The run rate concept refers to the extrapolation of financial results into future periods. For example, a company could report 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. Run rates can be used in a number of situations, including the following:
The extrapolation of 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.
The extrapolation of 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.
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.