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One of the most important purposes of a business plan is to give you a clear understanding of your financial trajectory. However, without an accurate analysis, those projections can easily be misleading. Entrepreneurs often underestimate the true cost of certain expenses, which can eventually prove to be problematic when it comes to execution.
Common expenses entrepreneurs are likely to underestimate
Research shows that 64 percent of small business owners report being hit with unexpected costs, which results in profit loss, being forced to readjust growth targets and having to let staff go to free up funds.
The human brain has a natural tendency to use mental shortcuts, also known as heuristics. You use heuristics in every area of your life, including when you estimate costs on a project or budget. The problem is, you don’t always go through the meticulous analytical process that’s required to come up with accurate figures. And in most cases, you’re more likely to underestimate than overestimate.
As you develop your business plan and flesh out the cost projections, here are some of the expenses that you’re most prone to underestimate:
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Developing a product is a complex process. You might think you’re prepared for all it entails, but there are always additional steps, revisions and tweaks that need to be made. This results in much higher costs than you originally anticipated, so keep this in mind.
Maintenance and repairs
When you purchase a piece of equipment, you typically aren’t thinking about the long-term holding costs. You’re simply looking at the price tag and determining whether you can make the purchase or not. The only problem with this is that things break down and need fixing. If you don’t account for these costs upfront, you may find yourself in a bind later.
The cost of hiring full-time employees is expensive. Unfortunately, many entrepreneurs only look at the salary component of this cost and fail to consider training, retaining, bonuses, benefits, 401(k) match programs, etc.
“A lot of entrepreneurs don’t even see this as a part of their budget. They just don’t get it,” David Katz, founder of Plastic Bank, said. “If your employees don’t have the right training, how will they be able to offer customer support? What is your overall plan for staff development?”
Insurance and taxes
The average entrepreneur understands there will be various insurances and taxes involved with starting and running a business, but it’s common to underestimate the extent of these costs. This is especially true as your business scales and needs more coverage.
“Some people think, ‘If I have this product, people will just flock to it,’ but they don’t have a system around finding customers. You really have to be focused on marketing and sales to connect with the people who want what you’re selling,” Katz said. “When you don’t know how to find customers, it doesn’t matter what your product is.”
A failure to properly estimate customer acquisition costs in the form of marketing and sales expenditures can really come back to bite you.
How to be more accurate with cost estimates
Now that you know which expenses you’re likely to underestimate, it’s a good idea to take the time to figure out how you can be more accurate with your cost projections and budgeting.
The following tips will prove valuable:
- Talk with multiple sources. It’s a smart idea to talk with as many people as possible when forming an estimate. Everyone will have different ideas, experiences and beliefs. By averaging them out, you can usually get the best result.
- Use three-point estimating. Are you familiar with three-point estimating? Also known as PERT, the Program Evaluation and Review Technique, this method asks you to create three different estimates: optimistic (O), pessimistic (P), and most likely (M). You then plug these numbers into the following equation: (O+4M+P)/6. This gives you a weighted average to work with.
- Create a buffer. Sometimes it’s best to establish a buffer when you aren’t sure you’re anywhere close to the right figure. By giving yourself substantial wiggle room, you can lessen the negative impact of missing the mark.
- Be willing to cut expenses. It’s always a good idea to leave some flexibility in your business plan projections. Highlight a handful of expenses that are conditional upon other projections being accurate. If you end up underestimating in certain areas, you can remove these items from the plan and hopefully get back on track.
- Track everything. Studying your competition can provide a great source of insight and knowledge into how you should price out something. “In the same vein as data documentation and collection, keep track of vendor prices, costs of parts and labor, materials, and all other resources used, which can assist in a type of projection called historical costing,” entrepreneur Cassie Tolhurst said. “This allows you to perform cost estimates based on previous work.”
Experience plays an integral role in cost estimating. Whether it’s for an entire business plan or a one-off project, you’re much more likely to make accurate projections if you have experience with it in the past. Understanding this, you sometimes just need to dive in and see what happens.
Adding it all up
You’ll rarely, if ever, make 100 percent accurate estimates when planning. However, when you’re aware of problem areas and know how to develop more accurate figures, you’ll find that you’re far less likely to make a big mistake.