September 19, 2020

Estimating your start-up business costs

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Before you take out a second mortgage, use these rules to figure out the realistic costs of setting up a business.

Most lending banks insist you have to have a business plan. When you have one that’s not the beginning and end of figuring out your start-up costs.

Jeffrey C. Shuman, Professor, Management at Bentley University, Mass, says, “The conventional wisdom is that an entrepreneur sees an opportunity, comes up with a business plan to capitalise on it, determines the capital that needs to be raised, raises the capital and then applies it to building the business described in the business plan.”

There’s one major problem with that model, says Professor Shuman. It all hinges on getting the business right the first time, and that doesn’t often happen. “In reality, it’s likely that some of your initial assumptions are pretty good and others aren’t going to be worth the paper they’re written on,” he says.

Shuman and others say that figuring out your start-up costs means regularly reviewing your assumptions and changing your initial model. Writing a plan is good because it forces you to write down everything you are going to need to start your business. However, that initial plan is likely to change repeatedly as you learn new things and incorporate them into the plan. Therefore, be willing to pull back.

It’s so tempting to add up everything you need for the full-fledged business you imagine, and decide it’s what you need to start out, but if you pull back and look for a smaller model it can give you a way to get started while also saving money.

Shuman uses the example of someone who calculates the total cost of starting a retail business in a local shopping centre. “You could start that way and write a business plan based on that amount,” he says. “But maybe you’d be better off renting a stand and testing what the demand is for your products at that location.”

This consumer testing reduces your initial start-up costs. The result is that the initial cycle of your business is dedicated not so much to generating profits as to generating information. “With this, you can fund your business on a cycle-by-cycle basis,” Shuman goes on to say. “When you go for the second cycle and for expanding your business, the numbers are now based not on focus groups or surveys but on real- world experience.”

Calculate your initial cash flow and figure out your start-up costs. It’s an area where businesses are sometimes less optimistic than they should be.

“Small business owners may underprice their product or service, thinking they have to come in at the lowest price point to compete,” says Barbara J. Bird, associate professor of management at American University’s Kogod School of Business. “They don’t necessarily need to do that.”

You should also correctly estimate your start-up time because time can be money.

Let’s say you’re going to have fixed costs such as a monthly lease. If you have to make improvements to a space before you can actually open for business, those fixed costs are going to be additional start-up costs until you can actually open for business. Many entrepreneurs draw up a timeline for their ventures and get tripped up on the safety and inspection requirements imposed by the many statutory bodies.

For that reason alone, one of the first places a prospective new business owner should go is to the local government planning or license department. Construction permits and inspections can push a prospective opening date back by months. If you fail to take into account the cost of this time, you could be short of working capital right at the start.

Finally, be realistic about the cost of money. Many small business owners finance their ventures by running up big balances on their personal credit cards. Others tap the equity in their homes. However, self-financing isn’t a practical option for larger ventures.

Tom Emerson, who directs the entrepreneurship centre at Carnegie Mellon University in Pittsburgh, says start-ups should figure in the cost of capital when determining initial expenses and cash flow. “The cost is usually based on what the interest would be, were that cash invested in something with similar risk on the market,” Emerson says. “It’s usually a figure that is a few percentage points or more above the prime rate.”

 

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