Forecasting methods come in all shapes and sizes — a range of practices that warrant varying degrees of thought, effort, and analysis. And it's generally best practice to leverage a more rigorous, nuanced forecasting process to guide your expectations and sales efforts.
But what if you lack the interest, resources, or need to leverage a particularly intricate, labor-intensive forecasting method? What can you do to put together rougher, quicker projections that can give you valuable perspective and still hold some water?
One way to approach that situation is to calculate your run rate based on your revenue data over specific time spans. Let's jump into a more thorough explanation of what run rate is, how to calculate it, when it's most useful, and some of the risks you assume by leveraging it.
What is run rate?
Run rate is a metric used to forecast a company's future performance based on previous data. It's typically calculated by taking quarterly or monthly revenue figures and extrapolating them to account for a longer period of time — usually one year.
Run rate is one of the more convenient metrics to gauge and project annual financial performance. Since it relies mostly on extrapolating sales projections from data gathered over limited time frames, it often works particularly well for growing businesses without much reliable historical data to lean on.
Businesses experiencing rapid growth within short time frames can also get a lot out of the concept. If a company sees its business rapidly expand over a few months, it might be better suited to base its forecasts on that growth period's run rate as opposed to relying on its longer-standing data.
Ultimately, the concept itself is fairly straightforward, and the formula used to calculate it reflects that. It's a relatively simple series of equations that can easily be applied to any revenue data accrued over a specific period of time.
How to Calculate Run Rate
Take your revenue over a specific length of time.
Determine however many of those lengths of time occur in one year (i.e., one year is 12 months).
Multiply those two figures.
Though run rate is typically based on monthly or quarterly data, it can technically be applied to any stretch of time. Here's an example of what that might look like.
Run rate is a metric that comes with its risks and potential benefits. If you're interested in leveraging the concept, it's important to know when and how to apply it.
Appropriate Times to Use Run Rate
Forecasting as a Relatively New Company
A young business probably won't have a wealth of historical data to rely on for its forecasting efforts. That's why run rate is one of the better metrics for that kind of business to fall back on. Any data gathered over any amount of time — typically within the confines of a financial year — can be plugged into the run rate formula.
That usually works for companies that might have only generated data for a few months. Calculating run rate allows them to put together rough forecasts that can help them set expectations and gauge the health of their businesses going forward.
Gauging the Efficacy of New Ventures
Run rate can be useful when launching new products, taking on new projects, or applying new tactics and methodologies. The metric is often a solid "before and after" reference point for those kinds of endeavors.
Calculating and comparing your company's run rates on both sides of a new product introduction, the course of a major project, or the implementation of new strategies can help you pinpoint if and how new pursuits have either improved or detracted from your business's financial wellbeing.
The Pitfalls of Using Run Rate
Though run rate is certainly an easy metric to calculate and refer to, there's no guarantee it will be reliable. Several factors can muddy the measurement itself, its accuracy, and its ultimate utility.
In many — if not most — cases, seasonality is going to have a significant impact on your sales activity. Certain months might be considerably more impressive than others, and depending on the time span you elect to report, your run rate could reflect that.
If your business generates the most revenue during the holiday season and the least during the summer, a run rate based on your sales in December will look totally different than one based on your sales in July.
That kind of seasonal volatility can make the metric unreliable or misleading — particularly if businesses knowingly report run rates based on above-average months to mislead potential investors or shareholders.
Fluctuations in Company Performance
In a similar vein to problems that arise from seasonality, shifts in company performance can often make run rate an unreliable metric. Circumstances within or beyond the company — like the emergence of new competitors or significant changes in churn — can make a specific time span particularly attractive or unsavory when calculating run rate.
Run rate assumes your business is going to maintain an even keel, but that kind of stability is never a given. Your company is bound to see times that are better and worse than others, so if you elect to calculate your run rate based on one of those peaks or valleys, you might find yourself with artificially high or unreasonably low revenue projections.
Ultimately, run rate is a useful metric that should be applied with caution and some degree of skepticism. The method can give you some valuable insight into where your company is headed based on where it's been recently, but it still amounts to a fairly rough projection that doesn't do much to factor the natural give and take of how businesses fair as time goes on.
Still, it's worth knowing what it is and how to determine yours. It can be applied quickly and offer some valuable guidance about what your company can expect going forward.
Originally published Jul 21, 2020 8:00:00 AM, updated July 21 2020