During a conversation with a business owner recently we were looking for ways to identify profit improvement opportunities.  That got me thinking about an old standby - the break-even formula.

The traditional formula is: Revenue * Gross Margin = Overhead.

It’s a simple concept, but in the daily bustle of running a business it can be easy to lose sight of its informative power.

Since this particular business, like a lot of businesses these days, sells services and not products, the idea of gross margin can be a little confusing.  Sure, a service business has a cost-of-goods-sold in the form of salaries and benefits for the employees providing services, but most smaller businesses don’t classify them as such on the P&L.  In that case, a variation on the break-even formula is more useful.

Revenue - Variable Costs = Fixed Costs…or

Revenue - Variable Costs - Fixed Costs = Net Profit or Loss

For most service businesses fixed costs are going to be relatively large and variable costs relatively minor.  The result is that within some range (unique to each business) revenue increases and decreases will have a dramatic impact on the bottom line.

Through the magic of algebra we can re-work the formula so that it can predict the impact to the bottom line of changes in revenue.  If we make Variable Costs a percentage of revenue we get and do a little reworking of the formula we get:

Revenue * (1 - Variable Cost %) - Fixed Costs = Profit

Now with numbers (in thousands or millions - whichever you like better):

$1,000 * (1.0 -.05) - $800 = $150

If we increase revenue by 5% we see a $47.5, or 31.67%, increase in net income.

$1,050 * (1.0 -.05) - $800 = $197.5

We would need to cut fixed costs by $47.5, or almost 6%, to get the same bottom line impact.  This isn’t a huge difference, but keep in mind that revenue growth compounds and cost cutting does not.

This is just one hypothetical example.  Your business will have different Variable Costs and Fixed Costs.  Plug in your numbers and see where the opportunities are to improve profits.  Perhaps it’s revenue.  Maybe it’s cost-of-goods-sold, or overhead - or a combination of the three.

The most expensive way to raise capital?  Selling equity, of course.

In my previous post on Unbundling Business I said that product innovation was probably best left to “two guys in a garage.”  It was a bit of a throw-away line, and I’ve received some off-line feedback to explain myself.

A concept that applies to any investment, whether in your business, in the stock market, or Las Vegas,  is Risk of Ruin.  This is a statistical concept with lots of math involved and you can read more about it at these two Wiki pages (Kelly Criterion, Gambler’s Ruin) if you’re interested.

In brief, Risk of Ruin is a methodology for calculating how much of your available funds to invest in an endeavor with a positive expectation.  A positive expectation being one in which the return is greater than the odds.  If you were to bet $1 on a 50/50 coin flip and receive $2.05 (your original bet plus $1.05 in “profit”) when you won, that would be a positive expectation.  If you received $1.95 (a $0.95 profit) upon winning, that would be a negative expectation.

Even long odds can have a positive expectation if the return is big enough: a 2000-1 payoff on 1000-1 odds is positive.  The trick in this situation is to stay in the game long enough to take advantage of the positive expectation.  If you risked every thing you own, you’d go broke most of the time.

Guard Your Capital With Your Life

And that’s the lesson for entrepreneurs.  Even if the payoff is large, if the odds against success are long, don’t risk all or most of your available capital.

We read all the time in the business press about the entrepreneur who risked everything, beat the odds, and reaped the rewards of money and fame.  But we don’t read about the other thousand who didn’t win and went bankrupt.  It’s called Survivor Bias.

You can read more about Survivor Bias and how it applies to entrepreneurs in my post on Luck and Success.

Experiment, Evaluate, Repeat

A better approach would be to risk a little on a lot of opportunities, discard the ones that don’t work, and then invest more in those that look promising.  When you have something that’s clicking and starting to pay off, that’s the time to dedicate your all to the project.

John Hagel of Edge Perspectives analyzes Dell’s possible spin-off of its manufacturing operations and puts it in the larger context of corporate restructuring through unbundling business types.

In brief, most companies today are still an unnatural bundle of three fundamentally different, and often competing, business types:

• Infrastructure management businesses – high volume, routine processing activities like running basic assembly line manufacturing, logistics networks or routine customer call centers.
• Product innovation and commercialization businesses – developing, introducing and accelerating the adoption of innovative new products and services.
• Customer relationship businesses – building deep relationships with a target set of customers, getting to know them very well and using that knowledge to become increasingly helpful in sourcing the products and services that are most relevant and useful to them.

What’s this mean for the entrepreneur trying to grow his or her business and shore-up cash flow and profitability?

If even a company with the resources of Dell recognizes the difficulty of trying to do all three, how much more challenging must it be for the business owner with a dozen employees, a stretched-to-the-limit line of credit, and 20 urgent items on their daily To Do list?

The Sweet Spot for the Smaller Company

It seems logical to me that a Customer Relationship business type is the natural competitive advantage for the entrepreneur.  Personal relationships with customers and nimbleness are the smaller company’s strengths.

Product Innovation is a feast or famine endeavor with high risk and is probably best handled by “two guys in a garage” who keep their day jobs or the start-up designed specifically for innovation and with deep-pocketed investors.

You can read more about my thoughts on this in a subsequent post: Innovating and the Smaller Company, and in a previous post: Luck and Success.

Infrastructure Management is best left to the large organization that can take advantage of economies of scale. If you’re in manufacturing, distribution, or similar business, you’d have more success concentrating on flexibility and customization.  Which is really just another facet of customer relationship management.

Now Is As Good A Time As Any…

To question the assumptions you hold about the business you’re in.  The economy is going through a rough patch, credit is less available, and your customers are hesitant to take on significant new obligations.

It’s your job to use your limited resources in the most effective way possible.  The first step is concentrating on what you do best.

And speaking of tough economies, you might want to read my series on Surviving and Thriving in a (Possible) Recession.  Part 1 can be found here.

If brevity is the soul of wit, I can think of no better example than Pick Two.  This little tool is as powerful as it is underused, so I’m doing my part correct that oversight.

Who Knew Software Geeks Were So Smart

Way back in the mists of time, maybe 30 years ago or so, software developers then, like today, were struggling with the unreasonable demands of their customers - both internal and external.  The customers wanted a solution tomorrow, that was bug-free, and didn’t cost an arm-and-a-leg.

Someone very smart came up with a simple solution to communicating the problem to customers and getting them to make tough choices.  It was called “Pick Two”, and did more to crystallize the problem than any lengthy whitepaper could dream of.

• You can have it Good.
• You can have it Fast.
• You can have it Cheap.

          Pick Two.

Just 17 words.  Even shorter than the Gettysburg Address, and just as effective.

Pick Two Applied to Healthcare

Not too long ago, Arnold Kling of EconLog posted his version of a “Pick Two” on healthcare:

• You can have the best quality healthcare.
• You can have unrestricted access to healthcare.
• You can have someone else pay for it.

          Pick Two.

I think this does a great job of summarizing the debate on healthcare in just 23 words.

Delegation and the Business Owner

So, in the spirit of experimentation, I am going to attempt an occasional series of Pick Twos.  Maybe we can create a new Meme together.

Today’s inaugural contribution:

• You can grow your business.
• You can do everything yourself.
• You can have a life.

          Pick Two! 

(To be honest, if you pick the second option, you’re probably stuck with Pick One.)

Think about it.  Agree? Disagree?  If you think you can have all three, prove it.

Have any Pick Twos you’d like to share?  Comments are open.

Joe Pulizzi of Junta42 and Newt Barrett of Content Marketing Today have teamed up to write "Get Content.  Get Customers.", a guide for content marketing.

They’ve put up a companion blog for the book and will give you a free sample.  Check it out.

Next, Conversation Starter has advice on How to Reward (and Retain) People When Money Is Tight.  Here’s a snippet:

• Responsibility along with empowerment is the best motivator
• Recognition inspires, not only the recipient but also others
• Different people see value in different things, so one should strive to understand what is important to individuals working for you. This is especially critical when working in an unfamiliar cultural environment.

Lastly, Jeff Cornwall of The Entrepreneurial Mind says: "Turn Your Competitors into Your Sales Force."

What seems like crumbs to them can become your feast.

Read the whole thing to see what he means.

Seth Godin asks: Do You Own Trees?  He uses the example of Newspapers being stuck on the idea that their value is in the physical form (i.e. Dead Trees) rather than the information. 

Of course, it’s easy in hind-sight to see the mistakes that the newspaper industry is making, but what about you?

Of course, there are trees in your business too. There are trees in the photography business (chemicals) and in the music business (plastic) and even in the personal computer business (computers). They may not be called trees, but they’re there.

This idea is worthy of some discussion.  Have any trees in your business you’d care to share?

The MarketingProfs give us Five Inexpensive Direct Mail Tools to Generate Sales Leads Fast.

My favorite counter-intuitive Tool: Special Delivery.  You’ll have to read the article to see how this can be inexpensive - and effective.

Finally, John Jantsch of Duct Tape Marketing advises Creative Emulation as a means to innovation.

Some of the best marketing innovations I have witnessed came about by some smart marketer emulating a concept long established in one industry and brining it over to another.

Happy Hours for florists?  How ’bout Ladies’ Night for dentists?

I came across an article on Forbes.com about the role serendipity plays in careers called "A Pinch of Luck," and it got me thinking about how luck influences business success.  Often, maybe even most of the time, it is a vital ingredient in creating those successes we read about in business publications.

To illustrate my point, here’s a classic thought experiment, with a twist, using a two-sided coin with a 50/50 chance of landing on heads or tails on any one flip.

Imagine that 2,097,152 people "invest" $1,000 each to enter a coin flipping contest.  The rules are simple: on each round of flipping, those who flip heads get to continue and those who flip tails are out of the contest.  This continues until one person is left - the person who has flipped all heads, however many in a row it takes. (It will take 21 rounds.)

All that money that was invested by the participants becomes the prize pool and it is awarded thusly:

• 9th through 64th place finishers receive $10,000,000 each.
• 2nd through 8th place finishers receive $100,000,000 each.
• The sole survivor, and winner, receives the balance of $837,152,000.

Because of the size of the prizes, this contest would receive a great deal of publicity.  Everyone would comment on how lucky the winners were, because everyone knows that you can’t control which way a flipped coin lands.

However, let’s change the scenario from flipping coins to starting up a business. 

Read the rest of this entry »

Sam Decker has posted his unpublished book 193 Creative Marketing Ideas for everyone to read for free.  With 193 ideas, not everything will work for everyone, but everyone can find several very good ideas to market their businesses for not a whole lot of money.

Seth Godin says that when customers complain, your response should be: "You’re Right."  He is NOT saying the customer is always right - read the whole thing to see what he means.

Finally, MarketingProfs gives us a simple way to use flowcharting to increase the effectiveness of our lead-generation efforts in Lead Generation Blueprints.  Spending a half-hour or so thinking about HOW you generate leads and WHAT you’re going to do with them will increase your return on investment of time and money.

Firstly, Michael Roberto in Conversation Starter gives his take on Growth During a Recession.

He has 4 dead-on points, and here’s one I didn’t think of for my series on Surviving and Thriving in a Recession:

…identify your most critical suppliers and distributors, and determine if any face the possibility of severe impairment to their business due to the economic downturn.

Next, Peter Paul Roosen and Tatsuya Nakagawa offer us "Give Yourself a Productivity Boost: Learn from Kodak’s Transformation" in Lifehack.

They interviewed Jeff Hayzlett and David Lanzillo of Kodak about their F.A.S.T program.  "A" is for Accountability and "S" is for Simplicity - and in my view Simplicity makes Accountability a whole lot easier.  It’s to easy to dodge responsibility when you can hide behind complexity.

Finally, BusinessPundit tells us how entrepreneurs can use social media in The Entrepreneur’s Guide to Social Media.  The post has links to a number of resources, so you might want to save a copy to your desktop.