Risks of using revenue run rate
Run rate isn’t always the most accurate metric. Like we saw in the previous example, if the month or quarter you use to estimate run rate is above or below normal, or if your revenue fluctuates over time, your results won’t reflect reality. Run rate also doesn’t account for churn, expansion, contraction, annual versus monthly contracts, or other factors affecting revenue.
Monthly sales can vary significantly based on seasonality, so a single month’s sales will not always accurately reflect annual sales or profitability. This variation can make your run rate calculations dramatically different if revenue was measured during the high season versus the low season.
Remember Company A? Perhaps, in January, they brought in only $12,000 in sales revenue—this would make their run rate a mere $144,000, less than half of what they estimated based on the data from June. Neither calculation is more or less valid—but one is likely much more accurate than the other.
One-time sales and expiring contracts
Large one-time sales can skew monthly or quarterly projections. Maybe you typically sell monthly contracts to smaller clients—landing a larger sale can throw off your monthly estimates.
Say Company A lands a single contract in July worth $50,000, in addition to $25,000 in forecasted sales. Based off of July’s revenue data, their run rate would be a whopping $900,000, which, assuming sales return to normal in August, is far too high.
Changes in company performance
The basic run rate calculation assumes company performance will remain the same throughout the forecasted period. Of course, things will no doubt change as the company grows—churn might increase or decrease, customers may be upsold or downgrade, or a new competitor might enter the market, stealing market share.
Let’s look at churn, since that more closely affects subscription businesses. Assume company A had a 5% churn rate as of June, and growth was expected to be flat over the following year. Reducing churn to 4% will increase the expected run rate over the next full year, while increasing churn to 6% will likewise lower the run rate.
Unlike seasonal fluctuation in customer demand, good or bad sales months are hard to predict–although equally capable of skewing your run rate. Landing a huge customer should give you a cause for celebration but not set your expectations.
Cost reduction strategies
If your company applies a cost reduction strategy, possibly after an acquisition, it's likely to focus on the most accessible savings to achieve a significant expense reduction. Suppose it uses this information to create an expense reduction run rate. In that case, it's likely to get an unrealistic amount as it will base future reductions on more difficult areas to compete.
Changes in capacity
The run rate might not be sustainable if the base period you used to derive a run rate applied a very high level of capacity utilization. You require some downtime to maintain the overworked production equipment in such a case.