Run rate definition
/What is Run Rate?
The run rate concept refers to the extrapolation of financial results into future periods. It is based on the assumption that current results will continue into the future, which can be a highly invalid assumption. In reality, there are many factors that can impact your future financial results, some of which will be completely unexpected. Consequently, the run rate concept can yield results that turn out to differ substantially from actual results.
Example of Run Rate
A company reports to its investors that its sales in the latest quarter were $5,000,000, which translates into an annual run rate of $20,000,000. However, many of the company’s sales are based on government contracts, some of which are shut down by the government prior to year-end, due to an unexpected lack of funds. This results in an actual full-year sales figure of $15,000,000, which is $5,000,000 below expectations.
When to Use a Run Rate
Run rates can be used in a number of situations. For example, it can be used to extrapolate financial results by the seller of a business when attempting to obtain the highest possible price for the entity. A high price may be obtained when the price is based on a multiple of sales. Another possibility is to extrapolate current results into future periods as part of the budgeting process. This works well in an operating environment that does not change much from period to period. A third possible use is to extrapolate current results when a business first earns a profit, since only losses were incurred in prior periods. This is useful for a startup company, which wants to show investors the rate at which it is now making money.
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Problems with Run Rate
There are several problems with the run rate concept that limit its ability to produce accurate projections. The main problem is the underlying assumption that current conditions will continue through the forecast period. More specifically:
One-time sales. A company may experience a large one-time sale and immediately extrapolate it into future periods to derive an unrealistically large sales run rate. A more viable run rate would exclude the one-time sale.
Contractual limitations. As was the case with one-time sales, there may be customer contracts set to expire during the extrapolated period, so the sales associated with them will likely expire, as well. If so, a run rate based on these contracts would be excessively high.
Expense reductions. A company engaged in a cost reduction effort (possibly occurring after an acquisition) initially achieves a large amount of expense reductions by focusing on the easiest savings, and uses this information to create an expense reduction run rate. This run rate is not likely to occur, since future expense reductions will be in areas that are more difficult to complete.
Seasonality. A company's sales may be subject to a considerable amount of seasonality. If so, an annual run rate that is based on the peak part of the season will not be achievable. A better approach is to develop a run rate that is based on an entire year, so that the full span of the selling season is factored into the calculation.
Capacity constraints. It is possible that the base period used to derive a run rate employed a very high level of capacity utilization within the business. If so, the run rate may not be sustainable, since some downtime will likely be required to maintain the overworked production equipment.
The run rate concept can also be applied to operational issues. For example, it could be used to extrapolate the number of transaction errors occurring in the accounting department, the number of coupons submitted by customers, and the number of units produced by a machine.