|Fred McKinney, president and CEO of the Greater New England Minority Supplier Development Council.
Last month I covered three important aspects of starting and running a successful business: doing your homework, planning realistically and financing your business adequately. In this article, I will cover the critical issue of profit.
Profit is the lifeblood of business. Without profit, a business cannot survive. Profit is what’s left over after all expenses and costs have been paid in full — the residual. The entrepreneur and the other stockholders are the “residual claimants,” the ones who own the profit.
Sales produce the stream of revenues that are the source of profits. Revenue is based on the prices that a business charges for its products or services and the volume of sales. One of the most important decisions an entrepreneur makes is to set the most profitable price.
The management of every business must determine what prices to charge. However, in some industries the pricing decision is based on competitive factors beyond the control of any individual company. If consumers view your product as being identical to those offered by competing companies, you will be unable to charge more than the market price for your products, or they will not be able to attract enough customers for you to survive.
Most entrepreneurs do not gravitate toward markets characterized by these highly competitive conditions, because the absence of pricing power usually results in lower profits. Most entrepreneurs, therefore, try in one way or another to distinguish their products and services from the other products on the market. This is what is called product differentiation. The more entrepreneurs can differentiate their products, the greater their ability to set the price of the product without the harsh consequences of losing sales from higher prices. There are countless examples of companies that have successfully differentiated their products from others on the market. The current case of the Apple iPad is a good case in point for a large business. This product has been positioned by Apple to be different from mini-laptops and from the cell phones. Whether Apple is successful with this product or not is still to be determined, but the fact that they took in 50,000 orders in three hours is a good indication that they are on the right track.
Most small businesses do not have the power of Apple to control prices. But every entrepreneur must think about how his product is different from the other products on the market. The important opinion on this matter is that of the consumer not that of the entrepreneur. If consumers think the products are “me too” types of products, it really will not matter what the entrepreneur thinks. Contrary to popular belief, being an entrepreneur can and should be a humbling experience.
The second component of revenues is the number of products/services that the business actually sells. This is determined by the market as well. Entrepreneurs have to identify the size of the market they are attempting to serve. Is the market for their product based on the number of people on their street, in the city, in the state, in the country or in the world? Entrepreneurs also have to consider the demographics as well as the “geographics.” Are consumers for your product or service of a particular ethnicity, race, gender, age or health status? Are these particular consumers increasing in numbers or shrinking? The larger the potential market for the products and the faster it is growing, the greater the potential sales and the greater the potential profits.
The entrepreneur, must then figure out how to attract consumers to purchase their products. Some entrepreneurs simply set up a shop and hope that people stop in and buy something. If that is your marketing strategy, you have a problem. Today there is a struggle for the hearts, minds and wallets of consumers. Entrepreneur, must figure out a way to convince consumers to buy from them as opposed to buying from their competitors. This is what marketing is all about. In order to market effectively, the entrepreneur must understand the consumer. Consumers have choices, and they have constraints. Consumers are most times rational in their choices, but not always. After all, how many times have we stopped and bought something that we know we did not need or possibly even want? But it is up to the entrepreneur to tap into the mind of consumers and satisfy their desires and wants. Successful businesses are successful because they satisfy some desire in the mind of consumers that is more valuable than the money in the consumers’ wallets.
In addition to the pricing and marketing, the entrepreneur must figure out a way to produce the product/service at a cost that is less than the price. This involves the management of resources. It is often here, in controlling costs, where entrepreneurs run into trouble. Some costs are clear: the cost of rent of the office or space used by the business, the cost of labor hired by the company, the cost of the material used in the production of the good or service sold. These need to be thoroughly understood and budgeted. But, in addition to these costs, entrepreneur, must understand some other hidden costs of running their business. In the last article, I addressed the issue of capital. Capital also has a cost. For example, let’s say that you started your business by taking money out of your savings account. That money was earning interest. Whatever the income earned by the capital used to start and sustain your business, it should be considered a cost of business. Your accountant does not count this as a cost, but you should.
Another cost is the cost of your own salary. It is common for entrepreneurs not to pay themselves in the early stages of their businesses. While this is often a necessity, it does not mean that your service to the business is without value. It is important for entrepreneurs to count the value of their time as a cost of doing business regardless of whether or not they are actually paying themselves.
The cost of capital and compensation costs are often left out of the entrepreneurs’ calculation of costs and therefore out of the calculation of profits. When they are left out, profits are overstated. I often hear from business owners who state that they made a profit, but somehow it did not feel like it. The reason it did not feel like they made a profit is that they probably did not pay themselves what they should have or did not consider the cost of the capital used to start the business. I highly recommend that entrepreneurs get into the habit of paying themselves the full value of their services as soon as they can and, if they cannot cash those checks to themselves, treat them as loans. When the business gets to the point of becoming successful, they can then “redeem” those loans to their business. And if you cannot fully pay for your services, you will exit the industry or change your strategy.
Earning a profit is not easy in any business. It takes the ability to understand markets, consumers and costs. There is constant change in markets, and entrepreneurs must adapt to these changes and make decisions with incomplete and, sometimes inaccurate information. Successful entrepreneurs make good decisions. Successful entrepreneurs earn profits. Profit is the most important measuring rod for a business and should be the primary goal of the entrepreneur. Pursuing other goals is fine, but none of them are possible to attain, unless and until the business earns a sustainable profit.