How much is enough?Growth Strategies — By Jim Lane on December 19, 2012 at 8:00 am
Fifteen percent. That’s enough. Well, that’s enough if you don’t start really questioning the challenging issues. But I’m getting ahead of myself.
Let’s start with this simple question: How much should my business be earning so I can be happy with it?
You experts out there might consider this more challenging question: What should my return be?
Recently, I took a rigorous (by Internet standards) look at Apple’s pricing and explored the power of the company’s approach, and its impact on its own strength and the strength of its competitors. Here, I want to look at what you have to cover with your price and what that means about margins.
Everybody understands, I hope, that you have to charge enough for each piece of fruit you sell from the fruit stand to cover the cost of purchasing the fruit. That is a direct cost. It is easy to determine because you can see the apple you’re going to sell.
Less obvious are direct costs that you can’t see, such as labor. Not only must you charge enough to cover the cost of the apples, but you must cover the cost of the time to wash and prepare each apple for sale. What you pay your apple preparer −whether that’s you or someone else− is also a direct cost. There is a little time, and therefore expense, required to prepare each apple.
But that’s not all.
You must also add enough to the price to cover indirect costs, such as the cost to sell and the cost to purchase and maintain your apple cart. They are not assignable to individual apples. A single cart can be used to sell many, many apples.
Similarly, if you employ someone to sell the apples, they can sell more than one apple at a time. So each apple you sell has to pay for the apple itself plus the hourly wage of your apple cart vendor, some portion of the cost to maintain the cart, etc.
But that’s still not all.
Assuming you want to grow your business, each apple sold must produce enough cash to pay for the next apple cart you want to buy. Otherwise, you must borrow money to buy that next cart and pay interest on the money. If you pay for it yourself, you get to keep the interest as profit. In Apple’s case, each iPhone pays for two iPhones to be built or an iPad or a Mac. The power of this idea cannot be understated for Apple.
But that’s still not all.
The final piece is you have to account for the unexpected. Shocks happen. For those of you who entered the workforce in the first decade of this century, you probably understand that shocks happen: Katrina, the economic downturn, Sandy. Life is full of surprises.
For the rest of us, I suggest you think in terms of this being the new normal. Most of my career was an abnormality in terms of how driven the economy was. Throughout most of history, this has not been the case and I believe we can expect a return to the mean here in the next few years.
So our apple cart has to produce enough profit that we can afford to repair our carts when the flood comes. Or replace an entire load of apples if one is stolen at gunpoint. Stuff happens and we need to include the cost of stuff in our pricing before it occurs, in little doses. After the flood, we can’t triple the price of apples to pay for the lost cart. People won’t pay it.
So that is all.
We only have to pay for the apples, our labor, our equipment, and a little bit for the inevitable shock. Common wisdom says that’s about 15 percent at the end of the day. You need to net 15 percent (savable in the bank after taxes and everything else).
Why 15 percent?
Historically, that’s been about enough to weather shocks and build some capital to enable continued investing in the business, etc.
How much is that?
It’s about half again as much as the average McDonald’s franchisee produces, according to some estimates.
In all likelihood, company-owned McDonald’s restaurants and higher performing franchises probably hit, and maybe exceed, this mark. New stores and underperforming stores probably pull the average down. So maybe the number should be higher than 15 percent if you want to be a top performing McDonald’s. It’s higher in another industry and lower in plenty of others.
But what should my return be? That is the real question.
So far, we’ve been looking at what your business should produce; we’ve ignored the larger question, Should I even be in business?
Assuming for a moment that you are in business as an investment −which is not the only answer to the question, Why are you in business?− then ask, What can I get for my money elsewhere?
Can you get a better return in another business? Should you sell your McDonald’s and purchase another better performing one? Or sell out completely and put your money in gold?
This question must be taken on from the investor’s point of view, which allocates capital among investment alternatives to produce a return.
If it costs $5,000 to purchase apples and a cart, and pay the vendor’s salary for one month, should you start the apple cart business or could you produce a better return by purchasing stock in another company?
If the apple cart earns 15 percent, you could expect to keep about $62 each month. Would you get more from another investment? How fast is gold appreciating? How fast is the stock market rising (or falling)? Are there companies that would pay more in dividends than this? And what interest rate would a bank give me if I lend it to them in the form of a savings deposit? (Not much right now.)
The operational question is, Am I producing 15 percent net profit from my business?
The strategic question is, Can I improve my prospects by allocating my investment differently? Should I sell this business and buy another or reinvest in this business to grow it because I can’t produce this sort of return elsewhere?