What is a Financial Model?
I talk a lot about financial models because they are very useful. So what is a financial model? In its simplest form, it is a set of formulas that together represent the relationships between all of the revenue and cost components of a company. For example, it shows the cost of fulfillment of each order, the cost of production for each product, etc. Its output resembles a company income statement. The really tricky part of constructing a model is to separate out all of the cost components and relate them to the revenue items while accurately identifying the costs that truly vary with sales and those that are truly fixed.
Most business owners think of their fixed costs as the costs they have to pay for each month, their cash flow “nut” so to speak. In many respects this has little to do with the costs that vary with production or service volumes that are needed for a financial model. Most small and mid-sized companies typically have little cost that is truly fixed. Even office space or factory space is only fixed in the short run. Given a little time, a company can take more or less space by moving. Also, a given size space can usually accommodate a range of volumes of business activity. This means that the cost per unit of production attributable to space will be highest at the lowest volumes for that space and lowest for the highest volumes for that space.
As another example, separating out how costs such as product design relate to the number of products offered, and the number of products offered relate to sales volumes is actually quite complicated.
At the end of the day, most costs vary with revenue volumes and successful modeling identifies and incorporates these relationships.
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