What is Your Pain

Being an entrepreneur we sometimes get wrapped up in solving what we perceive to be problems that others have.  Sometimes this works, however many times entrepreneurs either don’t fully understand the problem, don’t have the domain knowledge to effectively solve the problem, or they have incorrectly identified  something as an issue that really was not.

I have talked before about the goal of an entrepreneur is getting someone to open their wallet and take out a hard earned dollar bill in exchange for a product or service.  Obviously, most people will not hand over a dollar bill unless you can provide something of value to them.  Paraphrasing a great B-School lecturer that I greatly respect:

You have to first identify someone’s pain, you then have to validate that others have the same pain, finally you go about fixing the pain in exchange for that proverbial dollar bill. – John Doggett

Adam McFarland writes one of the better blogs I’ve seen covering many practical entrepreneurial subjects, sharing real life issues and examples that he deals with in his company.  He recently wrote a great post about being your own target market.  I couldn’t agree more with this approach for an entrepreneur.  Ask yourself what some of your daily pains are, and focus on the business of fixing them.  In addition to what Adam covers, below are a few of my thoughts on the many benefits of this approach:

• Most importantly, you have first hand knowledge about the issue,
• If you are a “common Joe”, there is a very good chance that the other common Joe’s around the world have the same issue,
• Because you understand the problem so well, you know what a good solution looks like
• You know the common characteristics or interests of the other common Joe’s with the same pain, and how to reach them,
  • This is beneficial in that you can discuss the pain and possible solutions with others like you,
  • Once you have a solution or product you probably have a good idea as how to reach your market.
• As Adam suggests, because you know the pain you are a good candidate to test the functionality and quality of the solution,
• Finally, because you too have the pain, you know what you would be willing (or not willing) to pay for a solution to that problem.

So, once again, what is your pain?  I’ve spent the last few days thinking about a few of mine, stay tuned.

I was recently talking to some local business owners about what it would take to put a product on their shelf, a product that I’ve developed and would like to take to market.  After talking to a couple businesses, working in the exact same industry, it became apparent to me that when I asked what their typical retail margins were for a product such as mine, we weren’t always speaking the same language.  I was given a few answers that were close to being in-line, and then I got a couple fliers.  So I dug deeper to determine how they calculated their “margin”, and found that “markup” and “margin” were being used interchangeably.

Why does it matter, well product pricing is a very important aspect of entrepreneurship and running a business, and probably a subject that a lot of people don’t fully understand?

That said, the concepts are actually quite simple.

• Markup is based on the cost one purchases a product for
• Margin is based on the sales price one sells the product for

The following equations are used in the examples below:

Margin (%) = (The price you sell at – The cost you buy at) / The price you sell at

The price you sell at = The cost you buy at / (100% – Margin (%))

Markup = (The price you sell at – The cost you buy at)

Markup (%) = (The price you sell at – The cost you buy at) / The cost you buy at

Markup = The cost you buy at * Markup (%)

The price you sell at = The cost you buy at + Markup

The price you sell at = (The cost you buy at * Markup (%)) + The cost you buy at

It is probably easiest to use two examples to show the concept.

Example 1.

The first is the case where you develop a new widget and want to sell it at all of the local hardware stores in the country.  Let’s assume that you are able to manufacture the item, and you will sell the widgets to a wholesaler, whom will take care of distributing your product to all the retailers across the country.

Your Pricing

Your cost to manufacture and package your widget is $10/unit.  You want this to make you rich over night, so you decide that you will sell the product to your wholesaler for $19/unit.  You have marked-up the product $9, which will cover your operating expenses and provide for a nice profit.

Your Cost = $10

Your Markup = $9

Price You Get = Wholesale Cost = Your Cost + Your Markup = $10 + $9 = $19

Markups and Margins

We can now calculate what your percentage markup and margin are:

Markup (%) = Your Markup / Your Cost = $9 / $10 = 90%

Margin (%) = Your Markup / Price You Get = $9 / $ 19 = 47.4%

We are already starting to see a markedly different set of values for terms that are sometimes used interchangeably.  If I were to ask you what your margin is and you replied 90%, that would be drastically different than the actual 47.4%.

Wholesale Pricing

Let’s continue, when you work out a deal with your distributor they tell you that they require a 25% margin to move your product.

Wholesale Cost = $19

Wholesale Margin (%) = 25%

Price Wholesale Gets = Retail Cost = Wholesale Cost / (100% – Wholesale Margin (%)) = $19 / (100% – 25%) = $25.33

From this we can now calculate the actual and percentage markup.

Wholesale Markup = Price Wholesale Gets – Wholesale Cost = $25.33 – $ 19 = $6.33

Wholesale Markup (%) = Wholesale Markup / Wholesale Cost = $6.33 / $19 = 33.3%

Retail Pricing

And finally the wholesaler is able to sell the product to the retailer.  In this industry we’ll assume that it is standard that products of this type are marked-up 50%.

Retail Cost = $25.33

Retail Markup (%) = 50%

Retail Markup = Retail Cost * Retail Markup (%) = $25.33 * 50% = $12.67

Retail Price = Retail Cost + Retail Markup = $25.33 + $12.67 = $38

So we can now determine the Retail Margin.

Retail Margin (%) = Retail Markup / Retail Price = $12.67 / $38 = 33.3%

In summary, the product that you developed for $10, after your markup, wholesale markup and retail markup is now selling at hardware stores for $38.

Example 2.

Now, lets work backwards.  You have developed your new widget and you know that your competitions product retails for $23 in hardware stores.  You know yours is slightly better, but will not be able to sell for $38.  You are pretty sure that your product will sell for $27.

Squeezing Margins

We’ll assume that (the same as in example 1):

Retail Margin (%) = 33.3%

Wholesale Margin (%) = 25%

Retail Pricing

So, if the suggested retail price of the item is $27, then:

Retail Markup = Retail Price * Retail Margin (%) = $27 * 33.3% = $9

Retail Cost = Wholesale Price = Retail Price – Retail Markup = $27 – $9 = $18

Wholesale Pricing

Now to determine the wholesale markup and cost:

Wholesale Price = $18

Wholesale Markup = Wholesale Price * Wholesale Margin (%) = $18 * 25% = $4.50

Wholesale Cost = Your Price = Wholesale Price – Wholesale markup = $18 – $4.50 = 13.50

Your Pricing

In this scenario, it costs you $10 to produce your widget and you are only able to sell it to wholesale for $13.50.

Your Margin (%) = Your Markup / Your Price = $3.50 / $13.50 = 25.9%

This is substantially less than the 47.4% margin that you received in the first example, but you can see how it allows you to make a business decision.  If the product must sell for $27, it costs you $10 to produce, then you have to decide if a 25.9% margin per widget is acceptable to pursue the opportunity, remember that the 25.9% must cover your operating expenses, marketing, with something left over in the form of profit.

What I have learned to do is to back into my revenue calculation, using a worst case scenario analysis.  I start by building a spreadsheet that has all of my revenue drivers – assumptions used to derive the revenue calculations.  I then build out an income statement, once again, using the revenue drivers to calculate the top line of the income statement.  Finally I build a cashflow statement that ties to the income statement in a couple ways, but primarily via the net income.

When doing a traditional business analysis, it’s easy to get wowed by the “estimated return”.  Some folks will do a sensitivity analysis on the estimated revenues, maybe the estimated expenses, and come up with equally wow’ing returns which do nothing more than distract you from the real question at hand – is this opportunity viable.  As I’ve mentioned, the problem is that while guestimating expenses and start-up captial requirements can be done with relatively fair accuracy, in many business plans doing the same for revenue isn’t possible.  That’s why this approach is so valuable.

So, once you have your revenue assumption sheet linked to your income statement and likewise linked to your cashflow statement, you can start the process of backing into revenue.  On the income statement, you can start by putting in reasonable expectations for expenses, taxs, etc.  On the cashflow statement, you probably have a reasonable idea of how much start-up capital you have access to, or will need to operate the company prior to having a stable revenue stream.  In addition, based on the net cashflow you can do some simple hurdle rate calculations such as net present value (NPV) or internal rate of return (IRR).

Once all of those things are set, then go back to the revenue assumption page and start entering assumptions until you get to a point where the business plan is just able to get by.  The spot where, “if at a bare minimum we are able to do this revenue, we can keep our doors open for business”.  This is really the make or break revenue of the company assuming that your access to start-up captial is limited to some ceiling.  At this point, you can now step back and take a holistic view of the revenue assumptions and projections and focus on the companies ability to meet those revenues.  The question then becomes about “can we make this revenue, or not?”.  Hey, if the company actually does 2x your assumptions down the road, congratulations, it’s a good problem to have!  But in your analysis, assume worst case, and back into the minimum revenue that you can derive to have a operable company (or opportunity you are willing to invest in), and if you have confidence that your company can meet those minimum requirements, you might have a winner.

Where it’s not so easy is around sales and estimating revenue.  The level of complexity around this estimation is dependent upon the nature of the business plan.  As an example, if you are writing a business plan for a new hotel that you want to build or purchase, it might be a little easier because your business by nature is bounded.  If I build a hotel that has an occupancy of 100 rooms, I can safely estimate that my revenue is going to be a factor of the occupancy rate (between 0 – 100%) for any given day.  A difference of 60% occupancy versus 70% occupancy might make or break a business opportunity, but at the end of the day, it’s basically a 10% difference in revenue over that period.  There are some methods to try to fine tune your estaimates, probably the most useful is comparables (often referred to as “comps”).  You can go to neighboring hotels and count cars in the parking lot to determine your competitions nightly occupancy.  You will likely not get the same occupancy the day you open, but your business plan can start to become more realistic when you have that type of data at your disposal.

Now look at what the internet has done for us.  A web based business plan is open for business 24 hours per day, 7 days per week.  It’s open in literally every region and country of the world.  It is not limited by only having 100 rooms of occupancy.  I always hear the guy that invented the pet rock is a millionaire.  I don’t know if it’s true or not, but lets say that when he invented it he had the internet at his disposal.  The inventor creates a web site, puts a picture of his pet rocks on the site for the world to see, and puts an order form on the site so that anyone in the world can order his pet rocks.

There are a number of unknowns with the pet rock business plan.  What is the size of the market, are all 6.7 billion people on this earth your market?  Probably not, only about 24% of the world’s population has access to the internet.  And what percentage of those internet users will ever see your site, not many?  Once on your site, what percentage will actually go about filling out the form and paying for the pet rock?  You see where I’m going, you end up with click through rates times conversion rates times other rates I haven’t even mentioned – a myriad of compounded rates.  What you end up with is a revenue estimate that is very sensitive, a conversion rate on your website of 2% versus 3% might make or break your business plan and mean the difference in millions of dollars of revenue.  There are industry standards that you can lean on, but in the end you have to use your gut feel for what washes out to be some sort of revenue estimate.

My advice to people is to ask themselves, does this revenue model feel right in my gut.  Does the revenue make sense, does it grow smoothly or are there huge spikes?  Is it conservative, did you back into the revenue?  If you are comfortable with those things, then it’s likely that your business plan is realistic and hopefully will have legs.

I see it time and time again – many times from people making major financial decisions for their company.  Some will argue that it is a bug in Excel, and according to some articles I’ve read the behavior is different between different versions of Excel, I don’t know if that is the case or not.  My argument is that people should understand the concept prior to blindly using the formula – and perhaps some clearer user instructions from the software providers.

What am I talking about?  Improper use of the NPV (net present value) formula in Excel and OpenOffice.

Net Present Value is the comparison of a dollar today versus the value of a dollar in the future.  Presumably if someone offered to give you a dollar today, or a year from now, you would pick today.  If I were given a dollar today, I could invest it at some interest rate and one year from now I would have a dollar and change.  That obviously has more value than being given a dollar a year from now – the difference being the change.  NPV is one of the primary analysis tools for valuing business opportunities.  Those decisions might include plant expansion projects, purchase of a new company, etc.  At the end of the day companies and entrepreneurs typically spend money today to make money in the future and NPV takes those expenditures (cash outflow) and profits (cash inflow) and gives you the “net value of the opportunity”, in today’s dollars accounting for inflation and returns in a discount rate.  Now, it is important to note that without a crystal ball, future cash flow from an investment is typically based on estimation, but that’s a different discussion.

What should be understood about the NPV formula in Excel and OpenOffice is that it gives the net present value of FUTURE cash flow.  If you include time 0 (today) cash flow you are improperly discounting the value of today’s dollar.  The net present value of a dollar today, is a dollar.

See the example below.  This particular example was done using OpenOffice, but you will get the exact same result using Excel.

NPV Calculation in OpenOffice

What you see is a series of cash flows, a year 0 (today) cash outflow of $1M, and then a series of outflows and inflows ending in year 7 with an inflow of $1M.  For the sake of this example, a discount rate of 10% will be used.

There are two results shown below the cash flow series, the top NPV result ($175,653) being incorrect and the source of many mistakes that I see from time to time.  The bottom result ($193,218) is the proper calculation for the NPV of this cash flow.  The mistake, which in this case causes for an understatement of the value of the investment, is caused because the cash flow series is being treated as if it were all in the future – and that is not the case.

The proper use of the equation when calculating an NPV on a series of cash flows is shown on the bottom result, ending in a NPV of $193,218.  The NPV formula, when used properly, should include the range of FUTURE cash flow, and that result should be added to the time 0 (today) investment.

Happy NVP analysis!