Modeling for business

When my partners and I sat down to determine if we could start a business on what we had to work with it ultimately fell to me to figure it out the answer. This is probably because I love spreadsheets, numbers, and models. But creating a model to forecast business income and expenditures is no easy task. Quality models require quality data, and unless you are buying an existing business there is often little hard data to go from.

In our case, however, my partners had previous experience in similar businesses and were able to provide me with some generalized data. Coupling that with my own business training and experience I was able to piece together projections based on several key variables.

Our business was to be a retail store, so I chose as primary variables the amount of inventory we had, our expected turn, and our profit margins. I was also able to speak to other business owners and do some basic research to predict what expenses we were likely to have and how much they would likely run.

Knowing that we were essentially starting from scratch, I set up a model wherein we started with a small amount of inventory and built up from there. I chose to be pessimistic with my variables, figuring both our turns and our margins would be low for the first several months. I then ran the model for a year and a half into the future to see how things worked out.

The result was that we needed to rethink our plans. We agreed that the model was probably too pessimistic, but it showed us where our problems lay. We were able to focus in on those areas in our next round of research to refine our estimates. Even then, however, we ended up with three scenarios rather than one model; a “pessimistic” model, a “probable” model, and an “optimistic” model.

Two of the three models showed we could make it. Armed with that information we deliberated and decided to move forward. The model showed what was possible, and it showed the key areas we needed to watch closely. Five months later our business is three months old, and the model is holding up amazingly well, even though there was no way it could capture the interplay of all the real variables we’ve encountered.

I highly recommend modeling to support business decision-making. Some of the key advantages I have seen include:

  • Helping you focus in on the core elements of your business.
  • Identifying restrictions in time and resources.
  • Uncovering areas where your business information or data may be lacking.
  • Revealing the interplay of variables over time.
  • Providing goals in your execution phase to keep you motivated–and identify trouble early on.
  • Giving something to measure against to assess progress and make corrections.
  • Identifying potential areas of give and take–if you overrun your budget in one area, where can you cut back some to compensate, for example.
  • Providing a common language and/or frame of reference for all key players in the business.
  • Uncovering what variables you just can’t know, and may even be unable to guess with any real confidence. For example, we knew we needed to spend money on advertising, but recognized that there was no way to quantify its effect in terms of our model. Similarly, we decided not to try to predict the results of any “Christmas Surge.”
  • Providing a launching point for in-depth discussions about the business, its operation, and any expectations partners may have.

And that’s just the beginning. Creating our model was about as close as my partners and I came to drafting a formal business plan, but the exercise of brainstorming the elements to be represented in the model, discussing the interplay of variables, and refining the model took us over much of the same ground a business plan would have. It made us face the unpleasant realities, and while we eventually rejected the initial indications that we didn’t have sufficient funds to make the business work, it helped us recognize the risks and accept them.

Three months in, I’m pleased to say our model indicates we’re on track. We’re actually beating our projections, and that is encouraging. We’ve needed encouragement more than a few times along the way. We’ll probably need a few more before we’re solidly in the black. Opening a new business is stressful, but I can’t imagine how much more stressed we would be if we were just “winging it” and had no real way of determining where we were and how we were doing. I remain a firm believer in models.

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One Response to Modeling for business

  1. Dan Stratton says:

    One thing about making a pessimistic model is that you get to feel great sooner! Congratulation on early success. Good to have a model to baseline from. Thanks for the reminder.

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