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From Boots To Business - Economics of Small Business
- 1. The Economics of Small Business Start-up
- 2. Objective Understand the relationships between the costs of operations, price structures, and sales volume to better understand the profit potential and sustainability for your planned venture.
- 3. Agenda • Economics Model of a Business • Revenues • Volumes • Margins • Operating Leverage • Implications for Risk
- 4. How the business creates and delivers value to the customer Why This is Important Business Model How the business captures that value in the form of an economic return Economic Model
- 5. Benefits of understanding your economic model • Helps build a sustainable competitive advantage • Informs your management decisions • Provides stability and consistency Are we making money or moving money? Why This is Important
- 7. • How many ways does your company have to earn money? • One source or several? • Implications for risk? • Is this a competitive advantage or a disadvantage? Revenue Drivers
- 9. Difference between Price and Cost • What price do you charge for your product or service? • How much does it cost you to deliver that single unit of product or service? • Does difference between the price you charge and your cost of production provide adequate cash to cover fixed operating expenses and generate a profit? Margins
- 10. The number of units of product or service you are selling or providing. • Is generally meaningless unless you discuss it along with margin • High volume alone is meaningless unless you keep something from each sale (margin). Volume
- 11. Example What does this mean for the economic model? Porsche 911 -- $91K Nissan Versa -- $13K
- 12. Example What does this mean for the economic model?
- 13. What does it actually cost to deliver one unit of whatever you do? • Changes in direct relation to your revenue • Direct labor, payroll taxes and costs per employee (CPEs), mileage, packaging, unit transport or delivery, raw materials • Variable does not mean optional Variable Costs
- 14. Expenses you have to pay no matter what sales you generate. • Remain the same over a given period of time • Include rent, brick and mortar location, salaries (not hourly pay), advertising, insurance, write-off of equipment (rainy day/replacement fund). Q: Are utility bills a variable or fixed expense? Fixed Costs
- 15. Definition: The volume of sales revenue needed to cover all of your costs over a given period of time. Break Even 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Sales Total Exp BREAK EVEN POINT Sales = Expenses
- 16. Economic Model: Break Even
- 20. Higher fixed costs (higher operating leverage) means • Greater risk • It takes more units of service each month to break even • But, once you get to break even, you make a lot more money Lower fixed costs (low operating leverage) means • Less risk • It takes less units of a service or product each month to break even Implications of Operating Leverage
- 21. Before You Open Your Doors, Ask Yourself: • How will I generate sales dollars/revenue? • What are my total sales-related costs to do that? • What are my fixed/operating costs for a given period of time? • How much sales revenue must I generate to cover ALL my costs so I begin to show a net profit? • Based on my research and analysis, can I generate the needed sales dollars and manage these expenses to have a sustainable and profitable business?
- 22. Key Takeaways: Understanding Your Economic Model REVENUE DRIVERS: How many ways can you separate your customers from their money? Does the number of revenue drivers increase or decrease your risk? MARGINS: What is left over after each unit of sale to pay fixed costs? What percentage of sales is that? When do you break even? VOLUMES: How many units do you sell each period? Is it enough to exceed break even? Enough to make it worthwhile? OPERATING LEVERAGE: New businesses should maintain a low operating leverage (high variable cost) model to manage risk and facilitate liquidity.
Editor's Notes
- Additionally: Understand how to arrange and re-arrange the levers of an economic model based on the stage of business.
- We will talk about the 4 levers in the economic model and how they interact to form your risk profile. A lot of this information may be intuitive and we will give you a common vocabulary to use when building your economic model. You want to know how your model impacts risk regardless of how you are funded (self, debt, equity).
- Instructor Notes: Business Model – How You Make Money – Customer Facing This is how the business earns its income that is valuated in the form of financial return. The Business Model, as discussed in Module 3, is how a company makes money What product or service does it sell? Who are their primary customers? What industry does the company compete it? Economic Model – How You Manage Money – Owner Facing Module 4 is about the Economic Model – How does the company manage their money? This is the aspect of business that the majority of people do not want to focus on, but can be problematic. Businesses often fail because they do not fully comprehend the importance of the topics covered in this module Emphasize that businesses create value for customers AND owners. Successful businesses are able to capture the value they create for customers and turn it into a shareholder return. Apps and website are good examples of how they create value for users without capturing that value for owners (monetization).
- Instructor Notes: This module is designed to help participants understand the importance of making moving money to be profitable over the long-term. Too often business owners move money through their sales income and access to various sources of operating cash like a business credit card or a line of credit. Unless owners seek to understand and evaluate the costs of doing business in relation to their sales income, they will never gain a clear understanding of their profitability. They often find this out when it is too late and their business is in financial trouble. The focus of Module 4 - how to understand if your business is truly profitable and what it takes to do that. This is where the rubber meets the road! Re-emphasize why its important. Illustrate with a company you are familiar with. One example is the difference between Southwest and American Airlines. Both firms compete in the same market space yet they leverage different business and economic models to deliver value to their customers. Discussion questions: If American knows exactly how Southwest does business, why can’t they imitate Southwest’s success? What is different about the two companies?
- Instructor Notes: Understanding the relationship between these four terms determines whether your company is profitable or not. Most small businesses don’t fail because they are not good at what they do. They don’t understand these levers/terms and how they fit together. The Four Levers of an Economic Model: Revenue Drivers - the sources of sales dollars generated by the company’s business activity Margins - the gross sales dollars minus first the company’s sales/variable expenses and second subtracting the company’s operating/fixed expenses Volumes - the dollar amount of sales needed to cover all the company’s variable and fixed expenses. It is only when the company has generated enough sales dollars to cover all expenses that it actually begins making money for you Operating Leverage - the relationship between the company’s sales/variable expenses (the numerator) and its operating/fixed expenses (the denominator) Key discussion question on operating leverage: Why would you want your fixed costs to be as low as possible in relation to your variable expenses? Why does that matter in your business?
- Instructor Notes: These are the products or services that actually generate revenue for the company through their sale and delivery. One question business owners must grapple with is whether to be “narrow” or limited/small in what they offer in their product line in order to be really good at what they do - or to be ‘broader’ with diverse products and services in order to attract a wider customer base. Discuss what the implications could be to their business for each of these approaches One driver allows focus, many allows for diversity. Both have risks. Discuss them.
- Instructor Notes: Ask how many revenue drivers Starbucks has (the number of ways to separate customers from their money) What are the ways Starbucks creates value for them (i.e., why they go there)? Then ask them to consider how all of that is captured through an economic model for shareholder benefit. As they list things, try to categorize them into the 4 components of the Economic Model (revenue drivers, margins, volume…operating leverage won’t be as obvious). If they are stuck or off base, prompt them with questions like “What else do they sell”? (revenue drivers), “How much do they keep on each single cup of coffee?” (margins), “How much coffee do you think they sell?” (volume)
- Instructor Notes: Margins will help participants understand what their true costs of doing business will be - both their sales-related costs (also referred to as variable costs) and their operating costs (also referred to as fixed costs). Does their sales revenue cover these costs for a given period of time? If yes, they can begin to understand at what point or amount of sales do they actually become profitable. This also called the break even analysis. If no, their business is NOT profitable and they must reassess the pricing for their products or their costs of doing business. Define gross margin as gross sales dollars minus the company’s variable costs. The company’s fixed costs come out of the gross margin dollar amount and this is your net profit. May use P&L handout as a visual aide to explain this concept. Question: Ask if anyone knows how much it costs them to deliver one single unit of whatever it is they sell. Discuss the high and low margins (i.e.: a workout facility/gym versus an IT company) - Emphasize the importance of this. Ask how to price a product - be sure that they understand the only way to price a product is based on what the customer is willing to pay. Instructor should note that the cost of a product/service also includes such things as wages, taxes, etc.
- Instructor Notes: This slide should be linked to the discussion on margins to emphasize the importance of understanding what amount of sales revenue is needed for a given period of time to cover the company’s variable and fixed costs for that same time period. The sales over that breakeven point is where the company actually become profitable and makes money. Volume is the amount of total sales dollars needed to pay/cover all the company’s variable/sales expenses and its fixed/operating expenses. A net profit is not actually generate until the company has covered/paid ALL of its expenses for a given period of time. Working through this process is called a breakeven analysis. Instructor may use a breakeven analysis example to demonstrate this concept. Reflect back on Starbucks’ volume. Then make the point that they have 3 levers in the right position (high margin, high volume, and multiple revenue drivers).
- Instructor Notes: The Porsche on the right sells for about $80K and the Nissan Versa sells for $13K. How different can the unit cost be? How much overhead can you support on a single sale of a Porsche? Have fun with this slide.
- Instructor Notes: This example is meant to show the difference between a high volume retailer (WalMart) and a more upscale retailer such as Neiman-Marcus. In the WalMart example margins are usually low. The store does not make much profit off of the items they sell unless they sell a LOT of whatever it is. Neiman-Marcus sells the types of goods where margins are high. They won’t sell the same quantity of items that WalMart does, but they can sell in lower quantity, and still generate a profit because they typically make more profit off each item they sell. Please use your own experiences as a consumer to bring some life to this example.
- Instructor Notes: Variable Costs are the costs associated with producing the company’s sales revenue. Examples: raw materials, supplies for your direct product etc. They are called variable costs because they “vary” depending on your company’s sales volume. The key is that the variable costs change with sales. That is the litmus test. “What does it cost for you to deliver your product or service?” and then tie it back to the Profit and Loss statement.
- Instructor Notes: Fixed Costs are the company’s recurring operating expenses such as its light bill, rent, employee salaries, etc. These are set or fixed and must be paid every month, regardless of your company’s sales volume. These are the costs that even if you do not make a single sale you still need to pay, i.e. depreciation, rent, utilities, insurance fees and advertising costs. Fixed costs are the company’s overhead and are paid out of its gross margins on each unit of sale. So, Starbucks has high margins and can support all the overhead (fixed costs) they have. Talk through some of the examples and throw them the last question to see what they say (could actually be fixed or variable).
- Instructor Notes: The best day in an entrepreneur’s business life is the day the company actually makes no money for the first time (breaks even, as opposed to losing money). Once business owners know their fixed costs, they can tell you how many units of product or service they need to sell to breakeven. Assuming they know their pricing, they can tell you the dollar amount that volume represents. Break even brings nothing home for the owner. Besides the sales required to breakeven, how many additional sales does the business have to generate to create enough profit for the owners to be able to pay their bills?
- Instructor Notes: The Joe’s Cup of Joe Coffee illustration shows a monthly P&L statement from a typical mobile coffee stand. Purpose is to show a basic example of how moving the levers of the economic model around can effect a business’ net profit. In this example - Variable costs include: coffee beans, water, cups, sugar, and all of the other coffee accoutrements. Monthly fixed costs include: Renting the space, cart lease payment, transportation/utilities expenses such as gas, and insurance. In this example, the cart is in operation 5 days a week, 8 hours a day. Joe’s averaged sales of 20 cups of coffee/hour during operating hours. Upon comparing the cost and pricing information provided above against Joe’s sales information (average of 20 cups of coffee sold per hour) we realize that Joe’s is breaking even - i.e. they don’t earn a profit or run at a deficit.
- Instructor Notes: This slide is meant to show the effect of increased sales volume. In the previous slide, Joe’s Cup of Joe Coffee reached break even by averaging 20 cups of coffee per hour sold. This month, business is little better: Word has gotten out about the great-tasting coffee and great service, and more customers are picking Joe’s instead of the competitors. Meanwhile, the owner of the stand has gotten more efficient, and can make coffee and complete the sale more quickly. This allows Joe’s to sell an additional 5 cups of coffee each hour, to average selling 25 cups per hour this month. This results in a net profit of $1,080 for the owner.
- Instructor Notes: This slide is meant to show the effect of improving a business’ margins. To do this Joe’s needs to either pay less for the coffee and other supplies, or sell the coffee at a higher price. In this example, Joe’s was able to do both. Joe was able to cut some deals with vendors, which shaved a nickel per cup off his cost. Meanwhile, he raised his price a quarter per cup from $2.00 to $2.25. This moves his margin from $1.35 per cup to $1.65, resulting in an extra $1200 in profit from the previous month.
- Instructor Notes: This shows that one is not better or worse…just different. Most start ups are low operating leverage, high variable cost companies because the risk is lower. Established companies have higher operating leverage and more reward. Emphasize the risk-reward dynamic and that entrepreneurs mitigate risk first.
- Instructor Notes: This shows that one is not better or worse…just different. Most start ups are low operating leverage, high variable cost companies because the risk is lower. Established companies have higher operating leverage and more reward. Emphasize the risk-reward dynamic and that entrepreneurs mitigate risk first.
- Instructor Notes: These are questions potential business owners should know the answers to before they go into business.
- Instructor Notes: This wraps it all up for them. Relate it back to Starbucks or another company you may have discussed with the group. Tie P&L/Income Statement back into the discussion. Reference that when the factors of the Economic Model are successfully put together, ultimately a company will get to a profit. Profit is the surplus remaining after total costs are deducted from total revenues.