Loss Aversion Budgeting
Rather than relying on will-power and ambition to achieving your goals, re-frame what it means not to achieve them.
Ah….the beginning of a new year.
The clock resets, as does your Year to Date profit and loss. It’s time to start afresh and set new goals for the next arduous 12 months of the small business grind.
It’s about this time when your accountant tells you to update your budget. Remember that thing? The 5-page document you paid her ~$3k 12-months ago? It’s somewhere in that bottom-draw…
If you’re like most businesses, you haven’t looked at that budget since it was developed. Perhaps you don’t even have one? I’m guilty of that too.
I despise the budget setting process.
The process involves a painful discussion/workshop with your accountant where you discuss a lot of trivial details and attempt to project your company’s expenses for the 12 months. A lot of minutiae.
When you do try to measure your actual performance against the budget, usually it’s way out because you didn’t project enough repairs and maintenance expenses for that broken down truck, or the recruitment fees to replace the staff member who decided to go MIA.
But realistically, how could you have predicted that?
Let’s be honest, budgets are almost useless because I have no idea what will happen next month, let alone next year…
A lot of work for not much gain.
Despite budgets being a pain in the butt, they do have their uses. The value is not the PDF or excel spreadsheet. The value is in the process. It can help you and your team quantify your company’s goals into an accountability framework. It gets you thinking about how you will practically achieve them by getting granular with your core business drivers.
For example, rather than setting a goal of just growing revenue by 10%, it makes you think about how you will grow the additional revenue. How many leads do I need to generate, at what average sale value, at what conversion rate?
Getting granular with business drivers can help you to manage and measure daily and weekly activity. This allows you to augment decision making with data — rather than making decisions based on gut feel.
In addition to the strategic value of having a budget, the immediate benefit is the ability to forecast your future cash and financial position. By assessing projected sales, expenses and cashflow it allows you to make proactive decisions. For example, if your sales are expected drop off a cliff due to the holiday season, having a process to understand the impact to cash flow can help you mitigate cash flow issues in advance, by getting access to finance, preparing for it.
In summary, a budget can help you be prepared.
But, they can also be limiting.
Break-Even Budgeting
In the early stages of starting my business, I knew I would be racking up losses. No big deal. Every business takes time to ramp up and be profitable, right?
I ‘borrowed’ some cash from my personal savings to fund the losses that would be incurred in the first few months of trading.
Despite having little revenue, budgeting for my monthly expenses was pretty simple. I had a good handle on what my outgoing, recurring expenses were each month.
Whilst my business was a lot simpler in those days, it was also much more stressful.
My Profit & Loss was continually in the red. I was burning money.
Even though I had the cash to fund these losses, I couldn’t help but cringe every time I saw my monthly P&L.
I hate the idea of waste and inefficiency, and looking at my business from a financial lens, I was literally throwing away money. Mentally, it hurt, a lot. I should have just dumped all that cash into a bin and set it on fire — because that was basically what I was doing.
After several months of continued losses I realised it wasn’t helpful beating myself up about it. Instead, I started to channel that pain and focus. My goal was to get to break-even — by selling more.
Ok, I think you’ve probably got the point that I am not a sales guy. I’ve been a technically trained accountant my whole life, so my sales journey was a steep learning curve. But I made it work. The daily battle of getting up every morning, prospecting and facing rejection after rejection. You win a few, you lose a few. Then, finally, the wins outnumber the losses.
I still remember the feeling when my business went from red to black. Pure relief. Mind you, there was still plenty of road ahead. We were ‘profitable’ at a ramen-eating level, but not if you adjusted for a market value salary.
So my feeling of relieve was driven more by the fact that we were no longer losing money. I had reached my initial goal. The pressure was suddenly off. I could sleep better at night. The world was back in equilibrium.
For a couple of months, I took my foot off the gas, slowed down on the push to prospect for new business. As a result, our sales started to flatline, even plateau.
We still weren’t ‘profitable’, but we weren’t losing money either. I was in this comfortable, but a weird place where just doing ‘’enough’’ was ok. And it was starting to gnaw at me.
The strangest thing was that, yeah, we were profitable, but that didn’t make me any happier. Well, nowhere near as happier as the moment we moved from losing money to making money.
Turns out, this is a cognitive bias that humans possess, known as Loss Aversion.
Losses are more powerful than gains
Imagine you’re walking to the bus stop and you find a cool $100 bill on the pavement. You look around to see if anyone is watching, then snatch it and shove it down the back of your pants.
How do you feel? Pretty luck right?
Still on a high from your recent win, you decide to indulge in a bit of retail therapy. You head to the department store on your lunch break and decide to buy a new jacket. It’s on sale for $99 — perfect!
After trying it on, you skip over to the register to pay for your new garment. You open your purse and are shocked to find that your $100 is missing. WTF!
You panic, get angry, frustrated with yourself on how you have managed to lose a $100 in the space of less than 4 hours! You reach into your pockets and pat your thighs, but you come up empty. The cashier proceeds gives you a weird, judgemental look.
You’re embarrassed and pissed at yourself — not only because you can’t buy the jacket, but because you’ve lost a chunk of your money!
Practically, you are not better or worse from a net cash position — because that $100 was a bonus you happened to find. But, the feeling of losing that money was greater than the feeling of finding it in the first place.
This is an example of loss aversion bias, which psychologists use to describe people’s tendency to prefer avoiding losses, to acquiring equivalent gains. In other words — it’s better to not lose $100 than it is to gain $100.
Loss aversion is powerful; in fact, studies suggest that the pain of losing something is twice as much as the pleasure of gains. We see it every day.
Now flipping back to my business profit situation, the feeling of making profit was nowhere near as powerful as not losing money. I was relying upon that sense of anger, fear and urgency to drive my performance to stop losing money. But now that was gone, where was the inner me to kick me up the butt?
Avoid The Threat
Loss Aversion explains why threats typically take precedence over opportunities when it comes to Motivation. The threat of loss often requires our immediate attention because losses are psychologically, extremely costly — even life-threatening. It’s hardwired into our DNA.
Losing a loved one to a Saber-toothed tiger or facing starvation from not harvesting our crop is a universally a horrible experience, so we’re built to do everything in our power to prevent that from happening. In my case, it was the potential of losing my business. I poured every ounce of energy into ensuring its survival…but once it was there — then what?
Without some form of an accountability system, I am probably the laziest human to walk the earth. I am not highly self-motivated — unlike my doggo Bella who loves to walk the earth— rain, hail or shine (side note: I admire the motivation of dogs).
This sucks because ultimately, it’s up to me to drive our company performance…and a lot is at stake.
Since the feeling of ‘gaining’ will never be as powerful as the equivalent losses, I reframed my situation.
I reframed my ‘goals’ as costs.
Opportunity Costs
Opportunity cost is the value of the lost opportunity, the benefit of the thing you could have done instead of what you’re doing now.
Typically applied in the field of finance and economics, opportunity costs are generally only considered in financial investment opportunities. If I invest in shares at a 10% yield, what is the opportunity cost if I invest that same money into my business, to generate more profit?
The problem is, most people don’t consider the opportunity costs of day to day decisions.
Opportunity costs are the most expensive when we miss opportunities.
The opportunity cost of not investing in training that new employee. Of not investing in that new product.
These opportunities are significant, and we overlook them all the time.
What’s worse? The opportunity cost of inaction keeps rising.
In important, strategic projects, the benefits are always ‘gain’ orientated. If we develop this new product, it opens opportunities to take market share. If we open this office, it expands our global footprint. Indeed the company will be better off by doing them, but being ‘better-off’ isn’t a strong enough incentive…well, for me anyway.
I’ve found it personally helpful to re-frame goals — not viewing them as opportunity gains I can potentially realise by achieving them, but rather the opportunity cost of not doing them.
The cost of not growing, of not being remarkable, of not helping my team be the best versions of themselves, far outweighs the gains of simply being ‘better’.
I regularly apply this in my personal life, but the most profound impact it has had is on my business — and it’s driven into our strategic planning process.
It begins with identifying and quantifying these opportunity costs and building them into our financial and strategic business goals.
Cue Loss Aversion Budgeting
In our next strategy session, my business partner and I talked about what ‘financial goals’ we desired to achieve from our business.
We asked ourselves these:
- What salary, beyond our current measly wage would we be really happy and would mean an above average personal financial situation for ourselves?
- How much in dividends did we want our business to produce every year, which would be a financial return, adjusted for the risk, sweat and financial capital we had invested in the business?
- Aspirationally, what would we like to sell our business for?
After a very personal and deep and meaningful discussion, we set our financial goals. They went something like this:
- Pay ourselves a $150k annual salary by end of the financial year
- Build the business to generate a $1M of EBIT per year
- Work only 20 hours a week in the business.
- Sell the business in 5 years for $20M.
These were our opportunity cost targets.
Of course, it would take time (and effort!) to achieve all of those goals, so we had to start small — starting with the first objective to increase our salary.
Knowing our actual fixed monthly costs, we added the ‘additional wage’ we wanted to pay ourselves. This set the new, opportunity-cost benchmark.
We then reverse engineered what new sales we needed to make in order to reach that goal in order to ‘break even’ on our target opportunity cost goal. Of course, with more sales comes more customers, and more staff and other costs required to service those new customers. As part of our budgeting process, we also had to consider the additional costs that would go with generating that new revenue.
By notionally reflecting the opportunity cost as an ‘expense’ in our budget, it set a new benchmark for what the business had to achieve as a minimum to break-even on our goals. Anything below our opportunity cost benchmark was framed as a ‘loss’ in our minds, which drove our ambition to level up as a business.
Our profit and loss was once again in the red. The objective was to avert these losses and do whatever it took to get back in black. The pressure was back on.
Loss aversion budgeting is a tool that we continue to use to this day. You can build one for yourself. Here’s how.
Here’s a step-by-step breakdown of how to create a Loss Aversion Budget.
The traditional accounting equation as you know is:
Sales - Expenses = Profit
Loss aversion budgeting requires you to reframe this equation. Rather than starting with your Sales, I want you to start with your actual expenses, then add your quantified ‘opportunity costs’.
Actual Expenses + Opportunity Costs = Target Sales Required to Break-Even
This value sets the foundation of your total costs, from an actual and ‘opportunity’ perspective you need to cover first, before the profit begins.
Let’s go through the steps of how to create a loss aversion budget.
- Define your opportunity costs
- Calculate your recurring expenses
- Add your ’opportunity costs’
- Calculate the sales required to ‘break-even’ on your total costs
Step 1 — define your opportunity costs
Ultimately, your financial goals will depend on the phase of your business machine and what you want to achieve from it. Some examples of financial goals are:
- Pay all the founders market salaries to the value of X by X months
- Give all employees a 10% pay rise, equivalent to XX $ by X date
- Pay a dividend of X by X date
- Work less than 4 hours a week on the business by X date.
Ensure you are specific about the $ value and time-frame you want to achieve each goal. Don’t worry yet about whether they are realistic. We will stress-test these numbers later.
Now that you’ve set each goal, quantify them.
For example, if your goal is to pay yourself an additional $70k salary per annum, your opportunity cost is $70k per annum.
If your goal is to work less than 4 hours a week on the business or (make yourself redundant), calculate how many staff you will need to employ to undertake the roles you play in the business, and calculate the monthly wages of those employees.
There are no rules on what opportunity cost goals you set.
The key is to be aspirational about your objectives. Whatever the result, try your best to quantify the goals back into dollar terms so you can build them into your budget. This allows you to understand what your business needs to execute in order to achieve them. Remember, your business is your machine, and you must engineer it to generate the outcomes that you desire.
2) Calculate your monthly recurring fixed expenses
Traditional budgeting fails most businesses because it’s impossible to predict what your expenses will be next month, let alone six months.
Instead of wasting your time predicting the future, let’s just focus on the things that you can control and have certainty over — starting with your monthly recurring expenses.
Review your most recent profit and loss statement and identify the costs that will always be recurring, no matter what sales or revenue your business generates. The most common examples include:
- Rent
- Utilities
- Insurance
- Wages
- Your salary
The total of these costs forms your monthly recurring expenses.
3) Add your Recurring Costs and Opportunity costs
Now that you’ve got a grip on your recurring expenses, add your opportunity costs.
The total costs represent the minimum, fixed costs your business needs to cover in order to break-even from an opportunity cost level.
Let’s take this fictitious company, Voltage Media as an example of how you can calculate your total opportunity costs.
Step 1: Identify and quantify your Opportunity Costs
The founder of Voltage Media, Brendan is overworked — stuck as a cog in his machine. Due to all the hours being worked in his business, he is suffering personally. Brendan needs support at a management level to help him take care of the ‘firefighting’ so he can free himself up to focus on higher level activities. An extra set of hands will help him work less hours in general.
Brendan has also been drawing a humble wage of $60k per annum. It’d be nice to give himself a pay rise so he and his family can live a more comfortable personal life. He’d like to pay himself $180k per annum.
Let’s quantify what these opportunity costs look like.
In total, Brendan will incur an additional $270k of opportunity costs in order to achieve his business goal of working less hours in the business.
2) Calculate your recurring fixed expenses
Voltage Media is a services-based business, so most of the company’s expenses are fixed costs — being mostly wages and the office rent. Irrespective of the how much revenue the company brings in, these costs will always be there month-on-month — so they’re all recurring in nature.
The company’s total recurring expenses is $2.1M per annum.
Voltage Media also has some variable expenses, which are on average 10%.
3) Calculate your total recurring and opportunity costs
Now, take your total recurring costs calculated in Step 2 and add the opportunity costs quantified in Step 1.
This means that Voltage Media will incur $2.37M of annual fixed expenses from an actual and opportunity cost level.
Now, let’s calculate what sales Brendan needs to generate in order to break-even on this opportunity cost.
Opportunity Cost Breakeven = Fixed recurring expenses / Contribution Margin
Break-even = $2,370,000 / 90%
Break-even sales per annum = $2,633,334
This means that Voltage Media needs to generate $2.63M of annual sales to reach opportunity cost break-even.
Budgeting for your sales
Looking at your target break-even sales from an opportunity cost lens often gives founders a humble dose of “holy crap, how the hell are we supposed to achieve that!”.
This is normal. Your opportunity cost goals should scare you. If you’re not setting stretch targets, you are settling for average.
Like achieving any goal, the key is to break it up into bite-sized chunks. You’ve set the macro goals, now it’s time to set the micro.
Starting with your revenue.
Step 1 — Understand Your Recurring Revenue
Most businesses will have multiple revenue streams. Most commonly, these revenue streams comprise of sales from different types of products and services.
What you need understand is is the predictability of these sales of occurring in the future. To help us understand the predictability of sales, and therefore cashflow, you need to understand what value of your sales is recurring in nature.
Recurring revenue includes all sales and income that are recurring in nature. These typically include retainer based contracts, subscriptions and managed services. Recurring revenue is the holy grail and you should consider ways to maximise this in your business.
Non-recurring revenue includes sales and income which are one-off in nature. This comprises mostly of project work — projects that you do for customers are unlikely to occur again.
Similarly to expenses, analyse your business activity and understand your current monthly recurring revenue.
Don’t pay any to the non-recurring, project revenue for now — I don’t like to forecast for stuff we don’t have any certainty over.
In our Voltage Media example, approximately 65% of revenue is contracted, retainer-based work. That means of the total $2.4M of sales the company did in the previous financial year, Brendan has comfort that $1.56M (65%) will reoccur in this year.
That’s revenue that we can bank on in our loss aversion budget.
Notice how the gap is lower as we already have some certainty over the revenue. Now we just need to make up the shortfall.
Step 2 — Split the revenue shortfall into bite-sized chunks
Looking at your budget from an annual basis is overwhelming and simply not practical.
What we want to do is split up your sales targets into months or quarters, then think about what activities you and your sales team need to be doing on a micro basis to achieve those targets. For example, get granular with your revenue equation as discussed in Principle 2. Calculate the number of leads and conversion rate and back solve what you need to generate to convert that into sales.
Take it a step further by converting the sales $ into units. For example, how many customers at what average sales price do I need to close to generate that revenue?
The more specific you can be with your micro-goals, the more focused you and your team can be to achieving them.
The final result
Using Voltage Media as an example, your final Loss Aversion Budget should look something like this.
Your goal is to avoid the losses, and get to break-even.
Conclusion
Business, like life, is an infinite game. There is no ‘end’.
You continue to grind and push forward, no matter what hurdle or obstacle you face. With persistent effort, you will achieve your goals, and you should celebrate these wins.
The challenge you face is that the feeling of winning will diminish over time.
Rather than relying on will-power and ambition to achieving your goals, reframe what it means not to achieve them.
Instead of winning, focus on not losing.
