That’s one ugly hole
Every business starts with a hole. You invest money to start. Even the simplest business needs some kind of up front investment. This is the hole you start with. Every year you operate below cost adds to the hole. There is only one way to fill the hole………..Profit!
The problem I see over and over with new business owners is that they don’t understand the economics of the business that they have entered. They dig a giant hole and try to fill it back up with a spoon. They work like crazy trying to shovel as fast as they can…….with that spoon. And they can’t figure out why they aren’t getting anywhere. Or worse yet…….they never stop digging a hole.
So why are they using a spoon? Because they confuse revenue with profit and spending with investing. The classic rookie mistakes. “I’m making money” What they mean is that money is coming in……but how much is going out to make that money. “It takes money to make money.” Ok, but how do you get your money back?
Breaking even is about getting your money back. Otherwise you would be better off not starting the business. The only way to get your money back is to make a profit on your product or service……..not just make some sales. The rookie doesn’t understand whether they need 4 customers or 400 to break even because they think in terms of revenue rather than profit. But any time you aren’t covering ALL your costs, you are still digging your hole. You haven’t even gotten out the spoon yet.
The rookie justifies not covering costs by the classic phrase….”I’m reinvesting in the business.” Reinvesting only happens if you have had profit to reinvest……….otherwise, you are still investing (digging your hole). Maybe that sounds confusing. Or like a distinction that doesn’t really matter. But it is this difference that you need to understand to ever get out of that hole.
Let me try to explain. Let’s say that you invested $20,000 to start up your business. Maybe you took that money from your savings account, put the expenses on a credit card, or borrowed from your family or friends or maybe a bank. That is your hole, $20,000. Now you are up and running. You have some sales. Let’s say that you sold $10,000 but you had cost of sales and operating expenses of $12,000. You just added $2,000 to the hole. This is where people tell themselves that they aren’t making money because they are “reinvesting”. Nope. You just spent $2,000 more than you made. You are still investing (digging). I am using the term investing here rather loosely. Investing implies that you are expecting a return on your investment. Not just spending money. The idea is to get your money back. Now you have to make $22,000 to get out of your hole.
But if you had revenue of $10,000 and you had cost of sales and operating expenses of $8,000 you now have a profit of $2,000. If you reinvest the $2,000 in the business, then your hole is still only $20,000. You earned $2,000 that was then available for reinvestment. HUGE difference. The problem is that if you aren’t tracking your spending, it is impossible to know if you are investing or reinvesting. You have no way of knowing if your are digging a bigger hole. So that is your first priority………figure out if you are still digging, or if you are filling the hole back in.
Once you get to where you are filling the hole back in, you need something way bigger than a spoon. You need at least a shovel. Making a 5% profit after you have dug a huge hole isn’t going to get you out anytime soon…..maybe never. You need to aim for at least 10%. In his book, Simple Numbers, Straight Talk, Big Profits; Greg Crabtree explains why a 10% profit is the new breakeven……especially if you are trying to grow your business. You need profits to grow your cash to truly reinvest in things like inventory, accounts receivable or equipment.
Knowing your numbers is necessary to determine the point where you are making a profit. Knowing your cost to deliver your product or service will help you figure out if you need 4 customers or 400 to cover your costs. This is where I see things fall apart all the time. Rookies have no idea how many customers they need (or how much they need to charge) and often shoot way too low……….filling the hole with a spoon when they really need to use a backhoe and just knock it out.
It always takes time to get cash flow positive. But it may never happen if you aren’t clear on your numbers and get your revenue and expenses in alignment. The only way for your business to sustain itself is through healthy profit.
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