(Thanks for reading, I’ve recently made a better version of this article here)

Whenever people ask me about financial sustainability, I talk about three buckets.
Almost every business can split their products and services into three categories, based on how much margin they make from each sale.
Like so many good things in life, they’re each fantastic in moderation.
This post will teach you about the three main “buckets” of work, how to balance them and how to create a sustainable business.

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.

For more on this topic, go to How To Get Comfortable With The Numbers, or click on the Financials category in the site menu.