Sep 092011
 
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profitability

Profitability – Keep Your Eye On The Ball

Is profitability what business is all about?  Going through all the various waves and cycles of rational and irrational exuberance, you begin to wonder.

Let’s get back to the basics.  When you start a business, why do you do it?  Is it because you want something to do with your spare time?  That may be part of what you’re looking for, but if that were the whole story, it would be called a hobby, not a business.  Is it because you want to help people?  That too may be part of the story, but if that were the only motivation, it would be a non-profit organization, not a business.  Is it because you want fame?  That may be some of what you’re looking for, but if that were all you wanted, there’d be more direct routes.  Is it because you want to “do what you love”?  Again, that could (and should) be part of the picture, but if it were all you were trying to do, again, we’d just be talking about a hobby, not a business.  I think you’re starting to get the point.  When you start a business, the vast majority of the time, the motivation is (and should be) to make a profit.

I will grant you that there are some great businesses that are started by founders who know that the company will likely never “see a profit” while they are still in control of it. The businesses are started with the main objective being to grow (in revenue terms) to a size where big competitors can no longer ignore them and rather than have to compete against them, just acquire the company, hopefully at a “handsome profit” to the founders and investors.  Granted, this strategy exists and it has worked spectacularly in certain cases.  For most entrepreneurs and most businesses though, this strategy is very risky and makes almost no sense.

Even for those companies that aren’t built to be acquired, there may be a logical reason why they need to go through the early stages of their lifecycle “bleeding red ink,” and only reach profitability several years down the road.  In certain cases, this makes a lot of sense.  There may be a great deal of necessary early investment in building a market presence and reaching a scale where profitability is possible.  This is true in some cases, but even when it is, it is not an excuse to lose money without any sense of when profitability will arrive.

It is important as an entrepreneur that you don’t deceive yourself into thinking, “sure it’s a lousy business now, but we’ll make it up in volume”.  As absurd as that sounds, you’d be shocked how many times I’ve heard and seen variations on that theme during my career.  Don’t fall into that trap.  Understand your break-even point.  Understand your cost structure and whether your gross margins at the outset and certainly at some foreseeable point in the future, will be sufficiently high to justify the risk you are taking by starting and running your business.  If you have investors who have any common sense and experience, they will require such analysis and forecasts from you.  If you don’t have investors, do yourself a favor and be very realistic about the business you’re in or you’re thinking about entering.  Don’t rationalize.  Make sure your assumptions about costs and revenues are realistic and don’t deceive yourself into thinking that if the business model is lousy in the beginning that it will somehow magically get better with time.  Typically, it won’t.

Time is precious.  Make sure you are spending it on business opportunities and potential deals that have a realistic chance for a level of success that justifies the risk involved.  Remember that, in the end, if a business is not profitable, unless you’re working some financial alchemy, there’s no way it can provide you with the economic benefits that justify the risks you are taking and the time you are investing.  Make sure the fundamentals of the business look good from the beginning, or that you can at least reasonably project a point on the horizon where it all “comes together”.  If not, you are likely to dump a bunch of money and time, among other resources, into a venture that had no chance from the get-go.

I look forward to your thoughts and questions.  Please leave a comment (“response”) below or in the upper right corner of this post.

Paul Morin

paul@companyfounder.com

www.companyfounder.com

 

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Jul 292011
 
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Pricing – How Much Should I Charge?

One of the common questions I hear is, “How Much Should I Charge”?  I get this question from startups and existing businesses that are bringing a new product or service to market.

When you’ve been doing it for a while, you realize that deciding how much to charge for a product or service is as much art as science.  However, as with most things, even though there is some art involved, it is not usually the best idea to just “throw the paint against the wall” and hope for the best.

Before you decide on an initial pricing strategy for your product or service, you should gather some key data that will help you make a better pricing decision.  Here are several data points you should obtain before deciding how much to charge:

  • What is the pricing for similar products or services in the market?  The easiest way to track and update this information usually is to create a simple matrix, either in a spreadsheet or word processing table.
  • How segmented is your target market?  Are there several price levels for similar products, depending on the attributes of the products and the characteristics of the segments?
  • How do existing users perceive the current products in the market at various price levels?  Bear in mind that many times you want to be at the higher end of the price range as a small provider.  You typically don’t have the opportunity to sell a huge number of units as a small business, so you want to be able to make a healthy profit on a smaller number of units.
  • What are the product or service attributes that existing users value most?  Often times you’ll be better off including fewer attributes, but making sure that those are the ones that users value most.  You do not want to over-engineer your offering and create the equivalent of what is referred to as “bloatware” in the software industry.  When you are obtaining this data, make sure you are talking to as many real, live people as possible, through whichever medium of communication you can.  Do not guess.  Talk to real potential prospects wherever possible.
  • How much does it cost you to create and deliver the product or service?  Don’t make the common mistake that I have seen over and over again, wherein you don’t have a good understanding of your costs and end up pricing your offering too low, thus losing money unnecessarily on every unit sold.  Note that once you have a good understanding of your costs, you often times have to go back to the drawing board in order to figure out how to produce your offering at a competitive level.
  • How much profit do you want to make?  Once you have gathered the data above and determined the level at which you can realistically price your offering, given the competitive landscape and your production cost realities, you may realize that you’re not going to make much profit.  In that case, you can consider how you may differentiate your offering, so you can price higher, or you can figure out how to reduce your costs, or both.  However, if after doing all that you cannot arrive at a projected profitability of the offering that is acceptable to you, you’ll need to walk away.  That is, unless you have motives other than reasonable immediate profitability for the offering.
  • Do you have motives other than immediate profitability for this product or service?  There are times when even though your pricing analysis tells you the offering is going to be a “dog,” you still decide to move forward with it.  Such motives may include the idea that this offering is going to be a “loss leader”.  In other words, although you know you will lose money on it, it will bring prospects to you, to whom you will sell other more profitable products or services.
  • Do you expect to have “economies of scale” when you get to certain production levels?  Sometimes you start out with a product or service that is not as profitable as you’d like, but you know that as your sales volume grows you will achieve economies of scale and thus have greater profitability.  The idea with economies of scale is that once you are producing or providing a certain number of units, your costs go down for some, if not all, elements of the offering.  This may be due to reduced unit material costs when you buy in certain volumes or to advantageous contracts you’re able to strike with suppliers.

So, in order to intelligently answer the question, “how much should I charge?” you must first arm yourself with several pieces of data.  This data comes from your prospective customers, your competitors, your suppliers, and from your own operation.  Realize as you start this process of determining the right price for your offerings, it is as much art as science.  Not every piece of data that you gather will be “black and white”.  You will need to make a series of assumptions and you will need to test and re-test those assumptions on an ongoing basis.  You will need to be flexible and not believe that there is one “right answer”.  As you go, keep in mind the question, “if I can charge more and the market is willing and perhaps even happy to pay it, why wouldn’t I?”  Also, remind yourself on a regular basis that you’re in business to make money, so if your analysis says otherwise, don’t convince yourself that somehow a particular offering that isn’t profitable in the beginning is somehow going to magically become profitable later on.

I look forward to your thoughts and comments.

Paul Morin

paul@CompanyFounder.com

www.CompanyFounder.com.

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Jul 272011
 
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What to Sell

Often times when someone is starting a business or looking to expand an existing business, their first question is: What to Sell?

Unfortunately for many, the response to the question is not based on any market research or often times even on common sense; rather, it is often based on what that person or company is good at or what they like to do.  This can make sense in some circumstances, particularly when what you like to do happens to be aligned with what the market is seeking, but typically it is not an approach that will get you the results you are seeking.

A better approach to figuring out what to sell is to go on a search for specific problems your target markets are trying to solve, then create and market a solution to those problems, at a price that is profitable for you and reasonable for your market.

Let’s look at a couple of examples of the right way and the wrong way to determine what to sell in your business.

What to Sell – Example #1: 

Sally is a good cook and she likes to cook.  Her friends and family constantly tell her that she’s a great cook and she should start a restaurant.  Sally thinks to herself, “you know what, I am a great cook and I love doing it … they’re right, I should start a restaurant”.  So Sally finds a location.  It’s a decent location and it already has most all the cooking equipment she needs from the previous series of restaurants that had occupied the space.  Since Sally is good at southern “Comfort Cooking,” she decides to go with that theme and calls her restaurant Sally’s Home Kitchen.  She’s very excited about her new business and happy that because the location already had equipment, she has had to invest less than $100,000 to open the business.  She opens the doors in April.  By September, after several grueling months of very few customers and mounting losses, she has to close the doors.

So what happened beyond entering the restaurant business, which has tremendous competition, is perilous for a novice entrepreneur, and has one of the highest startup and failure rates of all businesses?  Even without more details, the answer is quite obvious of course:  Sally did no research regarding whether potential customers in the environs of the location she chose would have any interest in eating southern “Comfort Food”.  As it turns out, Sally’s case was extreme, as she put her restaurant in an area where people were focused on “healthy eating,” with a predominance of vegetarians and other people focused on “heart healthy diets”.  The scenario could not have been much worse for Sally, but it all could have been avoided with a little research.  When she asked herself what to sell, she would have been a lot better off looking to help customers try to solve particular problems, rather than offer another solution that was contrary to what most people in her area were seeking.

What to Sell – Example #2: 

Now let’s look at an example at the other end of the spectrum:  Proactiv Solution.

If you watch TV at all, you have undoubtedly seen commercials for a product called Proactiv Solution.  It is a product that is used to treat acne, which is a widespread problem, particularly for adolescents.  The product was created to solve a very common problem and it is sold to a target market that is extremely motivated to solve the problem as soon as possible.  As we say, it is not a product in search of a market; rather, it is a product that solves a pressing problem of a very motivated existing market.

When you are deciding what to sell, you can learn a great deal from many of the “genius” elements of the Proactiv launch, which is widely regarding as one of the most successful products ever marketed on television.

So, why is Proactiv a great example of what to sell?  Here are just a few of the attractive elements of creating and marketing a product such as Proactiv:

1.)     It is solving a real problem.

2.)    The target market is willing to pay to solve their problem.

3.)    The problem resides at the emotional level of the target market, so the Pathos element of the Ethos, Pathos, Logos model is already overcome, de facto.

4.)    The target market is easily identifiable and reachable.

5.)    It is possible to visually represent the effectiveness of the product, thus triggering further emotional connection and credibility with the prospective client.

6.)    Although we have no specific information on the profitability of Proactiv, I can virtually guarantee you that the gross margin on the product is extremely high.

7.)    It is possible to offer the product at a price that seems reasonable to the client and still have very attractive gross margins.

8.)    Given the high margins, it is possible to invest aggressively in marketing, thus further accelerating product sales growth.

9.)    The problem is recurring, at least during a reasonable period of the prospect’s life, so ongoing demand from existing customers is likely.

This list could go on quite a bit, but you get the idea.  Proactiv is a great product that, without a doubt, is making a great deal of money for those bringing it to market.  That said, no product is perfect and undoubtedly there are some downsides to it, such as the risks of selling any product that customers are going to use on their skin.  But the focus here is on deciding what to sell, not risk management, and the most important elements of the list above are that the product solves a real problem, at a price that is attractive to consumers and profitable to the provider.

Hopefully these two examples give you the general idea of how you should and should not decide what to sell in your business.  You must be solving real problems and you must be able to do so at a price and cost that will allow you to make a reasonable, if not an extraordinary profit.  Otherwise, why are you in business?

I look forward to your questions and comments.

Paul Morin

paul@companyfounder.com

www.companyfounder.com.

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Apr 022011
 
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If you are starting a business, presumably you are doing so to make a Profit. Therefore, it is a cardinal sin to start a business to make a Profit, if you don’t in fact understand exactly what Profit is. Here we will walk through the basics of the Income Statement, which is the most fundamental of the several financial statements all businesses need to prepare and understand. Without understanding the Income Statement, it is not possible to fully understand what Profitability is.

The Income Statement has three basic elements: Sales (or Revenues), Expenses (or Costs), and Profit. In fact, Profit is just Revenues minus Expenses. So in a scenario where you start a business that has $100 in Revenues and $60 in Expenses, the Profit would be $100 – $60 = $40. This is a very simple example, but it gives you an idea of the basic elements of the Income Statement and how to determine the level of Profits.

The first element of concern is Revenues. As you can see in the example below, there is a reason that Revenues are often referred to as the “top line,” as they are literally the first line on the Income Statement.

As can be seen above, the next item on the Income Statement, after Revenues, is typically Cost of Goods Sold or Cost of Sales. These costs include all direct costs involved with providing or manufacturing the service(s) or product(s) that are generating your Revenues.

Once you subtract the Cost of Goods Sold (or Cost of Sales) from the Revenues, you arrive at Gross Profit. You may have heard the term Gross Profit Margin before, which is typically expressed as a percentage. So, in the example above, in 2007, the company generated $3,388,000 in Revenues and had Costs of Goods Sold of $1,839,000, which led to a Gross Profit of $1,549,000. This is a Gross Profit Margin of $1,549,000/$3,388,000, or 46%.

The following category of Expenses that must be considered is Selling, General and Administrative (S,G, &A) expenses. These are the Operating Expenses that allow you to sell your products/services and administer the business. As you can see above and below, SG&A Expenses often include such things as Advertising, Rent, and Utilities, among other costs that tend to be relatively fixed in nature – that is, they are costs that don’t vary directly with the level of Revenues.

Once the SG&A Expenses are subtracted from the Gross Profit, you arrive at the next level of Profit, which is typically called Operating Profit. You’ll also often hear it referred to a as EBITDA (“ee-bit-dah”), which stands for earnings before interest, taxes, depreciation and amortization. Don’t get hung up on all of these terms at this point, but just realize that when you hear someone talking about “ee-bit-dah”, they’re referring to Operating Profit.

In the following graphic, you will see that as you move further down the Income Statement, the next category of items to consider is referred to as Other Income and Expenses. This includes such items as Depreciation, Interest, and other non-SG & A or non-typical Revenue items, such as the gain on the sale of assets.

Once Other Income and Expenses are subtracted from, or added to the Net Operating Profit, whichever the case may be, you arrive at Net Income Before Taxes. Once Taxes are then subtracted from this amount, you arrive at Net Income After Taxes, which you’ll often hear referred to as the “bottom line” and now you can see why – it’s the last item on the Income Statement.

The example use above is simplified, of course. There are many nuances to understanding the Income Statement and financial performance in great depth. However, although simplified, the above example does give you the basics of what you need to know about how an Income Statement is structured, what the common important elements are, and how to arrive at and understand the Profits (or Income) of the business.

If you have questions or would like to discuss the nuances of how the Income Statement applies to your particular venture, don’t hesitate to contact us and/or leave a comment below, or in the top right corner of this post. Either way, we hope you have found this explanation of the Income Statement helpful and we’d love to receive your comments/thoughts/questions.

Paul Morin
CompanyFounder.com
paul@companyfounder.com.

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Apr 012011
 
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It’s amazing how many startup entrepreneurs do not take the relatively simple, but very important step of doing a basic break-even analysis on their business. Here you will learn how to do a very basic break-even analysis for your venture.

First, it will be important that you understand the meaning of a few terms:

Selling Price: this is the price at which you will sell your product or service.

Fixed Costs: these are costs that are the same regardless of how much you might sell. Typical examples would include facility rent, insurance (like property and general liability), utilities (may be variable in some businesses), etc. Just bear in mind that if it does not change regardless of how much you sell, it likely should be categorized as a fixed cost.

Variable Costs: these are costs that vary depending on how much you sell. Some common examples include direct material costs (if manufacturing products), sales commissions, direct labor (for either manufacturing or providing services), cost to purchase products or services for resale, etc. Remember that if the cost varies in relation to the amount you sell, it is likely to be considered a variable cost.

Contribution Margin: the difference between Selling Price and Variable Costs. So, if you are selling something for $100 and the Variable Costs of that sale are $60, then the Contribution Margin is $40.

Now that we have the basic definitions out of the way, let’s talk about how to calculate your break-even point in terms of both dollars of sales and units.

The formula to calculate the break-even point is very simple, as follows:

Break-even point = Fixed Costs / Contribution Margin

Let’s look at a straightforward example. Let’s say that you are running a business that has fixed costs of $10,000 per month and you are selling a product or service that has a Contribution Margin of $40. The break-even point in this example would be:

$10,000 / $40 = 250 units

If the units sell for $100 each, then the break-even point in sales dollars would be 250 units x $100 per unit, or $25,000 per month of sales.

As mentioned above, this is a very simple example. There can be many nuances in the break-even calculation, but this example gives you an idea of how the break-even point is calculated. I encourage you to do such a basic calculation for the business you are considering starting, or for the business that you are already running. Understanding both the unit sales and dollar sales necessary to break even gives you a good frame of reference for the results you need to achieve to begin to make your business successful. Remember, you must reach break-even of course, before you can become profitable.

If you have questions about this example or some of the nuances you are encountering as you try to do a similar calculation for your business, don’t hesitate to contact us and enter your comments/questions below.

Paul Morin
CompanyFounder.com
paul@CompanyFounder.com.

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Aug 112010
 
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One of the most common afflictions I’ve seen in companies that get themselves into trouble, is that they do not understand their cost structure.  In other words, they could be “shipping a dollar bill out with each order” and not even know it.  In our consulting operation at Wharton Entrepreneurial Programs, a very common occurrence was for a client to come to us stating that they had a sales and marketing problem.  The symptom was that they had very bad cash flow, and they immediately jumped to the conclusion that they were in that predicament because they weren’t selling enough product (or service).  Very often, when we’d go in and do some basic analysis, we’d quickly realize that if we helped them with the problem they thought they had, we’d only accelerate their demise.  The reality was that they did not understand the profitability of their products or their customers, so there was a real danger in just trying to sell more – what if by chance you started to sell a lot more of a particular product or service on which you were losing money with every sale – it could quickly put you out of business. They also often did not understand the concept of a break-even analysis and the difference between fixed costs and variable costs.  Make sure you understand where your business is making money and where it is losing money; without this knowledge, you are trying to sail the entrepreneurial sea without the navigational equipment and data you need..

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