How To Get Comfortable With "The Numbers"
There’s a minimum standard of financial literacy for any business owner who wants to make good decisions – they have to know some important numbers.
These fall into two categories; what the numbers are today, and what their options are for the future.
Grappling with these numbers allows you to see opportunities that your competitors miss, and avoid traps that snare other entrepreneurs.
Let’s look at these in more detail, so that you can identify any gaps in your thinking:
The Numbers Today
Most business owners are familiar with two sets of numbers:
1. How much they charge for their products/services, and
2. How much money they have in the bank.
These are both important, but they’re lousy scorecards.
What you want is x-ray vision; the ability to “see” the hidden numbers that tell the real story.
These include:
· How much it costs you to acquire each new customer
· How much a typical customer spends with you in a transaction
· How frequently your customers come back
· How much a typical customer spends with you in their lifetime
· How much it costs to create one extra product/deliver one extra service
· How much it costs to run the business (before you’ve sold anything)
· How much each unit contributes to your profit
· How many units you need to sell in order to break even
· How many units you need to sell in order to hit your profit target
You can learn more about these in
Revenue Calculations and Forecasts
Profit Calculations and Analysis
Numbers That Count Part One, Part Two, Part Three, Part Four
The benefit of understanding these numbers is that you can see how much each product/service contributes to the health of your business.
For entrepreneurs with a range of products/services, some of these are cash cows, some make a small margin, and some are loss leaders.
Cash Cows
A Cash Cow is a product or service that earns a heavy margin and delights a customer.
There’s nothing immoral about earning a high margin, so long as everyone is happy.
I pay $4 for a latte that consumes 30 cents worth of raw materials, and yet I remain a satisfied customer.
The same goes for a concert ticket, a business class flight, an eye fillet steak, a designer bag or an iPhone.
Customers love them, and they generate serious margins.
Cash Cows are often achievable through Value Based Pricing – where you can offer a customer something really valuable to them, even though it doesn’t cost you very much to produce.
Cash Cows are excellent.
Small Margins
A Small Margin item is something that you sell in high volume, but only charge a little more than what it costs you to produce.
Lots of products are sold like this, where the business owner charges a fair price for a commodity good.
This goes for petrol, chocolate bars, Dell computers, budget airline tickets or phone credit.
Customers love them, and they keep the business ticking along.
There’s not much room for error, but you also won’t be accused of profiteering.
Small Margins are often achievable through Cost Based or Market Based pricing, where you charge “the going rate” for something generic and interchangeable.
Small Margins are excellent.
Loss Leaders
A Loss Leader is a product or service that costs more than it earns, and sets up a second purchase that generates a heavier margin.
Many businesses create loyal customers through loss leaders, because they necessitate the additional purchases that then become Cash Cows, like why some bars offer free salty snacks – to sell more beer.
This goes for video game consoles, milk at the supermarket, razor handles, printers and Nespresso machines.
The initial purchase makes no margin, but the necessary follow-ups are highly lucrative.
Loss Leaders are sometimes excellent.
It turns out, these three buckets are sitting on a see-saw.
On the left are our Cash Cows, on the right are our Loss Leaders, and the Small Margins are just to the left of the centre.
Here’s the deal – you can have any combination you like, so long as the scales tip towards the left.
That’s financial sustainability.
I don’t care how you get there, but if it tips to the right, you’re not financially sustainable.
The Three Lies
What tends to happen at this point is the entrepreneur tells themselves one of three lies.
Lie #1 – Pretending a Small Margin item is a Cash Cow
This is easy to do, since a lot of your business’s costs are invisible at first.
The revenue feels like it outweighs the costs, but when we zoom out, we see that things aren’t so lucrative.
We’re not keeping much milk from the Cash Cow.
Lie #2 – Pretending a Loss Leader is a Small Margin
Also easy to do, since those invisible costs stay hidden.
We can see some income from our activities, but the amount of work involved means that it hasn’t actually made a profit, at least not in this first instance.
If this becomes the first of many purchases, then we’ll make a margin, but in this case it’s been an overall loss.
Lie #3 – Pretending a Loss is a Loss Leader
A Loss Leader that doesn’t lead to anything is…a loss.
There’s really no way to celebrate a loss.
We can celebrate the use of a Loss Leader to acquire a new customer, but if it doesn’t work then we have to admit what’s happened.
This lie is often accompanied by words like “good exposure”, but this is a consolation prize at best.
If you can’t identify what it will lead to, then it’s not a Loss Leader.
This is why we need clarity on the numbers today – to dispel the myths we all tell ourselves about which items are doing the heavy lifting.
You can create a cash cow if you deliberately design for one, but it won’t happen by accident.
You can build a business on small margins, but the daily grind of running a business erodes your buffers the moment you lose focus.
Loss leaders are sometimes wise, but not if they aren’t leading to future cash cows.
The balance is your responsibility as a business owner – to always have more cash cows and small margin items than loss leaders.
If you don’t have the ability to calculate or read your current numbers, maintaining this balance will be based on guessing and blind optimism.
Better to learn how these numbers work today, make a few tough decisions and enjoy a better quality of sleep in the future.
The Numbers Of The Future
There is not just one singular future for your business – you have lots of options as an entrepreneur.
This choice can feel overwhelming or paralysing.
I see three distinct skills here:
1. The ability to see new opportunities for the future – dreaming up ideas and stealing concepts from other industries.
2. The ability to quantify the impacts (the pros and cons) of these new opportunities – seeing the cost and the benefits without too much bias.
3. The stomach to make a decision without having total certainty – to be comfortable with having “enough” information and the ability to make quick adjustments as things change.
Knowing your numbers is vital for that second skill.
Once you have the initial spark of an idea, you can start sketching out the financial impact of this opportunity, and find ways of making it easier/more lucrative.
This takes out some (but not all) of the uncertainty out of the equation, and gives you the best chance of making the right decision without freezing.
You can learn how to:
· Forecast how much it would cost to outsource something you do today
· Forecast how much it would cost to insource something a partner does today
· Estimate the pros and cons of raising your prices
· Understand the pros and cons of adding a new product/service to your menu
· Understand the cost and benefit of a new customer acquisition campaign
· Understand the cost and benefit of a customer retention campaign
· Identify the ways in which you could reduce your costs without undermining quality
· Make a clear list of your assumptions, so that it’s easier to update them as things change
· Identify your sensitivities (small changes with large impacts), so that you can monitor and defend against problems in the future
You can learn more about these in:
How To Improve Your Revenue Streams Part One and Part Two
How To Reduce Or Restructure Your Costs
How To Make Sense Of Your Profits
How To Improve Your Financial Model
My suggestion is to use these lists to identify any gaps you have today.
Eventually you want a simple dashboard that tells you what the important numbers look like each day/week, but to get that you’re going to have to wade through the messiness and complexity of your financials.
Please don’t try and shortcut this by having someone else create your financials for you, that’s like sending them to your gym class in your place.
You’ll grow stronger as a business owner by learning how your company earns, spends and retains money – this is what gives you the intuition of what opportunities to pursue and which to decline.
This is a learnable skill – every successful business owner who has come before you has walked the same path.
None of them were born with the ability to use Excel.
My suggestion is to make your own models from scratch, starting with the basic calculations for your costs, revenues and margins.
With practice, you’ll get much faster at the “What If?” questions, allowing you to create quick back-of-the-envelope financials with confidence.
