Most business owners underestimate the importance of understanding the economics of their business model. In the same vein, most overestimate the number of factors that impact their model. When an entrepreneur understands their business model, they can truly start to implement impactful business strategy.
This conversation can get more complicated for businesses with excess of $20 million in revenue (this article isn’t for you). But for smaller businesses, most succeed by being really good at a few things. Being a “one-trick pony” can have its’ benefits to a certain point.
When breaking down a business model, there are 4 distinct areas to understand – revenue channels, cost of customer acquisition, fixed operating costs, and direct sales costs.
Working with my clients, I discuss with them “levers”. What levers can they pull in their business to impact results? When you break a business down in this manner, it becomes easier to make decisions.
I talk a lot about strategy with business owners. The impact of strategy is amplified when an owner considers the levers that drive their business results. Understanding these levers and the inputs that factor into them can often go a long way in driving profitability.
Why These 4 Areas
Every business is different. However, there are typically 4 impactful areas for all small business owners.
First, businesses must determine how they will sell their product or service and to whom they will sell to. It is assumed that for a business to stay in business, its product or service has value. Once that bare minimum credential is met, who or how does this business strategically sell its product or service?
Next, each business will have a cost to acquire a customer. In plain English, they must create as many customers as possible with their marketing. The acquisition price of customers is crucial because it can drive strategy around building repeatable customers, profitable channels, and pricing.
The direct sales costs are variable. How much does it cost each time you sell your product or deliver your services? This can be somewhat simple for products – how much do the products your selling cost? For services, how much do you have to pay in employee and supply costs to deliver your service?
Last is fixed operating costs. These are the costs it takes just to “open the doors” daily. These are often referred to as fixed costs. As a business grows, fixed costs typically grow disproportionately. This can indicate a yellow flag. There can be good reasons for this disproportionate growth, but it can also indicate waste.
Understanding these four factors and the different levers that can impact each is vital in developing business strategy and growing the top and bottom lines on the income statement.
Revenue Channels
For this discussion, the definition of revenue channels is most likely different than the traditional one. For our purposes, a revenue channel is a way sales are made with different customer acquisition costs or direct sales costs.
Let’s review an example. One of my clients is a group of day spas. While they offer different services (massage, facial, massage add-ons), we decided to look at their business model by customer types. Specifically, we broke their revenue channels into new vs. returning customers. Why did we do this?
First, we knew that the pricing structure for services was universally developed. In other words, our pricing structure was mostly based on the time to perform the service and overhead.
However, our big differentiator was the cost of customer acquisition. Almost 100% of our marketing and advertising costs were aimed at generating new customers. The only marketing to prior customers was mostly emailing newsletters and specials. The only cost for this was someone’s time to write the emails and the email service itself.
Armed with this, we could calculate how many customers were new versus returning and how much each type typically spent.
Customer Acquisition Costs
Marketing and advertising can hurt or help a business. More money is wasted in marketing than in any other area of business. On the flip side, good marketing can be a huge driver for a business.
There are two elements to customer acquisition costs. How much does it cost to acquire a customer at the most basic level? Once determined, a business can play with its’ “marketing cocktail” to decrease customer acquisition cost. A business can also benchmark itself to determine if its marketing methods are more or less efficient and effective.
ChatterBuzz recently put a median estimate of customer acquisition at $45.27 using Google Paid Search. That means that you may be in trouble if you are acquiring customers at $45 but only selling them a $30 service. To make those economics work, your customer must be using your service 3-4 times for you to be profitable.
Let’s put some strategy behind this. What if we start looking at other marketing methods that drive that cost down to, say $25? How does that affect revenue?
I always use the phrase “build a better customer” with my clients. Essentially, I am saying how do we get customers to return to our business more than they currently are? What if we start allocating more funds to increase recurring customers? How can we tell if that is working? Knowing your business model in this manner will help answer those questions.
With our day spa client, we determined that almost no costs were spent on “building the better customer”. Almost all marketing and advertising was to generate new customer business. As a result, the first time a customer walked in the door cost $49. The second time, it cost almost nothing. The profit for first-time customers was only 6% compared to 43% for repeat customers. Do you think this determined some of our strategies in the future?
Direct Sales Costs
Every service or product has a cost associated with it. With a product, this can be somewhat simple. I stress the word “somewhat”. Often, most costs associated with selling a product are the costs of that product itself. However, other costs can be significant. Merchant fees can be 3% of sales. Shipping, if applicable, can represent up to 15-18% of sales.
Determining the direct costs of services can be slightly more complex. You still have supply costs (for example, our day spa client had to buy lotions and other materials). You also many times still have merchant fees. However, the main direct sales costs for services are typically labor. For our day spa, this was the employee time for the people performing massages, facials, and other services.
The cost of delivering services for our day spa typically didn’t change much, whether it was the customer’s first or second visit. This won’t always be the case. For instance, many business models lose money on the first customer experience because the follow-up visits will be much more profitable. Think about a pest company that does extra work to set up a new client but just does maintenance work after that.
Knowing this cost allows small business entrepreneurs to increase their profitability. They can do this primarily through two methods: decrease costs or increase revenue.
Margin creep is a real thing. Most small businesses I work with are terrible at increasing their prices. This isn’t just my clients – small businesses are notoriously bad at increasing prices. However, when you know your business model, you can make adjustments if you see margins start to shrink.
Fixed Operating Costs
When I start working with clients, the first desire they often tell me about is cutting costs to increase profits. This is understandable – cutting costs is seemingly one thing that is firmly within their control. However, most small business owners are relatively good at limiting waste in their businesses. They often feel bad about that meal out with employees or that software that is a little expensive. I explain that eliminating these items often doesn’t add up to what they think.
Don’t get me wrong, I have walked into businesses and helped them cut thousands of dollars per month. However, this is typically the exception to the rule. Most small business entrepreneurs are thrifty.
Fixed cost often has a different importance when it comes to your business model. Fixed costs often determine the amount of revenue needed to be profitable. To get this concept, let’s first determine a fixed operating cost. Fixed costs are expenses incurred regardless of the level of revenue achieved. Good examples are rent, software, insurance, utilities, bank fees, and others. Sure, insurance and utilities may be slightly variable based on revenue, but not significant enough to change the other factors in your business model.
For our group of day spas, we knew that we had fixed costs between $11,500 and $13,000 for each location. We determined that based on our historical customer mix, we had to have approximately 250 customers before we could start to make money.
Putting it All Together
We just scratched the surface by giving examples of where strategies could be implemented by knowing your business model. However, as you can see in just a few short examples above, looking at your business this way can drive decision-making.
All business owners want to spend time on things that matter within their business. Most want to know they are not wasting their time. As a business owner yourself, I am sure you have spent a lot of time on a project that ended up not being that important. Using this method to help determine strategy may not prevent that in the future, but the chances of spending time on a bad project decrease.
The math and logic of putting this analysis together may feel overwhelming. However, the simplicity of looking at a business this way should be refreshing. Breaking things down in a structured manner gives business owners a valuable tool for determining real action steps to take.
Krieger Analytics Can Help
Running a small business can feel overwhelming. When analyzing business strategies, it can be good to have a professional at your side. Our CPAs at Krieger Analytics are trained in analyzing markets to determine which steps you should take to grow your business. Whether you need an accountant to get your business off the ground or if you need a CFO to help you get back on track, Krieger Analytics has someone for you.
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