Topics Covered In this Article: Click the relevant subject to view
Overview Content
Knowing Which Assumptions to Use
Determining What Value to Use for Growth Assumptions
Summary / Goal of Shaping the Expenses Section
Introduction to Shaping Expenses
What does it mean to "shape" Expenses?
You want your expenses to increase over time by adding assumptions to your input metrics. In fact, the only time you'll be looking to decrease expenses over time are (usually) in your COGS (if this is appropriate for your business).
For example, the hope of many physical goods companies is to renegotiate contracts with distributors, shipping entities, etc. so that as time goes forward and volume of sales increases they will actually achieve better gross profit margins and they represent this by lowering the expected costs over time within the financial model.
One Time Change Assumptions
Use this for very specific, narrative changes.
For Example, I have certainty that in 6 months I'll be renegotiating my payment processing fees from an average of 3% of revenue to 2.75% of revenue and there should be no change to the initial value of 3% until the month my contract / payment agreement becomes eligible for renewal.
Optimize Metric Value
Use this when you have broad targets / aspirations for what you would expect the value of a metric to be as well as a target timeframe to achieve that value but don't have specific growth rates backed by data / historical trends.
For example, if you have an onboarding cost of $20 per new customer and you expect to work continuously to improve that onboarding cost to $10 per new customer within the next 3 years.
Growth Assumptions
Use this when you want to mark an expense for unlimited growth. Adding a growth assumption will also make this expense reactive when you go in to hard code the historical value in passing months. This means if you have a big jump in an expense that has a growth assumption attached to it, the value going forward will pick up from the previous month's adjustments and "react" going forward.
For example, if I have an expense that I have said is $2,000 per month with a growth assumption of 5% it will grow to $2100 in the next month. If it turns out that for some reason it grew to $6,000 instead, when I go to correct the monthly value in the model to $6,000 the following month's value will now be an increase of 5% from my newly updated value of $6,000 (to now be $6300) instead of continuing to grow from the original value of $2100.
Optimize Change Rate
Use this only when you expect that how quickly / slowly an expense will grow changes over time.
In all but the rarest of instances, it will be more appropriate to use the "Growth Assumption" change type when working in the expense section of the model.
How Big / Small Should My Growth Assumption Value Be?
If you don't have a trend of 3-6 months of data to show you what your growth rate "should" be input then you won't have a "right" number to input.
In cases like this, you're using your best guess / intuition for expected growth- if you're hesitating here, start with 2%.
Don't focus on the fact that you're "wrong" at first. What matters is "how much" you're wrong by and you'll get visibility of this as you under or over forecast your expense for the next few months while you establish that data and going back in to correct each month will get you closer and closer to a growth rate that gets you "closest" most consistently.
If you do have data but need help analyzing your growth trends, you'll need to use this formula to find the growth rate : (final value- initial value) / (initial value).
Likewise, if you need to convert annual growth rates to monthly, here's that formula: Annual To Monthly: (1 + Growth Rate)^(1/12)-1
On the other side, if you need to convert a monthly growth rate to annual, here's that formula: Monthly to Annual: (1 + Growth Rate)^(12)-1
Demonstration of how "Growth Assumptions" cause the model to 'react" to changes
The goal of Shaping the Expenses Section
Add assumptions to all of your flat expenses. Percentage of revenue and expenses that are built around custom formulas will already be reactive and grow / shrink with revenue or operations so those don't have as high a risk of being "flat" and what we're looking to eliminate here are all "flat" expenses.