The run rate is a forecast of how much your company will earn in the future, based on past performance. If you earned $2 million last year, say, the run rate for the next three years is $6 million. A revenue run rate calculation is simple, but it's also easy to misinterpret the figures.
Run Rate Example
Suppose you've been in business for a month and you want to calculate the run rate for the rest of the year. Take the total sales revenue for the month, then multiply by 11. That gives you the run rate. If you've been in business for five months, take the sales revenue for the year to date and divide that by five. Then multiply by seven to get the run rate for the remainder of the year.
An alternative approach to run rate calculations is to divide the base period revenue by the number of days in the base period. That gives you daily sales revenue. Then multiply that by 365, for example, to get the revenue run rate for the coming year. Here's a run rate example: you earned $150,000 in 50 days, which is $3,000 per day. The run rate forecast for the coming year is slightly over $1 million in revenue.
Run rate can also be used to extrapolate other trends: how much your company will slash expenses during the year, the rate of errors in the accounting department or the rate of manufacturing errors on the assembly line.
You can use a run rate forecast to make short-term predictions as well as long-term ones. Say you want to know how much revenue your sales team will bring in the rest of the month. Calculating the run rate day-by-day can give you the answer. If it's the 11th day of the month, figure out the daily revenue for the first 10 days. Extrapolate that to the remaining 18, 20 or 21 days.
Why Use Run Rate?
There are lots of formulae for projecting future income. A run rate forecast has the advantage that it's simple and quick. You can do a run rate calculation in Excel, but you can manage it with pencil and paper or your phone's calculator app. A run rate forecast is a go-to choice in several situations:
- You run a start-up, and the company finally turned a profit. Even if you only have profits from that one reporting period, you can use the period's revenue to make a run rate forecast.
- You're budgeting for the future, and you want a quick projection of future income.
- You're selling your business, and the run rate makes the company's future earnings look good.
- You want to raise capital but haven't been in business long enough to establish a track record. The run rate can demonstrate the firm's potential to investors or lenders.
- You've made major changes, and you want to see how the company's performing since they went into effect.
- An inventory run rate forecast looks at how much inventory you'll probably sell over a given period. You use that to determine if you have enough stock on hand.
If your operating environment doesn't change much over time, or you expect it to stay stable in the near future, a run rate forecast can be a reliable tool. However, there are many situations when relying on a revenue run rate calculation will give you bad predictions.
When Run Rates Go Bad
Making a revenue run rate calculation is quick and easy because the formula uses one simple metric, such as sales revenue. If your financial picture isn't simple, run rates won't give you an accurate forecast.
- Suppose a big, one-time sale pumps your revenue up for the first quarter. If you project the quarter's sales with a revenue run-rate calculation, it will give you an inflated, unrealistically large result.
- Say you have a contract that brings in steady revenue but expires in the current quarter. If you include the contract sales when you figure the run rate for the next two quarters, the result won't reflect reality.
- When you cut costs, the first cuts usually eliminate big items, followed by smaller, surgical cuts. The initial big savings probably won't happen again. If you make a run rate forecast for how much expenses will go down, the initial results can skew the projection.
- Does your company experience seasonal highs and lows? A restaurant in a summer resort will do its best business during the summer tourist season. That doesn't reflect business the rest of the year.
- If the base period involved your company working at or close to peak capacity, the period might not be a good base. Usually, after you push equipment, production lines or staff to their limit, they'll need some downtime.
There are steps you can take to counter these problems. If, say, you have a one-time sale or an expiring contract, subtract the related revenue out of the base period figures before you calculate the run rate. If you have a seasonal business, use the entire year as a base period to get a more realistic revenue projection. You can avoid mistakes if you research your base period and your business situation before you crunch the run-rate numbers:
- Are you closed on weekends or holidays, generating no revenue?
- Did you have a spike in sales because you rode a temporary fad or trend?
- Was there a sudden shift in consumer behavior during the base period?
- Are there major events that impacted your revenue? Businesses might see a big spike if, say, the Olympics is held in their town. A hurricane or earthquake can depress revenue just as much.
- Customers sometimes rush to close deals before their fiscal year ends. That can give your revenue for that period a boost.
You can still get a good run rate calculation if you make allowance for these factors, eliminating anomalies, so the base period represents your normal. If you're using the daily revenue to calculate a run rate, for instance, don't count the days when you're closed as part of the base period.
You should also take special factors into account when you project the future. Say you have a seasonal business that generates the most revenue in the summer. You want to project the run rate for the next three years. You use your past 12 months as the base period to avoid skew and get $720,000 for the next three years. If you want month-to-month revenue projections, dividing $720,000 by 36 months gives you $20,000. But that's not going to be accurate because your future revenue will still peak in the summer.
Even in a smaller period, such as the next month, you may have day-to-day fluctuations. If, say, your business runs Monday through Friday, you won't be bringing in revenue on the weekends, which makes your weekday totals higher.
Run Rate Complications
Even if you take all the random factors into account, run rate has its limits as a predictive tool. If you're in a stable economic situation, it's useful, but if your revenues fluctuate a lot, it's tougher to get a good forecast. Run rates don't predict wildcards, such as technological innovation; streaming services, for examples, have reshaped the TV experience. Subtler social changes can throw things off, too. Baby boomers are aging and dying off. Gay marriage has become increasingly common and acceptable. Shifts such as this can open new markets for your company, or close them off.
It's also important to consider that you're not operating in a vacuum. Along with making a run rate calculation, consider how competing businesses might change the environment you operate in. Are they planning to roll out new products? Are they undercutting your prices? Are they actively working to woo your customers? Are you working to win over theirs? Are new companies entering the industry? Even if you can't predict the exact impact, you need to be aware that your rivals can overturn your revenue run rate calculation.
- Accounting Tools: Run Rate
- Elorus: Revenue Run Rate Explanation and Calculations
- CFI: Revenue Run Rate
- Get Control: Common Run Rate Forecasting Mistakes — and How to Avoid Them
- 3Q Digital: Forecasting By Monthly Run Rate
- Fast Company: 5 Unexpected Factors That Change How We Forecast The Future
- Heidi Cohen: How to Develop Your Sales Forecast
- Phocas: Stock Coverage: Do you Have Enough?
- Run rates are not necessarily the best way to gauge the performance of a company. Other factors may muddle your numbers and not give an accurate representation for how the company will do in the future. For example, if the quarter you are projecting from is during the holiday season (when companies generally earn more money), your projection will most likely be higher than what the company will actually earn.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com