Contents
About the Instructors
Jim Stice is a professor of accounting at BYU. He teaches employees of multinational corporations about business accounting.
James D. Stice, PhD, is the Distinguished Teaching Professor of Accounting in the School of Accountancy at BYU. Professor Stice has been at BYU since 1988. He has co-authored three accounting textbooks and published numerous professional and academic articles. In addition, Professor Stice has been involved in executive education for Ernst & Young, Bank of America Corporation, International Business Machines Corporation, RSM McGladrey, and AngloGold Limited and has taught at INSEAD (in both France and Singapore) and CEIBS (in China). He has been recognized for teaching excellence by his department, his college, and the university. Professor Stice currently serves on the board of directors of Nutraceutical International Corporation.
Professor Jim Stice received a PhD from the University of Washington as well as master’s and bachelor’s degrees from BYU, all in accounting.
Earl Kay Stice is the PricewaterhouseCoopers Professor of Accounting at the Marriott School of Management at BYU.
He has been on the full-time faculty at Rice University, the University of Arizona, and the Hong Kong University of Science and Technology (HKUST). He has also been an Executive MBA lecturer at HKUST, SKOLKOVO (Moscow School of Management), China Europe International Business School (CEIBS), the University of Illinois (US), and INSEAD (Singapore and Paris). Professor Kay Stice has received awards for high-quality teaching at Arizona, Rice, and Brigham Young University, and he was twice selected as one of the top ten lecturers at HKUST.
Professor Stice has been engaged in executive training and corporate training in the United States, Hong Kong, China, Russia, Malaysia, and South Africa. He has also been an expert witness in major cases involving compensation for losses and tax disputes.
Professor Stice received his bachelor’s and master’s degrees in accounting from Brigham Young University and completed his PhD at Cornell University (US).
Introduction
Welcome
– Hi, I’m Jim Stice. I’m a professor of accounting at Brigham Young University. This is by brother, Kay. – I’m also a professor of accounting at Brigham Young University. – As accounting professors we teach financial analysis, cash flow projections, product costing, and cash management. – All of these topics are important to the management of a small business. In fact, all of them highlight ways in which small business owners put their businesses at risk. – In this course we will explore five characteristics of small businesses that make them more likely to fail.– [Kay] Those five characteristics are insufficient capital, poor cash management, poor record keeping and controls, improper product pricing, and uncontrolled growth.
– Now, before taking this Financial Essentials for Small Business course, you might considertaking our Accounting Fundamentals, our Finance Fundamentals, or our Income Tax Fundamentals courses. Among other things, those courses provide a more comprehensive overview of business in general. – With that said, we have designed this Financial Essentials for Small Business course to be self-contained, and we carefully explain any terminology that we use. – In short, this is an introductory course with no prior knowledge necessary. – The fact is that the vast majority of small businesses fail.
– And with those business failures go the life savings and the dreams of the person who started the business. Join us to learn about the five characteristics to avoid in order to increase the likelihood that your small business will succeed.
Overview: Finance Essentials for Small Business
All businesses start small
– All businesses start small. – Here are some examples with which you may be familiar. – Apple was started in 1976 by two friends, Steve Jobs and Steve Wozniak, working at least part of the time in the garage of Steve Jobs’ parent’s home in Los Altos, California. – Apple’s first financing arrangement came when Steve Jobs convinced an electronic parts supplier to give him parts on credit, agreeing that he would pay for the parts when he and Steve Wozniak sold the first batchof completed computers, the Apple 1. – Well in 1981 Microsoft was a 32 person softwarecompany that had recently moved to Bellevue, Washington from its original headquarters in Albuquerque, New Mexico.
That company had been started in 1975 by two friends, Bill Gates and Paul Allen. – When IBM released its influential IBM PC in 1981, IBM chose not to develop the operating system itself,but instead outsourced this task to that small company Microsoft. – The rest, as they say, is history. Microsoft has leveraged its position as the primary provider of operating systems for personal computers, to become one of the most influential companies of our time. – Exxon Mobil was created through the entrepreneurial energy of one person, John D. Rockefeller, in Cleveland, clear back in 1862.
– This small oil company started by Rockefeller with just $4,000 of his personal savings eventually got so big that the US Federal Government decided it was a monopoly, and broke it into several pieces. Both Exxon Mobil and Chevron are remnants of the original Standard Oil Company started by Rockefeller. – Walmart was also started through the energy of one person, Sam Walton. After World War II, Sam borrowed $20,000 from his father-in-law and bought avariety store in Newport, Arkansas.
By 1962 Sam Walton had built a chain of 16 variety stores. – Sam had become convinced that there were big opportunities in opening discount retail locations in the smaller US towns and cities that were being overlooked by the traditional retailers such as Sears. Walton pitched his idea to a couple of retail chains, but he couldn’t generate any interest. – He finally had to fund the startup of his first discount store with his own money, putting up 95 percent of the financing, with another three percent coming from his skeptical brother Bud, and two percent from the person he hired to manage the store.
The first Walmart location opened its doors on July 2nd, 1962. – Now, let’s keep in mind that a business doesn’t have to become large and famous to be a success. Solid small and medium size businesses are the foundation of communities. – But however you define success, for each success story there are hundreds of small businesses that die before they ever really get going.– The most common reason for a small business to fail is that the underlying product or servicejust doesn’t satisfy a market need.
In other words, customers don’t want the product or service. – But small businesses are also often killed because of predictable and preventable business mistakes, insufficient capital, poor cash management, poor record keeping and controls, improper product pricing, and uncontrolled growth. – Let’s learn about the factors that frequently kill small businesses.
Introduction to starting small
– You have a great idea. You have a product or service for which the world has been waiting.You’ve scraped together enough cash to get your idea off the ground. You have a location.You’ve done your advertising. You just know this is going to work. And six months later you’re out of business. Statistics from the Small Business Administration indicate that about half of new businesses fail in the first five years. Many new businesses fail and the reasons are many and varied. In this course we’re going to address some of the primary financial reasons that new businesses don’t make it.
There are, of course, many non-financial reasons that new businesses struggle. Poor marketing, poor location, poor product quality. We’re going to limit this course to the financial reasons for business failure. If you get everything right but the financial side of things, your business is going to struggle. Of course, if you get the financial side of things right and drop the ball with the non-financial aspects of the new business, you’ll struggle as well. With this course we’ll stick with the financial aspects of struggling new businesses because that’s what we know a little something about.
We have identified five common reasons that new businesses that struggle seem to face. Of course, this is not an exhaustive list, but these five reasons seem to consistently pop up when it comes to new businesses that struggle. Those five reasons are insufficient capital, poor cash management, poor record keeping and controls, improper product pricing, and uncontrolled growth. Before we get started, let me first say that several of these reasons for struggling are interrelated.
Uncontrolled growth can relate to poor cash management. Poor cash management can relate to poor record keeping, and so on. While these topics can be interrelated, we will address each one separately and then comment on the interrelationships when they are apparent. So let’s get started.
Insufficient Capital
Capital to start a trucking business
– Even as we speak, a friend of ours is getting into the long distance trucking business. – He owns a truck and he contracts with a driver to drive the truck for him. – He finds his customers in companies that want to ship goods long distances, but don’t have a big enough need to hire one of the large trucking companies. – Our friend says that the most difficult part of his business is finding the right customers who want their goods shipped to the right place and are willing to pay the right price. – So the scheduling and contract negotiation functions of his business are very interesting, but those are topics for another day.
– Yeah. Let’s talk about the financing for this small business. – Our friend originally thought that he could get into his trucking business with $35,000. He would use this money to buy a used tractor, the front end of the truck, the part where the driver sits. – But then he learned that used trucks that he could buy for $35,000 wouldn’t be compliant with California emissions standards.So the set of potential shipping jobs that he could get staying out of California would be dramatically limited. – That meant buying a newer truck for $52,000. So our friend had to secure even more startup financing.
– But wait, he wasn’t finished. He also needed to buy a trailer, another $10,000 as well as tarps, straps, and chains for another $2,500. – So in total our friend needed $64,500 to get going.Fortunately for him he had access to that much capital. – But if his original supply of capital had been limited to, say, $50,000, the entire business venture would have died right there because of a lack of financing. – Would-be small business owners often don’t think through all the costsof getting their business started.
– As a result, many small businesses with good ideas die because of an insufficient initial capital.
Insufficient capital
– Let’s begin with the money needed to start a business. Too many new businesses start their business without enough capital. They just don’t have enough money in the bank to support them while their cash flows get up to speed. It turns out that the rent has to be paid, the utilities have to be paid, equipment may need to be purchased or rented, the employees have to be paid, inventory has to be purchased. All of your expenses have to be paid, while you’re waiting for potential customers, first to find you, and then second to pay you.
There’s often a lag between when you get paid for provided a good or a service, and when you have to pay your vendors. And generally, that lag is not in your favor. Also, when starting a business, it takes time for your customers to find you, and for you to get your sales and marketing efforts up to full speed. During that time, your expenses will continue to need to be paid. It would be nice if all customers would pay immediately. It would also be nice if vendors would wait to be paid until you are paid.
Yeah, that would be nice. Many businesses are forced to close before they are able to find out if their business model has a chance to demonstrate that it’s sound. They just run out of money! I found when working with small businesses that owners have two tendencies. First, they overestimate their cash inflows, and second, they underestimate their cash outflows. When starting a business, realize that it will take time for cash inflows to start flowing. But the cash outflows start flowing immediately.
Make sure that you have access to sufficient capital to allow your new business venture enough time to succeed. Consider a simple example. I have dreamed my entire life of opening up a small restaurant. I’m a good cook! Many have suggested that I have a talent for cooking. I enjoy interacting with people. Why not give it a go? I found a location. That costs money. I’ve rented equipment. That costs money. I’ve hired employees.
Poor Cash Management
Managing cash on the beach
– I have a friend who’s a small business owner. Let’s talk about his cash flow management practices. I will disguise the actual nature of his business to preserve his privacy. – So, what is the nature of his cash flow management issues? – He operates, let’s say, a beach side shop in a vacation beach area. He sells food, souvenirs, and some groceries. He also rents jet skis and scooters. – Well I’ll bet his business is very seasonal. High business in the late spring and summer and almost no business in the winter. – Exactly.
He tells me that he maintains a rolling 30 day cash flow projection. He forecasts how much cash he will collect from customers, and how much cash he will have to pay the suppliers for each day for the next 30 days. – So, has he ever had a big crisis that threatened his survival? – Yes, a few years ago. It was rumored that one of the big cruise lines would begin using his harbor as a stopping point. Of course this would dramatically increase customer traffic. – Well I’ll bet a lot of new competitors materialized. – Exactly, my friend said that new business owners came in, built or rented large store locations, filled them up with inventory and purchased large collections of scooters and jet skis.
A lot of money was invested in the area. – So what happened? – Well the rumors turned out to be completely false. No cruise lines came to the harbor. – Ah, I can imagine the problems.Without sizable cash inflow from cruise line passengers, these new competitors wouldn’t be able to maintain their cash payments for rent, inventory, wages and so forth. So, how’d your friend do? – He did great. Throughout the excitement he just calmly proceeded with his normal business practice of constantly balancing his expected cash collections and expected cash payments for the next 30 days.
Because he carefully monitored his cash flow, he was able to safely ride out the bubble and the subsequent crash. – So, how’d he do after the crash? – He actually made quite a bit of money,buying up the scooters and store inventory from his bankrupt competitors. The competitors who had not carefully planned and balanced their cash flows.
Cash flows
– We know you’ll need sufficient capital to get your new business through the critical first few months. Let’s assume you’ve made it through those first few months. You will still need to track your cash inflows and outflows to ensure that you have sufficient cash to pay the bills that are surely coming. Whether you are at the start of your business or well into the lifecycle of your business, managing cash is critical for the wellbeing of your business. Cash management does not happen by chance. It is up to you to ensure that your cash is managed. We will do this by preparing a cash forecast or budget.
Let’s start our discussion of cash management by distinguishing between two types of costs,fixed costs and variable costs. Fixed costs are exactly that, they’re fixed. Budgeting for fixed costs is relatively straightforward. The amount is fixed, at least over the short term. Variable costs are costs that vary relative to some activity or cost driver. For a restaurant, for example,costs might vary based on the number of customers. For a shop at the mall, costs may varybased on the number of hours that the shop is open, labor costs, utility costs, and so forth.
Now there can be a number of cost drivers, or in other words, costs can vary for a number of reasons. It just depends on how complicated you want to get. For our example, we will assume one driver that results in variable costs just to keep things simple. Adding more drivers makes the arithmetic a little more complex, but the concept is still the same. Now step one in cash management is to identify all of your fixed and all of your variable costs. All of those costs.
It’s easy to forget an expense here or an expense there, and before you know it, your cash forecasts are useless. The cash forecast is only as good as the inputs. Now let’s go into the fast food restaurant business. What costs associated with this business will be fixed and which will be variable? Before I can nail down the variable costs, I need to ask this question, variable relative to what? I’m going to assume that certain costs vary based on the number of customers. For a given month my fixed costs will involve rent on the building, rent on my equipment or loan payments if I’m purchasing the equipment, utilities, insurance, and advertising.
Estimating the number of customers
– Answering the question how many customers can we expect is the hard part, please don’t gloss over this question. Your business will fail or succeed based on the answer to this question.How many customers can you realistically expect? In our restaurant business we need to knowhow many customers to expect every shift, so we will hire more or less people depending on expected customer demand. We will need more or less food based on customer demand. Many costs will vary based on anticipated customer demand. Answering this big question is beyond the scope of this video, but it would involve such things as scoping out your competitor’s volume of business, assessing expected population growth in your area, surveying potential customers, and a whole host of things.
Your forecast of sales will be critical in helping to prepare your forecast of cash inflows and outflows. To our example, I’ve done a very careful analysis and determined that I can expect 5,000 customers per month, or about 167 customers per day. Implicit in this 5,000 customer number is a selling price that number will impact customer traffic. In developing this sales forecast I have assumed that each customer will spend on average $8 per visit.
We will do some sensitivity analysis with these numbers to determine what might happen to our profits if more or fewer customers show up. Now that we have a reliable forecast of our cost driver, at least as reliable as possible, we can now compute our variable costs. Please note that as our business grows and matures we will be able to determine a much more reliable estimate on the number of customers we can expect. For our fast food restaurant business we will assume that I have three types of costs that vary depending on the number of customers,food, packaging and labor, the more customers the more food of course, the more workers, and the more cups and napkins and such.
Of course, there will be more costs but hopefully you get the idea. Based on my forecast of the number of the customers I can expect, I anticipate the following variable costs for a month,food costs of $12,000, packaging costs of $2,500, and labor costs of $6,500, for a total forecasted variable cost of $21,000 for the month. Now, with variable costs of $21,000, and the number of customers expected to be 5,000, we can determine that our variable costs are $4.20 per customer.
Cash flow example
– Let’s tie this together in one example. Let’s suppose that I forecast customer demand for myfast food restaurant over the next three months to be, in month one 4,000 customers, in month two 4,500 customers, and in month three 5,000 customers. Let’s also assume that I have $10,000 in the bank right now. I also estimate my fixed costs to be $16,000 per month, and my average selling price and estimated variable costs to be as follows, I estimate my average selling price to be $7 per customer in month one, $7.50 per customer in month two, and $8 per customer in month three.
The reason for the lower selling price in month one is to entice customers to come in and give my business a try. As word gets out and my business earns its reputation, I forecast being able to increase the average selling price per customer. I also estimate that my variable costs will be$4.30 per customer for the first two months, and increase to $4.40 per customer in the third month. Now you can start to see how my cash will begin to flow, both into the business and out of the business. We are going to assume that all bills are paid in the month they are due, and that customers will pay me in cash.
We can certainly relax these assumptions, but let’s keep it simple to get started. Now my next step is to forecast my cash flows for this three month period. I do that by beginning with my cash on hand at the start, add to that my expected cash inflows from customers, and subtract my cash out flows for my fixed and variable costs. The result is the cash budget that you see here. Well, where did these numbers come from? Let’s look at the first month as an example. I forecast 4,000 customers at $7 per customer that results in a forecasted cash inflow of $28,000 for the first month.
The $17,200 comes from the variable costs of $4.30 per customer times 4,000 customers. The $16,000 represents my forecasted fixed costs for the month. I then did the same thing for subsequent months. Now, what’s the first thing you noticed? I sure am glad I had $10,000 to start. This gets back to having sufficient capital to start your business. Next, my cash outflows exceed my cash inflows for the first two months of my business.
Poor Record Keeping and Controls
Hiring a bookkeeper
– We have always loved reading the James Herriot stories. – Yes, we have. For those of you who’ve never read them, the James Herriot stories are first person accounts of the life of a country veterinarian in the hills of Yorkshire in England. – James and his volatile but charming partner Siegfried run the veterinary practice in a pretty loose fashion. They take good care of their clients, the animals, but their bookkeeping and cash management practices are horrible. – The following is extracted from James Herriot’s account of Siegfried’s efforts to hire the business’ first bookkeeper This comes from the book, “All Creatures Great and Small.” – Miss Harbottle, the prospective bookkeeper, came into the business office and “paused at the desk,“which was heaped high with incoming and outgoing bills “with here and there are stray boxes“of pills and tubes of cow udder ointment.” – “Stirring distastefully among the mess, “she extracted the dog-eared old ledger “and held it up between finger and thumb.
“‘What is this?'” – “Siegfried trotted forward, ‘Oh, that’s our ledger. “‘We enter the visits into it from our day book, “which is here somewhere.’ “He scrabbled about on the desk. “‘Ah, here it is.“‘This is where we write the calls as they come in.'” – “She studied the two books for a few minutes “with an expression of amazement “that gave way to grim humor. “She straightened up slowly and spoke patiently, “‘And where may I ask is your cash box?'” – “‘Well, we just stuff it in there, you know.'” “Siegfried pointed to the pint pot “on the corner of the mantlepiece.
“‘Haven’t got what you’d call a proper cash box, “‘but this does the job all right.'” – “Miss Harbottle looked at the pot with horror. “Crumpled checks and notes peeped over the brim at her. “Many of their companions “had burst out onto the hearth below. “‘And you mean to say that you go out “‘and leave the money here day after day?'” – “‘Never seems to come to any harm,'” Siegfried replied. – “‘And how about your petty cash?'” – “Siegfried gave an uneasy giggle. “‘All in there, you know, all cash, petty and otherwise.'” – Situations similar to the one described here are not unusual for small businesses.
How does a business survive with such bad bookkeeping? Some businesses do well in spite of their bookkeeping inefficiencies because their fundamental business is doing so well that the inefficiency stemming from bad record keeping only reduce profits instead of eliminating them altogether. – But of course most small businesses do not survive, and poor bookkeeping is a contributor to the demise of many of them. Poor bookkeeping leads to a host of problems,trouble collecting accounts, difficulties with suppliers over late payments, problems getting bank loans because of the inability to prove profitability, inability to assemble reliable costs and revenue data in order to make pricing decisions, and just general inefficient use of time.
Record keeping
– Let’s now turn our attention to the next area where new business owners tend to drop the ball. That is the area of poor recordkeeping. Most new business owners hate to worry about the recordkeeping. They would rather worry about customers, and sales, and innovation, and growth, and everything, other than recordkeeping. Proper recordkeeping and internal controlsare the blocking and tackling of new businesses. Not very glamorous and not very interesting,but, it needs to be done, and it’s safe to say that it needs to be done well. When I graduated from college with a degree in accounting, oh, so many years ago, I naively assumed that businesses existed so that accountants could account for them.
Accounting was the center of my universe at the time, and I incorrectly assumed it was the center of everyone’s else’s universe as well. I couldn’t have been more wrong. I quickly learned that while proper recordkeeping and adequate internal controls were essential to the successful running of a business, those features were not the business. You can liken proper recordkeeping and adequate internal controls to the keeping of statistics in a football game.The person tracking the statistics is not on the field playing the game, but, those statistics are very helpful to those who are on the field playing the game.
As we discussed in the previous video on cash management, you need to track your inflows and outflows, or cash, so that you can forecast future cashflows. All we’re talking about here is developing a system of tracking your inflows and outflows, your obligations to others, and other’s obligations to you. It can be as simple as that. Depending on the size of your business,you can purchase accounting software off the shelf. There are a number of great products that will do the job with minimal training, but, it is critical that someone take responsibility for keeping the books.
Why is it critical? Three reasons off the top of my head: first, more accurate information about your business will assist you in running your business better. You will need information about cash inflows and outflows, and about who you owe, and who owes you. Second, if you ever need external financing, bankers or investors will insist on accurate financial information. They will need that information to assess business risk. You need that same information for that same reason. Third, taxes.
Controls
– Now, about controls. What are they? Controls are procedures that should be in place to ensure that one, the information that is being collected in your accounting system is accurate and reliable, thereby helping you to run your business better. And two, to safeguard your assets and your records. Now, what sort of controls should I have on information that I will collect?You will need to answer questions like: How will you document that your cash outflows are legitimate business expenses? You better have proper documentation. If I’m in a business that has inventory for resale, how will I know how much I have on hand? How do I know how many hours my employees have worked? You better have a system for tracking this information.
And of course, you will need a system that collects information about your cash inflows and your cash outflows. And you also need to know who you owe, and who owes you. We’ve talked about that. What else? Well, you’ll have information that’s confidential about employees. Pay rates, Social Security numbers, etc. That all has to be safeguarded. What about customer lists?What about pricing information? As you can imagine, there’s a lot of top-secret informationrelating to the inner workings of your business that you don’t want getting out.
You need to ensure that you have systems that protect your information and ensures that the system producing your information is accurate and reliable. One last thing to mention that is often taken for granted. You will need to safeguard your cash. You will need procedures in place to make sure that cash and checks are quickly and correctly deposited in the bank, and that only authorized expenditures are made. This is no fun to talk about, but we tend to assume that those with whom we work are looking out for the best interest of the company.
Now, that is often the case, but it’s also often not the case. Many individuals are looking out for them. You need to make sure that those individuals are never given the opportunity to be exposed to a situation where they might compromise their integrity. That is done by developing a set of controls within your business to ensure that information is collected quickly and correctly, and that procedures are in place to ensure that assets, especially cash, are handled properly. Now, remember we said at the outset that this topic is the no-fun part of business.
Improper Product Pricing
Pricing a consulting job
– One of the problems that small business owners have is that they improperly price their products and services. Sometimes they set their prices too high driving away business, but more often they set their prices too low and end up not covering all of their costs. – I’ve got some personal experience with this, a story with a good ending. – Okay, I know that you operate your own small business providing executive training courses. – Correct, a few years ago I was invited to provide a one day training course to a group in Kuala Lumpur. The group asked me to quote them a price for this one day course. – Kuala Lumpur, where’s that? – Kuala Lumpur, locally known as KL is the capital of Malaysia.
– All right, so what was the pricing issue? – Well see they just wanted the one day, so my first thought was, “Well, how much would I accept for one day of work?” Would I do it for $1,000? – 1,000 bucks for one day of work, most people would be happy to make $1,000 a day. – That’s what I thought, then I realized that it would take me about five working days to design the course, one day of delivery but five days of course design, so I wasn’t willing to work for six days for just $1,000. – Well then just increase the price, how about $5,000? – Yeah, but then I thought about the travel time.
I live near Salt Lake City in Utah, I checked the flight schedules, and I would have to fly from Salt Lake to San Francisco, from San Francisco to Hong Kong that’s a 13 hour flight, from Hong Kong to Singapore that’s another four hour flight, then sleep overnight in the Singapore Airportto catch the 6:00am flight the next morning to Kuala Lumpur. It would take me almost two full days to get there, and about the same to get back. – So all together this one day course would consume about 10 days of your life, counting the one day of delivery, the five days of preparation, and the three or four days of travel, plus a few days of serious jet lag once you return.
– Exactly, I got tired just thinking about the whole thing. – So what’d you do? What price did you finally quote? – Well after thinking about all the costs in terms of time and effort I proposed a price of $15,000. – 15,000 for one day, but really after you thought through everything carefully, it was more like 12 days of work and recovery. Did the company accept your price? – Well that’s the good ending, I asked for 15,000 and they said yes. I designed the course, flew across the Pacific, slept overnight in a Singapore Airport, delivered the course, turned right around and flew back, and then enjoyed a few days of glorious jet lag at home.
Product pricing
– What can be so hard about pricing a product? Don’t you just figure out what your costs are,and then add some sort of markup for profit? Oh, that it were that easy. If your price is too high, regardless of your cost, someone in the market will underprice you, assuming that the quality of product or service is similar. In many cases you will be a price taker, and you will have to manage your cost so that you can earn a profit given a certain price as determined by the market. Now let me say that again, in most instances you don’t price your product to cover your costs, instead you determine if given a certain market price your cost structure is such that you can earn a profit.
The biggest mistake new business owners make in product pricing is not considering and covering all of their costs when entering a market. Now, it is true that when you are initiallytrying to penetrate a market you may be willing to lose a little money to gain market share, but that strategy is not sustainable over time. Over the long term you must cover all of your costs, all of your costs. Let’s consider the following example. We have a friend who’s in the wedding announcement business. The business is operated in a small town out in the middle of nowhere so that there’s not much competition in the local area.
We’ll relax that assumption in a minute. Our friend calculates the production costs of each wedding announcement order, and then adds $50 to arrive at a selling price. Since the production costs are $14,000, as seen in the chart here, our friend divides that cost by the 40 orders received in a month to get $350 per order. She then adds $50 to cover other costs and charges $400 per order. Well, as you can see, that strategy isn’t working out very well. Our friend is currently losing $3,000 a month, why? She didn’t factor in all of her costs.
She’s covering her variable costs, but the amount being contributed to cover fixed costs is not enough. Note also that our friend doesn’t draw a salary from the business, instead she shares in the profits. Let’s set the price so as to cover all of our costs. Since our total costs are $19,000,that’s our variable costs and our fixed costs, and the number of orders is 40, we get a cost per job of 475. Let’s just add $50 to that number and see how we do. The results are in this table,looks like if we set the price at $525 per order we will make $1,400 a month, awesome.
Uncontrolled Growth
The USFL
– You’ve heard of the NFL? – Absolutely, the National Football League. – How about the USFL? – Ah, I haven’t heard them mentioned in a while. The USFL was the United States Football League,a rival professional football league that operated for three seasons from 1983 through 1985. – That first season, 1983, saw the USFL owners as a group lose millions of dollars. These losses were caused by fan interest being less than expected and player salaries being more than expected. – In response to these losses in 1983, the USFL tried to fix their profitability problemswith an approach that is often used by small businesses owners.
– What approach is that? – They tried to grow their way into profitability. The rationale was if we grow faster, we’ll become more profitable. Classic mistake. – A better approach is to first fix the profitability of your existing operations, and then think about growing. – Ah, but alas, the USFL made the common outgrow our problems mistake and tried to grow out of their profitability problems. So in the second season, 1984, the League grew in two ways. – First, they expanded the number of teams. In the inaugural season there were 14 teams.
In the second season the League expanded to 18 teams. – Second, the teams grew their player payrolls. The initial plan was to hold to a strict salary cap of $1.8 million per team. But some of the owners couldn’t resist signing expensive big name players to try to raise the profile of the League. – Some of the well-known players who got their start in the USFL were running back Herschel Walker, who was paid $1.4 million per year by the New Jersey Generals, and quarterback Steve Young, from our own Brigham Young University, who signed a 40-year $1 million per year contract.
– Steve Young’s $40 million contract was at the time by far the largest contract in professional football history, even surpassing all of the big stars in the established NFL. – As expected, this rapid growth strategy in number of teams and in player salaries failed to turn the money-losing League into a money maker. – After the 1985 season, the League ceased operations. In its brief three-year history, the team owners had lost a total of at least $180 million. – The lesson? If you’ve got profitability problems or cash flow problems, faster growth is almost always not the solution.
Growth
– Now to our last topic uncontrolled growth. Growth is awesome, increased market share is good, sales trending upward is the dream, and unmanaged growth has killed a lot of companies. Growth must be carefully done or it could be fatal to your business. The reason being is that growth often requires cash, and cash is often the one thing that new businesses do not have a lot of. In fact, a lot of new business owners when faced with the cash flow issues associated with starting a new business, they mistakenly think that the solution to their cash flow problems is to grow faster, not realizing that the fast growth is causing the cash flow problem in the first place.
In other words, they hit the gas when they should hit the brake. How does growth cause cash flow problems? Well think about it, in a typical business that is selling a product to a customer on credit, that is the customer will pay in say 30 days, you as the business owner need to pay your rent, pay your insurance, pay your employees, pay for the inventory, then sell that inventory, and wait for 30 days to collect the cash. To grow faster means you need to buy and pay for more inventory and then sell that inventory, and wait for 30 days to collect the cash.
The more inventory you have to buy the more inventory you have to pay for, and then still wait 30 days to collect the cash. Well, let’s just have our suppliers wait longer to collect from us until we collect from our customers. Remember this, your suppliers are having the same cash flow issues that you’re facing. They would like to receive their cash sooner rather than later. You’ve all heard of the company Home Depot they are located throughout the United States. They had sales of almost $79 billion, and they reported profits of over $5 billion.
Well back in 1985 sales had reached $700 million, and they were growing at a rate of over 40 percent per year. They were spreading stores across the southern half of the United States, and they were poised to grow north. Their problem was that they needed cash to finance their growth. The trouble was their cash from operations had been negative for the three previous years. They had borrowed over $200 million in the previous two years, and that was now all gone, and their stock price had dropped significantly in 1985, meaning raising cash through anequity issue wasn’t going to happen.
Conclusion
The lost farm
– We mentioned the James Herriot veterinarian stories in our previous discussion of poor record keeping and controls. – We’d like to tell you about one more James Herriot story, this one a cautionary tale. This story comes from the book All Things Bright and Beautiful. Now just a quick warning, there’s no humor in this story and it doesn’t have a happy ending. – Turns out a young farmer was fulfilling his dream of owning and operating his own small farm in the hillsides of Yorkshire. – He had worked for a number of years in the English steel mills, saving his money so he could buy his own place out in the country. – And even though he was a city boy he was making a good go of it.
With the initial investment of his life savings and with a bank loan he expanded milk production. – He even stretched the budget to squeeze out the money to build a new modern milk barn. He probably extended himself financially a bit too much, but he thought he could make it. – He built the walls, he poured the concrete floor himself, it was a proud structure. – Then disaster struck, his herd of dairy cows was decimated with a contagious bacterial diseasethat caused the new calves to die before even being born. – The cows themselves survived, but the young farmer had no new calves to sell and the milk production of the weak and sickly surviving cows went way down.
– In the end the young farmer could see that his reduced monthly income was not going to be enough to pay off his loans. – So he sold the cows, the barn, and the land for enough to pay off his bank loan and then he retreated back to his old job in the steel mills. – Back to the steel mills, working for someone else, minus the life savings that he had lost when he had had to sell his farm. – In the story the veterinarian James Herriot wrote how he used to visit that farm in later years, taking care of horses of the new owners. – The new owners used the proud little dairy barn built by the hands of the hopeful young farmer as a storage shed for grain for their horses.
– A grain storage shed, all that was left of the dreams of a young farmer, now toiling away in some steel mill somewhere. – The moral of the story a failed small business is not just a sign of the workings of supply and demand in the market. – A failed small business represents the lossof someone’s life savings. – And the loss of someone’s dreams. – You don’t want that to be you.This course is intended to highlight common mistakes made by new small business owners. – Let’s review the key points of the course.
Next steps
– So what should you do next? That depends on what you identify as your particular small business problem. Are you having trouble with poor records? Are you finding your financial reports to be uninformative or too often nonexistent? Then like it or not, you need to learnsomething about accounting. I suggest you take a look at our Accounting Fundamentals course in Lynda.com. Are you having trouble managing your cash flow? Are you always feeling cash squeezed with not enough financial capital to invest in the assets, information, and people that you need? Then you need to learn a little more about the field of finance.
You can get an excellent overview of the key concepts in finance in our Lynda.com course,Corporate Finance Fundamentals. Maybe you feel like you are operating your business blind.Your profitability seems low, but you can’t figure out why. Then you need some exposure tosome simple techniques of financial analysis. Again, I point you to our Lynda.com courseFinancial Ratio Analysis. Finally, remember that there are lots of qualified business advisers out there. Sometimes it makes some sense to spend a little money to meet with an experienced business adviser.
Describe your business, your plans, and your frustrations to this outside adviser. She or he can then help you sort through the weaknesses of your business to identify the things that you need to work on first. Small business are the source of creativity in an economy. A small business is a precious thing, the embodiment of a person’s ideas, energies, and ambitions. I salute those of you who have the entrepreneurial spirit and have started or are thinking of starting your own small business. I wish you great joy and success.