Importance of Testing Financial Models in Food Businesses
(Listen on Apple or Spotify. Full transcript below.)
In the world of food entrepreneurship, having a solid business model is crucial for success.
However, what happens when your projections don’t match real-world outcomes?
This common issue is the topic of our recent podcast episode where we unpack the importance of testing financial models against reality, why it’s essential, and how to effectively identify and resolve these discrepancies.
Understanding the Disconnect
Recently, I encountered several clients grappling with the question: "Why doesn’t my model match reality?" This inquiry usually arises when founders notice significant variances between their financial forecasts and actual results. For instance, one client discovered that their labor costs were far higher than they anticipated. They had meticulously crafted their financial models, detailing pricing, cash flow, and break-even projections. Yet, reality revealed unexpected variables, prompting them to seek clarity.
Another situation involved a founder whose cash flow was constantly falling short of expectations despite what they thought was a solid financial model. Exploring these discrepancies is crucial because they indicate that something may be off track—whether it's the accuracy of the model or the assumptions upon which it was built.
The Importance of testing financial Models
As we recently discussed, the first step in mitigating risk is to have develop essential financial models. But equally important is the need for testing financial models regularly. This ongoing comparison of expectation vs. reality helps identify misalignments early on—before they escalate into significant financial challenges.
If you’re not regularly reviewing your numbers and testing your financial models, you may overlook discrepancies until it’s too late. As one founder aptly put it, “Where’s all my money?” This moment of realization can be jarring, often revealing fundamental issues in both the model and its execution in real life.
Testing Your Financial Models: A Step-by-Step Approach
Step 1: Analyze Your Pricing Model
The most significant impacts often stem from discrepancies in pricing models. It’s essential to accurately assess costs for ingredients, packaging, and labor and develop a pricing structure that yields the necessary profit margins. After establishing these costs and associated prices in your model, you must ensure that these margins are actually achieved. If they are not, investigate where a discrepancy exists between your model and reality.
For instance, if your model assumes you can produce 100 units in a single day but in reality you’re producing 90, actual labor costs per unit are different than your model and adjustments should be made.
Step 2. Test Your Break Even Model
Testing your break-even model involves assessing whether your actual revenue and expenses align with expectations for a given period. If you are generating less revenue than anticipated, it could be the cause of not breaking even. If you are hitting your revenue targets but seeing losses on your P&L, operational spending may be the cause.
Were there unexpected costs? Or is your breakeven point higher than originally calculated? Understanding these elements can direct you toward necessary adjustments in your model and your business.
Step 3: Test Your Cash Flow Projection
A cash flow model projects a businesses cash availability at many points in the future. To test this model, compare actual cash on hand against your projections. Are your spending habits consistent with expectations? If you’re consistently running low on cash, it may hint at larger issues with either your pricing model, sales, operational costs, or even inventory management.
Step 4: Adapt and Communicate
When you identify discrepancies, determine whether they are due to model flaws or business execution, and then adapt either your model, or your strategies, accordingly.
Additionally, communicate and discuss these findings with your team. Involving your team fosters a collaborative environment and helps align everyone with the business objectives. Sometimes, a third-party perspective—a business coach or consultant—can provide valuable insights into what might be going wrong and how to correct course through testing financial models.
For example, recently with a client we identified cash flow discrepancies were being caused by a buildup of inventory. Pricing Models predicted that 100% of new inventory would be sold within the month it is received, but in fact upwards of 15% remained in inventory and had been accumulating over time. Discussing this as a team they created an effective strategy to move this product from inventory and prevent the buildup in the future, thus bringing reality back in line with the model.
Practical Takeaways
Start Small: If you're overwhelmed, begin with one model—cash flow is often the most straightforward, to evaluate your business health.
Use Benchmarks: Track your unique key performance indicators (KPIs) for revenue, costs, and profits, making it easier to identify areas requiring further analysis.
Test Regularly: Don’t wait for yearly audits; make it part of your routine to check models against reality monthly or quarterly.
Stay Flexible: Businesses are dynamic, so models and strategies should evolve as new challenges and market conditions arise.
Conclusion
Testing financial models against reality is not a one-time task; it should be an integral part of your business operations. By continuously evaluating and adjusting your models in response to real-world data, you can make informed decisions that enhance the flexibility, viability, and success of your business. Keep in mind that models serve as a guide—not a fixed rule—and being adaptable is key to navigating the complex landscape of entrepreneurship. Embrace the practice of testing financial models regularly, and you will set your business up for long-term success.
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Episode Timeline
00:00 Introduction to Testing Financial Models for Food Businesses
02:57 The Importance of Matching Models to Reality
05:47 Innovative Business Models in the Food Industry
09:05 Challenges and Regulatory Obstacles
11:55 Building a Sustainable Local Food System
15:09 Testing Financial Models Against Reality
17:58 Practical Steps for Founders
21:01 Labor Costs and Production Efficiency
23:46 Conclusion and Future Outlook
30:48 Understanding Model vs. Reality in Business
34:25 Adjusting Business Models for Actual Sales
38:15 The Challenge of Letting Go of Models
40:42 Testing the Breakeven Point Model
47:00 Cash Flow vs. Breakeven Analysis
52:22 The Importance of Testing Financial Models Thoroughly
57:34 The Role of Coaching in Testing Financial Models
Full Episode Transcript
Welcome to the Good Food CFO podcast. I'm your host, Sarah Delevan, joined as always by our producer, Chelsea Stier. Hey, Sarah. So earlier this season, we did an episode on what we called the three essential models that you think every founder really should have in place in their food business. And we got some good feedback on that episode. But when we finished recording, I want to ask you what
happened after that? Yeah. basically, immediately after we recorded that episode, I started to notice in my day-to-day work that founders were talking about, bringing to my attention the fact that their models weren't matching reality. And obviously, this episode hadn't aired yet, right? And so it just was happening very naturally. In some cases, founders were coming to like office hours, for example, and saying, hey, Sarah, I noticed that
you know, my labor costs, for example, in my model are not matching reality and saying sort of like, how could this be happening? And how do we figure, you know, this out? And what are the steps that we take? And then similarly, but a little bit different, one of my clients, with them, I recognize that their model didn't match reality. And I had to bring it to their attention because it can be difficult, especially if you're not managing the finances and the sales and like every single part of your business.
to identify when something is sort of getting off track. So right after we recorded that episode, I came to you and I was like, Chelsea, we need to do a follow-up episode that really dives into how to ensure that your model is representing reality and really what do you do when it doesn't? So like, how do you recognize that your model isn't representing reality?
What steps do you take once you identify that? You know what I mean? And how do you move forward? And so that's what we're talking about today. Yeah. I mean, I remember when we recorded the episode, you calling out, you know, very specifically that when you create these models, they're not something that you make once you're like, okay, yeah, this works. And then you tuck it away and you never look at it again. Right. Exactly. I'm really excited to get into this conversation. I think there's going to be
some really good tips here for founders. But before we get into that, we have a news story that we're sharing and I love this story. It highlights a business and really a business model, right? That is changing the way, truly changing the way that food business is done. And we get to celebrate this regional system, this regional food system that is
really utilizing sort of non-mainstream infrastructure. Yeah. And the result of that is that the farmers and producers, I'll call them, they get to maintain more of the margin, right? More of the revenue that their product is generating when it goes to that final consumer, which is something we touched on in the last episode, this idea of different ways of doing business, different forms of infrastructure that
work very differently than the national distribution models that we currently have. And this idea that I truly believe in, which is that it can bring financial benefit to not only the owners of that business, but also the producers and the farmers who sell through that business, the employees and the community at large. And I think we absolutely see that in this article.
Yeah. And so this article, which came from Civil Eats, and we're going to link to it in the show notes, like we always do. One of our faves. It is really telling the story of farm stops, right? And specifically, the first one that we really meet in this story is Argus Farm Stop, which was founded by William Brinkerhoff and his partners about 10 years ago. I thought this was really interesting. They started the farm stop.
with only $180,000. now today, they operate two different markets with two cafes. They employ 65 people and they partner with roughly 200 local farms, which by the way, I don't know if we said this yet. This is in Michigan. Okay. So 200 local farms in Michigan, food producers and artisans.
And in 2023, the stores made $6.5 million in sales. That's amazing. When you think about the area that this farm stop covers, right, the number of people that are supporting this and the fact that $6.5 million of revenue, you know, passed through these two locations, it's really, really awesome. And if you take that number, that's 6.5.
And you then take into consideration that farmers at these farm stops set their own prices, as do the producers and the artisans, I believe, and they get to keep 70 % of the revenue. That's massive. We're talking about 70 % of $6.5 million going directly into the pockets of what we're going to call small businesses to sort of cover, you know, cover that whole spectrum of, you know, folks who are selling there.
It's really amazing. And the model is a consignment model. So the way that it works is that farmers bring their products to the farm stop maybe once or twice a week. I think it depends on the type of product you have, the type of farm you are, et cetera. But you bring it to the farm stop, you unload it, you price it yourself, and then the sales happen and you get reimbursed. That's 70 % for the products that are sold from your farm.
I think it's a really, really interesting model. And as they say in the article, it sort of lands somewhere between a grocery store, a farmer's market, and a food hub, which is really interesting to think about. Yeah. Yeah. And going back to this idea of the producer keeping 70 % of that sale price, right, of the revenue, that is a significant difference, right, from the average, what we see is 15%.
of any retail going to the growers, the producers, the artisans. Yeah. What you're talking about there is like the larger scale grocery store, like quote unquote, traditional grocery store where perhaps 15 % will actually make it back to the farmer. What Kim Bayer, who is the owner of Slow Farm, which is a farm that actually sells their organic produce to Argus, about this percentage difference is that rather than being price takers,
which is what you are when you are working within this national distribution or working with really large national grocery chains, you actually get to be the price maker. You are literally able to price your product on the shelf at Argus and at other farmstops, which just does not exist in what I'm going to call traditional grocery retail. Yeah. And like you said, these farmstops, this model,
is kind of, as you said, between retail, farmers market, food hub, but they do operate differently on that consignment sort of model. It's something where, like, for example, with a farmers market, right, it allows the farmer to not have to be there in order to sell their product. Yeah, there are limitations, right, to every
Every model is going to have a bit of a limitation, right? So the advantage of being at a farmer's market is you get not even 100 % of the revenue because you still have to pay a percentage to the farmer's market, right? But you perhaps get to keep more than 70%. You usually do. But you have to be there as the farmer on site, right? Or you have to hire a representative to be there on site. You've got a truck, you know, that's brought, you know, your food down. You're spending several hours there.
a long distance that a lot of farmers have to travel. We talked about that in a prior episode, right, where it's a lot of hard work. If you've got farming to do, it's difficult to be off farm for several hours a day, right, several days a week. And so the FarmStop model really alleviates that kind of pressure and that sort of need to be off farm for such a long time, which I think is a really great step forward.
in thinking about how we can get locally grown food to more people. Yeah. And Brinkerhoff's actually quoted in the article talking about the struggles of a small farmer. He said that too many small farmers quit because there isn't enough money and it is too hard. And that he says we are trying to change that narrative to make it sustainable economically to be a small farmer.
Yeah. If you think back to that news article we talked about in terms of dairy farming and how the number of dairy farms was shrinking, but then the size of dairy farms was growing, right? We see that same thing happening in non-dairy farms, but the impact of Argus goes beyond putting more money into the hands of farmers, producers, and artisans. It's actually resulting in the growth
the acreage of farmland in Washtenaw County where Argus is located. So you've got this region that is going against the standards, sort of what we are typically seeing across the country. And I think that you can absolutely point to Argus and the work that they are doing as a catalyst for that positive change, which is really thrilling. Yeah, it's exhilarating, you know, and
I think though, Sarah, we do have to talk about here because with every change, right, with every change maker comes obstacles that we have to learn how to get through, right? And so I think creating this sort of alternative food system comes with its own set of obstacles, namely regulatory obstacles. Can you talk a little bit about that? Yeah. mean, listen.
rules and regulations are in place typically to protect people, right? But one of the sort of unfortunate side effects of that is when you are creating a brand new system, a brand new infrastructure, the sort of old rules will apply to this new system, this new store type, and it can cause some issues. the article points to an example in 2016 where the Michigan Department of Ag and Rural Development
cited Argus for selling eggs from small farms that hadn't processed their eggs in a licensed facility. That is not allowed outside of farmers markets. So reportedly there was a complaint and after that complaint, the department actually seized 90 dozen eggs from Argus, which is really sad. I've seen product, farm product, animals.
you know, get seized for rule breaking such as this and that food goes to waste, the farmer, right, loses that investment. There's a lot of kind of unfortunate side effects of this. But on the positive side, in the weeks following that seizure of the eggs, the Argus founders actually went to work, started talking with, you know, the local departments and farms and other experts as well as elected officials.
to find a way for unlicensed farms to sell directly to customers through Argus. And so it seems frustrating to think that you have to create a workaround. But listen, if that's what it takes to achieve your goals, then that's what it takes, right? So now farmers can bring their eggs to Argus and customers can pick their eggs up from Argus, but Argus cannot accept payment.
And that was an acceptable solution to allow egg sales to happen and for Argus to be the conduit for it, which is great. But as you say, like nothing new comes without, you know, bumping up against some rules, some regulations, some misunderstandings in terms of like how things have always been done before and how we might want to do them now. But I think what's really positive is that Argus is now, you know,
A, trying to grow beyond just this farm stop or these two farm stop locations, but to become a single point of contact for school kitchens in the community, right, and other types of organizations to come and get locally grown produce, dairy, eggs, etc., right? And it's continuing to build a network, right, and to create resilience for a local food system who's now not just relying on home consumers but has a more diverse
clientele, if you will. And then one step further is that they're actually starting to take the lead on education. And in March, they held the first annual National Farm Stop Conference in Ann Arbor. There were 120 participants from across the country, including representatives from communities who are looking to adopt the model, policymakers who are hoping to understand it more, and, and this is very exciting,
senior representatives from the USDA. And this is big because the USDA needs to understand limitations, needs to understand what people in communities like this are trying to do so that they can create support systems for the work, including grant funds. So I find that tidbit of information that was sort of tucked at the end of the article to be really, really exciting.
Yeah, grant funds and education, right? Because anytime you're introducing something new, as we just talked about, you're going to run into regulatory issues. Everything that Argus has learned over the past 10 years to be able to share that with others who want to adopt this sort of model and system in their local communities. Like that's such a treasure, really. Yeah. Yeah. And honestly, Sarah, it just takes me back to
something that you really talked about in our last episode, you where we talked about the sale of Siate Foods, which was you very explicitly expressed, right, that a change in the food industry needs to happen. Yeah. But that at the same time, there is absolutely in no world that you felt like that should be on the shoulders of food founders. Yeah. But that also we don't have to wait
for change in the infrastructure, in the system. And yeah, I think this is such a great example of that. Yeah, I think there are a lot of people who are waiting for the government to step in and do something. You know, at the time we're recording this, we're waiting to hear on whether the FTC is actually, you know, going to put a stop or if they're effectively putting a stop to the Kroger-Albertson merger, you know. And I think if we wait around for the government,
We're never going to see the change that we want to see. And you're right. I don't think that the farmers, for example, should bear the responsibility of growing this good food and also creating the infrastructure. They don't have time. What's cool is that William and his partner, they have done the work. They have said, we recognize or we have an idea for how we can support these farmers, how we can create a system that
is a new idea and that may work. So let's give it a try. I also can't end this new story without saying that this is a very low tech way of going about changing the food system. I think that there is a time and a place for tech, but as we've talked about many times here, Chelsea, food is physical. It takes people to grow food and to pick food, and it's an essential item. No matter
what physical movement, human touch is going to be required in this food system. And so it's beautiful to see new ways of thinking that don't require expensive tech investment, you that aren't relying on technology. They aren't radically trying to change the system, but they have tweaked the system and they have tweaked it in a way that is having a huge impact. And I just absolutely applaud Argus, their founders, their team.
And the farmers and communities that are supporting it. I cannot wait to watch what happens and see farmstops grow throughout this country. Yeah. And I would just echo something you said at the beginning, which is, you know, I love to see this movement forward by looking backward.
Well, just I think we should move it forward to the main episode. You think it's time? Yeah, let's get to it.
As a Good Food founder, do you ever feel like your work is done in a silo? Is it difficult to feel confident in your business and financial decisions because you don't have a sounding board? Well, in our weekly CFO office hours, you'll not only get the chance to work shoulder to shoulder with the Good Food CFO herself, Sarah Delevan, but also with a small group of your peers. Together, you can support each other through the work of building a business on your own terms.
Passes are available now on our website. Just visit the goodfoodcfo.com and click on coaching. And now back to the show.
So Sarah, like we talked about in the intro to the episode, after talking about the different financial models that founders, A, should have in place before they launch their business, but if they don't, should get them in place ASAP. You really wanted to talk about something that we didn't get into in that particular episode, which was testing financial models. Yeah. It's been interesting.
I love it when real life informs what we talk about here on the podcast, like testing financial models. What was happening in the real world with clients and coaching members was that people were either asking the question, why doesn't my model match reality or why doesn't reality match my model? Then in another instance, I was trying to convince someone essentially that their model and reality were not the same.
and trying to illustrate that for them. And I really felt compelled, as we said in the intro when I sat down to write an episode on a completely different topic, which we will still cover, it just what was coming out of my brain and onto the keyboard was this idea of how do we test financial models against reality, but even more so like why should we be doing that and what does that actually look like?
And Sarah, like as this is coming up for you in these real world situations with clients, I guess I have a couple of questions. First of all, what prompted them to ask the questions like right for you to get there, but then also what did you do or how did you identify that this was the disconnect? It was between the model and reality. That's a great question. So I'll start with the founder who
recently brought it to my attention in coaching and saying like, why doesn't my model match reality? So they had identified, for example, that their labor costs were higher than what they had expected them to be and what they had modeled them to be. So they had gone through the process of building some of those essential financial models like
your pricing model where you can see your margins and you get a sense of what your labor costs per unit should be. They built a break even model. They had those things. They had a cashflow model. It was something that we had worked through together previously. And so they were recognizing at least this one element is not matching up with what I thought it should. And I don't know why. And they were trying to
kind of understand that. So that's great, right? What that means is, A, they have a model and B, they're looking at their finances. They're looking at the financial outcomes of a month or a week, right? And they're recognizing the differences and they're wanting to dive further. In the other instance where I was wanting to sort of say, hey, client, your model is not matching reality, that was happening as a result of cashflow, just
never really getting to the point where it should have based on the model. There's this model that when we look at it, it makes perfect sense, but there's something going on in the real world where we're not seeing the results of what the model says we should be. For that reason, we decided to also dig in and say, what is happening here? A, is there something wrong with the model?
B is the model technically right in terms of its math, but how it plays out in reality, like is that different? And so we have to get to the bottom of essentially like what is broken in this hypothesis essentially that we have for our business. And so Sarah, what I'm hearing you say right off the bat, right, is that as we talked about in the prior episode, number one, you have to have these models in place in your business.
But then number two is you have to monitor how it's going, right? You need to be testing financial models. Because that's when you will start to see, something is not matching up here. And if you're not reviewing the numbers, if you're not doing that on a regular basis, then you would potentially miss something like that until, guess, down the road, you're like, wait, where's all my money? Yeah.
That's absolutely right. In both of these instances where a founder is saying, hey, my reality is not matching my model. And when I'm going to a founder and saying, hey, I think there might be something wrong with the model because reality isn't matching up, it's because something got off track. It's because we recognize that labor is higher than what had been modeled. It's because we recognize that like, we
thought that cash flow was going to be really positive and it is not. What is going on here, right? Where it's kind of moving in the opposite direction. In both of these instances, the founders have great products that are selling well and that's actually a bad thing, right? And I like to call this sort of thing out because when you have a model that isn't working, typically the result is that the finances are
worse than you expected, right? The financial outcomes are less positive than what you thought they were going to be. And so continuing to sell this very popular product, this product that your customers love, then makes your financial situation worse instead of better. And so this is an argument. I think this whole episode is like an argument for slowing down and testing financial models.
And so we're going to talk about, think in this episode, like what does it look like when you reach a point where it's like, uh-oh, I'm recognizing that my model is broken, right? We're sort of going to be talking about that because those are some real life examples that I've already, you know, brought up. But I want to steer people in the direction of how do I test financial models early on so that I have confidence in it and then I can go and sell the heck out of this product.
or go and grow this business because I’m testing financial models and I know that my model is true or I've modified my model so that it is true, right? And I can predict my outcomes with some level of certainty, which if you think back to that Essentials Models episode, right? Part of the question there was like, how do we de-risk the business? And you can't really de-risk the business, but in hindsight, like after recording that, like what you can do is testing financial models.
as the closest you're going to get. Yeah, that will help to, quote unquote, de-risk the business. Okay, so I'm ready to dive in. Where do we start? Well, I think going back to those three essential models, there's something that you can do to testing financial models versus reality in each of those. But I think where the largest impact is had is in that pricing model. Because as we know, food is
Like the food industry, the food business is margin-based. We know that our cash flow is a direct result of our margins, right? And so we have to get this right. And what I see very commonly is that founders will build out their pricing model, right? And in that we've got, just to reiterate, we've got our ingredients, we've got our packaging, we've got our labor, right? And all of those costs per unit.
come together to essentially say, okay, this is what it cost me to make one unit and then I'm going to price it such that I get a, you know, 55 % profit margin, let's just say. If that model is not reality, then you're generating a different profit margin, which means you're generating a different cash flow than what you expected. And the trickle down through the other essential models, right, none of them will be working correctly. And here's the deal. You have to go into the real world.
The only way you can test financial models and if it will really work is to do it. So my advice here is like you can start slowly, right? And this is echoed in some other advice like, you know, launch into retail in your own backyard or launch into retail with some independent stores, right? That's a way to test financial models, sort of walk before you run, right? You can test it out at your farmer's market, et cetera, et cetera. And by the way, as we said in the previous episode,
you're going to continue to test financial models through time and over time, right? As your business changes, as production changes, as your employees get raises, like you name it, an input or an element changes, you have to reevaluate that model, test financial models. But getting back to the core here is we have an idea of what the costs are going to be for our product and where we see
The discrepancy happened most here when we're testing financial models versus reality is with labor. And the reason that this is, and I've probably talked about this before, I know that I have in some COGS episodes and things, is because when our team comes to work, if we're doing our own production, they're not showing up with a kitchen ready for production. Everything is not ready to go, right? There's setup.
at beginning of the day. There's cleanup at the end of the day. There's managerial responsibilities for somebody on your team, right? There's receiving of product. There's putting away, there's all of these other things that go on in a kitchen outside of production. So that's one way that like that model can be incorrect when you're comparing the model itself to reality. Another thing that happens is we have to make an assumption of how many units we can produce in an hour, in a day, in a month.
Right? And if that assumption is incorrect, that is going to throw off the cost to produce your products. Because essentially, it's going to take more labor if it takes more time. Right? You have to test financial models in reality to see, okay, I thought we could make 100 units in a day. Can we? Maybe you can make 100 units in a day, but is it taking two people or is it taking three?
So is every element of my model correct or is there something that needs to be tweaked? And then what you do is you say, I can produce 100 units in a day, but it takes three people instead of two. I have to add that third person's labor into my pricing model. Does it still work? Can I still obtain the margin that I need to to have a cashflow positive business or to build a business with the level of debt that I feel comfortable with?
This is actually reminding me of your conversation with Charlotte around the time study. Yeah. And we often talk about time studies in an effort to save money, in an effort to become more efficient, but it's also a tool for testing financial models. I think that's a great point to bring up here. Yeah. So, labor, that's a big one. Are there any other areas within our pricing model that we want to be really keen
to testing as soon as possible or just really highlight that this is another area that you want to look at. Yeah. I'm going to give a very, very specific example in regard to production of a product. So the example I just gave is associated with labor and in-house production. There may be, I know that there are many food businesses who work with co-packers, who work with processors of some kind.
have seen a discrepancy between model and reality is in the processing of a product, right? So let's say you, I'm going to use like an animal as an example, just because I think it's very clear for people. Let's say you raise chickens or you buy chickens from someone, let's say a ranch, okay? And you can
sell that chicken whole or you can sell that chicken in parts. And so we're going to make an assumption for this example that you sell that chicken in parts. And you've built a model that says, okay, we pay X number of dollars for the chicken and maybe that chicken weighs five pounds. And then through the processing of turning it into chicken breast, chicken legs, chicken thighs, chicken wings, and then maybe the organs that we can also sell, we lose a little bit, right? We lose the weight of some of the bones, we lose the weight of some of the skin. And so what we
there's a little bit of loss there, right? So you might have a yield as we call it of let's say 80 % of the original weight is actually the selling weight of that chicken now, okay? And so you've built that into your model. And now you're saying, okay, now we've got these four five products and we're going to sell all of them. And when we sell all of them, we generate X number of dollars. And all of that can be correct. After testing financial models, that model is true. There's nothing
broken in the model. But what may be happening in reality, and we've seen this with businesses, is that you're not selling every part of the chicken every time you process one. To explain that a little better, maybe chicken breast, boneless, skinless are the most popular item that you sell. For every chicken that you sell, you sell the breast but like
the legs and the wings and the organs go into the freezer, right? And so let's say you harvest 100 chickens, you might sell through 100 chicken breasts like that and have a bunch of inventory of the other parts. So where the model is different than reality is that your model is assuming we're selling every piece of the chicken as soon as we bring it in. And reality is saying we're selling lots of chicken breasts, but we're holding onto inventory of
legs and thighs and wings. And so then what is happening in reality is you have to harvest more chickens because you're out of chicken breast. You're out of stock. So you're not generating the revenue that you expected to based on your model and you're having to spend money on new product to come in, right? And what happens is because founders are so busy running businesses is that they sometimes lose
sight of or lose track of like what is going into inventory or what am I not selling or how is my product like actually selling through. And so that is not an error in the model in that you like calculated the labor needs wrong or that you calculated the yield on the chicken wrong. It's simply that the assumption that the model made is not how customers are actually buying.
And the awareness of that is really important because then you can start to make decisions and change some things, hopefully in an effort to start selling more of that product that was going into inventory so that you are generating the revenue that you thought you were all along. so that's my other question that I have is like, first, I heard you say, you you can look at it and maybe think about how can you sell those other pieces? Is there also
something that you can do around changing the model to speak better to what is actually happening? Yes, that's a great question. So what I would recommend specifically in this case is like, okay, keep that model, right? But now let's build, I'll make this real world again. So in the real life example of working with a client where we were recognizing that cashflow was not happening the way that the model was suggesting,
We essentially broke apart the model and it wasn't chickens, but I'm going to continue on this example. We broke apart the model and said, okay, what were our actual sales here? Right? The actual sales in this month, for example, were X number of dollars. And in order to bring in that product, how much did we spend? And that was X number of dollars. And let's just say it was $50,000 in expenses to bring in that product. And then it was $40,000 of income.
of sales, right? And so when we kind of step away from the model, kind of break it apart and say, okay, I see what your model is saying and I don't know why it's broken. I don't know why it's not working. But what I do know is that reality shows us that we just spent $50,000 and we only got $40,000 worth of revenue. What's why? What's going on? So then what happened, real world example, is that
we asked other people in the company. This model is broken. We don't specifically know what's happening other than to say that we're losing money, it appears, on this product. So when you dig a little deeper, what we discovered was, the legs, the thighs, the organs, many of them are landing in inventory. And so if we look at, that $50,000 purchase,
We sold $40,000 worth of product and a bunch went into inventory. When we calculate the value of that inventory, it's another $40,000 to $50,000. Yeah. Then you go, that's where the rest of the money that my model said I was supposed to be bringing in is going. It's sitting in inventory. It's in the freezer, right, in the case of if we have a chicken. What was interesting was the founder had said, well, great, my model's not broken. I said, well,
Your model is not broken, but your model is making an assumption that is not reality. We need to look at reality and go, okay, if for every $50,000 we spend, we know we can generate $40,000 on this product, but how do we get the remaining $40,000, $50,000 in inventory? How do we turn that into revenue? This is a huge
eye-opening aha moment for a founder when they go, my God, like, yes. And we need to prioritize getting stuff out of inventory so that we have money. And then conversations and decisions can be made, right, where you can, in this case, get your cashflow back to where you thought it was going to be and sort of modify the model, restructure things, right? Maybe you're selling chickens as whole chickens instead, right? And maybe you're incentivizing people to do that.
The possibilities are sort of endless from there. But I think, you know, to kind of summarize the answer to your question after a very long response is like, tear apart the model or just look at reality and put aside the model for a minute and go, okay, but what's my actual dollars and cents here? Yeah. And I can imagine that that would be really hard for a founder in the sense that you've spent all this time
You know, we get attached to things, right? You've put so much work into building out this model. There's probably some pride in that. And then when it's not working, it's got to be something else, right? It can't be my model. Yeah. And that's such a good point too to bring up is like, sometimes, and I'm sure that I'm guilty of this as well, is like, the model says this. The model says this, that's how it should be working. And it's like,
I have so much compassion and empathy for that founder in that instance because it's like, hear you. I hear you. I believe you. I cannot find an error in your math, but something is broken. I need you to look away. I need you to forget about that model for a minute and look at reality and sort of do whatever learning needs to be done there so that we can fix this and that we can make it better. But I think you've hit on something with
which is very true, which is it can be really hard to get a founder to let go of the model. Yeah. And another aha moment that I actually had, Sarah, in this conversation is that, you know, I said a minute ago, how can you actually change the model or fix the model like to more match reality? And as you were talking, I realized, it's not really about fixing
the model, it's about changing the strategy, like with the chicken parts, right? That's when I realized it as you were talking is like, there is nothing that we can change in the model that's going to sell a bunch of chicken thighs that we're not selling. And so it really is about looking at, okay, so this is the reality. What am I going to do with that? Yeah. And the reason that that relates to the pricing
model is because typically, again, you've structured a lot of your business and a lot of your other models on this idea that I'm going to spend this much to produce a product or products and I'm going to generate this much, right? And so I've got for every chicken that I sell, I have a particular margin that I am generating, right? But as I kind of laid out, if you're not selling the entire chicken or if you're
yield is lower than what you thought or any myriad of things, right? Then the outcomes are different. Your margins are different. Your cash flow is different. And it's rooted in the model that starts it all off, which is that product cost and pricing model, right? Yeah. And that's going to trickle throughout the business. Exactly. Yeah. So I think that's some really good things to think.
through as you are looking at your pricing model. But in our original episode, we also talked about a couple other models, right? And the next one that we talked about was the breakeven point model. Yeah. And I'm curious, how would you go about testing that? I mean, most simply is if you're generating the revenue that you thought was going to produce a breakeven number on your P &L and it's not.
That's a sign that something is not working right. So it could be because of some of the issues we talked about that can relate back to the pricing model and to the margin, or it could be that you are spending more in your operating costs, let's say, than you had anticipated. And as a result, your breakeven point is higher than you had expected.
when that's happening, right? So when you're like, wait a second, I'm hitting $150,000 a month in revenue and I should be breaking even here and you're not, that's a key, like that's an orange flag as I like to sometimes say, to go and look at, what was my projection and what is actually happening? So step number one, if I was going to kind of lay out like, what do you do in this scenario? I would look at your expenses. I would say, okay, what was I?
What did I think I was going to spend on subscriptions? What did I think I was going to spend on operating labor as opposed to my production labor? Is my rent in line or my insurance is higher? Where is there a specific discrepancy in spending? Maybe there isn't one, and then that's going to push you back up to that pricing model and doing a deep dive there. If there is a discrepancy in your spending, the next step would be to ask yourself, is this a one-time thing? Is that an anomaly? Because I had to
pay for repairs that I wasn't expecting or just something random and one off? Or is this an increased expense that is going to carry forward month over month over month? And in that case, you have to adjust your model and redetermine your breakeven point. Yeah. And so this is taking me back to, again, it's like I kind of have to shake myself out of it or my brain of like, when we say test financial models, it doesn't just mean,
It's Friday, we're going to test financial models today. It means we were literally looking at this month over month as you work through to that break even point, you're following up, you're checking line by line, right? Like you're doing that work of reviewing the model versus the actual on a regular basis. And if you have a bookkeeper,
someone who keeps your books, if your books are structured in a way that's very helpful to you, your models should mirror the layout of your P &L, for example. So it can be very easy for you to just kind go line by line to see is everything matching up the way it's supposed to be.
I'm a very, I think, of like tactile person. I take notes when I'm listening because that's how it like sings into my brain. If I'm analyzing budget versus actual, I'm typing the actual numbers in right next to my like forecast or budget so I can actually absorb where are we off or where are we, you know what I mean, overspending or underspending, things like that. So do it the way it works for you, but know that it doesn't have to take a lot of time to do it. know what I mean?
It literally can be 30 minutes. I will say this is something I am familiar with from my experience managing a retail business, like a food service retail business. When we looked at our PNL, now granted, I didn't have everything on my PNL, right? Because I worked for a corporation. So it didn't look exactly the same, but a tactic that I learned early on and that I used throughout my tenure.
is to break our P &L into four sections. So top line revenue, COGS, and gross profit, right? And then our operating expenses, and then at the bottom line, essentially, right? That contribution profit. And each of those four sections had a goal listed, right? So you had your revenue goal.
And then once you got down to gross profit, the goal was your gross profit to be 75 % of your revenue. And then once you hit your, we called it controllable contribution, right? After your operating expenses, that goal was 50 % of that top line revenue. And then what was the total profit percentage goal of, and it made it very easy instead of being able to go line by line, by line, by line to just go, am I hitting these targets?
And if I'm not, I know where I need to look. That's great advice for breaking that down. I so appreciate that because it can be overwhelming, especially if you're someone who hasn't been doing this work for a while. if you're totally new to it, I think it's great advice to go, did I hit my revenue goal? Yes or no? Were my cogs in line with what I expected?
them to be or what I need them to be, yes or no, and then you can dig in from there. I love that advice. Yeah. So this is all talking about our getting to that break even point, but from there, right, then we're really starting to look at our cash flow and then potentially our growth plan. And when it comes to that cash flow model, what is really going to – like what's the
difference here between the break even and the cash flow when it comes to testing financial models? Well, when we talk about break even, we're looking at, this is like, we'll kind of call back to that previous episode, but if you're not really solid on this, I would recommend going back and listening to it. But that break even is sort of representative of like a P &L for many businesses where we're looking at the cost to produce the number of products you actually sold, right?
and you're operating expenses for a given timeframe. And we're trying to see what that breakeven is. A cash flow model is literally projecting the cash we expect to have on hand at given points in time in the future. So this is a model that's actually going to be evolving over time. And the way that we verify whether or not this model is matching up with reality
is essentially we've projected our cash balance far into the future. And every week or every month that we come in to check on this and review the cash flow, we're going to see how far off the cash balance is from what we projected. Right? So if my actual cash balance is $25,000 lower than I expected it to be, similar to what you just said about how you check your P &L and you check that top line number, and if it's that far off, you know something went
differently than planned. And then you dig into what went differently than planned. And what I think is interesting here, and I'm going to go back to the chicken example, is that again, it was like the model was telling us that we should be expecting a certain amount of money from every purchase that we make, right? So we're buying a hundred chickens. We should be expecting a certain amount of revenue to come in.
And based on those revenue projections, we would have a certain amount of cash in the bank in like each month, right? We actually look at it weekly. But we didn't. We were always running low. And I know from my experience that if we're running low on cash, there's two things that are likely happening, right? One, we're overspending on things we hadn't predicted that we would be spending on, or two, our margins are not what we think they are, right? And so
This is the real life example of we had a model that as far as we knew was working. We had actuals versus projections that like, you know, in terms of our breakeven point that weren't really far off. And so we actually weren't getting a lot of information from that either. And it was the cashflow itself, the cashflow model where it was like, hold on a second. We had one of our top priorities to have a cash runway of, you know,
three, four, five, six weeks based on these purchases and sales and we don't. We're like week to week here. What's going on? And that's what really drove this questioning of where is this broken? And it gets a little complicated if you have more than one sales channel, if you have more than one product. Because here's what I also want to share here, right? Is that this particular example that I'm sort of like ambiguously talking about,
In reality, there was an issue with one model surrounding one sales channel and one set of products very specifically that was having a huge impact on the entire business. It was that because we didn't test every single financial model independently when we launched the product,
we then were on a hunt for what is causing this issue. And that's another thing that you're really making clear to me right now as we talk this through is that, yeah, you do have these different models and these different models represent almost like points in time, right? In the cycle of a product, right? So that first pricing model is like the creation of the product.
I mean, yes, the sale of the product too, but then the break even is we're adding, it's like one product, then the break even where it's a set of products. And then the cash flow is like the set of products in relation to the business. Right? Yeah. And I can see how if something's broken in that pricing model and you didn't test it, yeah, you might not notice that right away because it might be very granular.
And then you get to the breakeven point. And again, it might be a little bit off, but you're like, it doesn't seem like it's that. And you don't really notice that it's actually a problem until you're looking at the volume on a cashflow. Yeah. Model. Yeah. Right. And, and then that has to lead you all the way back to the pricing. So you're just making me realize like, yes, we need to test at every point. We need to really get.
clear on how all of these things impact the next? Yes. Going back to the chicken story, there was a beautiful model, but the model was not tested. Hindsight is 2020, right? So let's talk about what we could have done there. What we could have done there is said, here's the model. Here's our first 100 chickens that we're bringing in. Did we generate the amount of revenue from the sales that we thought we were going to?
Did we sell through all the product that we expected to? That can be as simple as what testing financial models against reality is, right? It could be, okay, we have this pricing model and it says it's going to take two people and it's going to take one day and we're going to produce 100 units. so based on that model, our total spend should be X number of dollars on labor and X number of dollars on product, right?
We run the production and we go, it match or does it not? And if it doesn't match, we dig in and go, what's the difference, right? It is so common for us as people and founders to go, okay, we've got the model, now let's go. Let's go big. And I love that energy, but I say slow down.
I say try to replicate reality, right? Like even if it's not the full scale thing, like how can you test your theory in the most real world way, right, before you move forward? And then as your business changes, continue to test, right, your theory in the real world. And it doesn't mean you wait to launch your business. It means you launch your business a little.
And then you go from there. You know what I mean? It's like you don't have to be big tomorrow. What I want for people is to be financially solid, financially successful. And when we get three years into a business, two years into a business, and then we're discovering, hey, this isn't working how I thought it was going to, it's later than it needs to be to do the investigating.
And I think part of the reason that we do that is because there's also these myths surrounding business and food business in particular where says, you're not going to make money until you're number five. You're not going to make money until you sell the business to someone else. So when we're believing, we're infiltrated with these ideas of like, well, I'm not supposed to be making money now. Then we go, so I just need to sell more. I just need to work harder. I just need to get through it. Exactly. And that's not necessarily the truth. so I
want to encourage people to test financial models. And I think this is also a great way to talk about coaching and consulting, but particularly I think coaching works really well for founders in this way where you can say a couple of things. You can say something like, hey, Sarah, will you check this model for me? So the one example I've also sort of been talking about today where a founder came to coaching and was like, I know that my model and reality don't match.
Her questions for me were, can you help me figure out what it is that isn't lining up? And then can you help me figure out how I change reality to better match my model? Because it's kind of like, I need reality to match my model for this business to work. So can you help me to do that? And I think as you pointed out, we can get so attached to a model.
that it can be hard to see what's like maybe broken in it or your model may be exact. You may know that you need to make reality mimic that model, but that's going to involve some tough conversations that might involve you coaching your team to be more efficient. That might involve letting someone go from your team. These are all very real founder and CEO things that you may have to deal with. And so having a coach, having a group of people
that you can go to to say, help me work through this can be immensely helpful. It's just that second set of eyes to look at things and go, I can see what's broken here. And let's be honest, oftentimes the founder will know what's broken and just need some confirmation. And especially if there's a difficult conversation on the other side of coming to terms with why reality and the model don't match, it's like,
you really want to be sure that this difficult conversation you're going to have, this difficult change that you need to make in your business is the right one. You know what I mean? And that it actually needs to be done. And I'm realizing as I'm listening to you talk about this, especially in a place like office hours, yes, they're going to get that coaching from you and have that confirmation that you're talking about. But in
the preparation to maybe have some of those difficult conversations, what a blessing to have other founders to like bounce that off of. Yeah. And likewise, if you have a partner in your business, you know, and I always recommend that like sort of one person, you know, the division of responsibilities, you know, is good to have because then when you bring a financial model to someone, you know, they're internally, they can...
question you and kind of challenge you. And I would encourage founders to take their models to someone to challenge them. Test yourself. Practice explaining why this model makes sense. And that is scary and that can be hard, but it's a way to practice and it's a way to really understand in the model building process if you've got any errors in there. I do that with you, Chelsea. Like sometimes when I'm building a model, right? I'm like, Chelsea, I need you to look at this model with me and I talk through it.
and make sure that it's working properly and that it's representative because it's a lot of information that's going into a model. Then check the data and challenge yourself. Was I right with my forecast? Was I right in my hypothesis about my business? Here's the thing, be glad if you find out that you're wrong because that means you can fix the issue. Here's the thing.
You don't have to have a coach. It just can be helpful to have one, especially if you're working solo, you're working in a silo. You've got everything in your mind. Another thing that's been really nice to see with some of the folks that have come to coaching, it's like, they may recognize, my model is not matching my reality. The next question is, how do I change this? There's usually someone on their production team or someone that they need to
communicate the reality to, to help them make changes. Sometimes you need a little bit of guidance on like, how do I best communicate this? What's the information that I should share? But having a partner can make it easier. It might be someone who's like internal on your team. think especially if you need to make cost cuts or you need to make team cuts, there's a lot of energy, empathy, and thought that has to go into those processes.
The more you test financial models, the earlier you test financial models, the less likely you are to have these sort of very difficult, immediately needed conversations in your business. And the less likely you are to find yourself in some financial difficulties, which is one of the main things we want to avoid. So is there anything else that we need to think about, consider as we head into testing financial models?
I think just as always, be kind to yourself. Be honest with yourself. If you don't know something, if you need help, if you're stuck, you know what I mean? Just talk to someone, get it out of your head. Start simple. If you feel inclined to just start with cash flow and say, is my cash flow what I expect it to be? Then start there. I provide recommended orders to do things in because to me, it makes the most sense and I think it
gets to the root of certain things sooner, but the most effective thing is going to be the thing you actually do. Start with what you have, check in on it, and just go from there. Do the work. Do anything that will get you to do it and to look into the numbers.
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