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Wednesday, November, 18, 2009

Budgeting metric that entails extrapolating performance over a specified period of time.

This'll be a quickie issue before we gear up for the end-of-the-year slog PMBA intends to take you through. Anyway, a favorite activity of sports fans early in a season is to look at the statistics of a player and say, "Why, if he continues at this rate, he'll hit X home runs." So, if Alex Rodriguez were to hit 7 home runs at the beginning of a season, like in the first four games, you would project that at that rate, he would hit 284 home runs during the season. That is, 7 * (162 games/4 games) = 7 * 40.5 = 283.5. (You round up to make your favorite player look even better.) But of course, this statistical method is useless in sports, because nobody can keep that pace, even if they're on steroids. But as an explanation of run rate (or more exactly home run rate), it really is all you need to know.

Businesses use the run rate in budgeting or performance projections because they have a general idea of how well they have done in the past, and that gives them a sense of how well they can do in the future. Analysts can also use run rates to get a sense of how a company is doing compared to how it has done in the past. It is a useful metric but not terribly exact, since it involves extrapolation of current trends into an uncertain future. So companies and analysts have to be careful in how they use a run rate, because in certain instances, it is no better at projecting performance than is the number of homers A-Rod launches in the first week of April. Run rates exclude the impact of seasonality, potential changes in business climate, challenges posed by new competitors — pretty much everything that can impact a business. Still, a business needs to have some idea of what it is accomplishing in the moment or what it can accomplish, and oftentimes, the best place to start is with the run rate. Thus companies often use run rate as a beginning, not as an end. It works particularly well when a business has many long-term contracts, as these result in a more stable revenue base. It works less well with sales of particular products, which, again, are subject to a variety of factors that are not amenable to guesswork.

A run rate can come in handy in budgeting if a company wants to plan a certain amount of sales growth, or knows that its business has been growing by a steady percentage over many years. By knowing the current run rate and that percentage growth, the business can get an idea of what it will make, all things being equal. So if you run a business that has been in operation for 7 years; every year that business has grown by 5%; during the first quarter you have sales of $50,000, and it's time to budget for next year, you can figure your current run rate as $600,000, and then add $30,000 for next year's budget. The steadiness of the business lets you use the run rate to help in planning. Of course, if the economy falls off a cliff or a competitor undercuts your business, your run rate goes out the window.

Businesses can also use the run rate during the year to determine if they are on track to meet their budget projections from the prior year. So, using the same business, if it's March of next year and we projected sales of $630,000 for the year, we can say that we need quarterly sales of $157,500 to be on budget. If sales for the first three months are $37,000, $45,000, and $47,000 (total = $129,000), we know we are behind our projected run rate. Of course, this is where knowing how seasonality impacts a business illustrates the weaknesses of run rate as a performance analysis tool. If we know that 25% (or $157,500) of the revenue comes in December due to the holidays, we know that the rest of the year, we need only average $42,954/month ($472,500/11 months). Now let's go back to our first three months:

$129,000/3 = $43,000

In reality, the business is right on schedule. Or say you have an unusually good January and have revenues of $100,000, which comes to a run rate of $1.2 million. But you also know that some customers pushed forward their purchases because of their own budget constraints. In the succeeding months, you know your sales will drop precipitously. Using a straight run rate won't tell you this. Still, it's a basic tool that businesses use — just don't let it trick you into thinking anyone will ever hit 284 home runs.

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