you), you should get idea of how those debts may affect you as you expand. Experts generally advise you to look at your existing receivables as a percentage of current sales and project that percentage to future sales. For example, if you have sales of $200,000 and receivables of $10,000, then you have a relationship of 5 percent of accounts receivable to sales.
However, it is possible for accounts receivable to increase beyond the existing proportion. For example, you may acquire more slow-paying customers. Determine whether your cash flow can withstand a variance in the percentage and how much of a variance. Also, consider whether you need to change your policies or look into loan possibilities.
5. Support for increased activity
The most difficult costs to project are those needed to support increased activity, such as research and development or additional staff. Since you may need to take into account seasonal fluctuations, reinvestment of profits, contingent liabilities and so on, it is advisable to have a professional aid you in creating a cash-flow projection. If you do not already have professional assistance, contact the National Association of Personal Financial Advisors or the American Institute of CPAs.
During an expansion phase, expect your cash balance to decrease before showing a gain from profits. The timing will vary with your specific circumstances and industry, but effective cost management will aid your businesses expansion on the way to profitability.
