into the world of reality.
At Intelligent Wireless Systems of Prairie Village, Kansas (a company that had developed radio frequency [RF] transceiver modules for the automation and control industry), founder Ed Meltzer needed funds to complete development and roll out his first products. Meltzer had an unfair advantage. Since the product technology was licensed from another firm that was fairly well known, Intelligent Wireless received a lot of inquiries and even purchase orders for its products while they were in development. Even IBM called one day. Meltzer supplemented these inquiries with calls to buyers of RF products.
Some questions Meltzer asked included: What’s your time frame for purchasing RF products? What’s the application? Is your project funded? Is there a scheduled launch? Is your application mission critical? How many units would you buy in a best- or worst-case scenario?
When he added everything up, Meltzer had some 750,000 units he could sell in the first year. Incredibly, he based his first-year revenues in 1997 on selling approximately 2.5% of what his research suggested-18,000 units–and throughout the five-year planning period never assumed he would hit more than 25% of what his research showed.
At the end of the day, Meltzer was not conservative enough, at least for 1997. Raising the required funds took longer than expected, so there was much less time in 1997 to hit even the conservative target.
Cost of goods sold. No one will invest in a company where not even the founder is sure what the cost will be to produce the product or service. To get over this hurdle, Meltzer simply took his product design to the product manufacturer he knew he would be using and got a bill of materials from them. He took their prices and added in a fudge factor of 25%.
Gross margin. In reality, the cost of goods sold is simply a means to the gross margin. Gross margin is defined as sales less cost of goods sold, and is usually expressed as a percentage. What must the gross margin say or not say?
First, the gross margin should not be too far out of kilter with the gross margins that are earned in the industry at large. For instance, the National Restaurant Association reports that the gross margins for full-menu, table-service establishments are about 36%.
If you’re opening a restaurant, and your financial projections show a 25% gross margin, up goes the red flag. If your projections show a 45% gross margin, up it goes again. While the former deviation is a tough sell, the latter is possible to overcome–but only with a plausible explanation. Breakthroughs in technology, manufacturing techniques or management styles can change the economics of doing business and create an exciting investment opportunity.
A gross margin on a projected income statement is utopia. In real life, there are strikes, stock-outs, equipment outages and absenteeism. To add credibility to projected gross margins, build in a fudge factor of 2%-3%.
Selling, general and administrative expenses. The easy part of this projection is the general and administrative costs. If