As an entrepreneur and investor I am constantly analyzing what it takes to be successful for all types of businesses. Though this number is probably overstated, it has been said that 90% of all businesses ultimately fail. The sad part is many of these failures could have been avoided if the entrepreneur had just done some “simple math” prior to taking the leap of faith.
So what is the simple math every investor and entrepreneur should consider?
First, start with how much you want to make? Though the entrepreneur is usually the last to get paid, it’s important to understand the expected return on your time and investment. Once you know the expected return you can determine what it’s going to take to get there and whether this amount is realistic.
Let’s pretend you are considering opening a local clothing store. Typically a well run retail businesses generates a profit of approximately 10% of total sales. If your goal is to make a profit of $50,000 you will most likely need to sell at least $500,000 in products.
Once you have an idea of how much you need to sell you can do some simple math to better understand what it will take to get to these sales and profits.
Let’s consider sales volumes. Simple math says you must sell 5000, $100 products per year to generate $500,000. Average dress $200? That’s only 2500 dresses per year! This equates to just over 200 monthly, or approximately 8 dresses per day. If you are selling $20 t-shirts this sales volume goes to 80 a day!
Whatever your combination of shirts, pants and dresses, you must determine if the market is big enough to support the volume. Is it realistic to think you can generate the level of sales in the specific market at the specific location? This simple math will help you determine if this is possible or not.
On to the profits. Why do you only keep approximately 10% of the $500k as profits? To begin with, more than half is usually paid to suppliers. An average gross profit margin for retail is approximately 35% after sales and discounts. Jewelry stores typically operate at a margin a little greater and bike stores a little less. Know your market and adjust accordingly.
Simple math indicates of the $500,000 in sales, only $175,000 (Sales minus the cost of goods) will be left to pay expenses. Thats a big chunk of sales before you even get started paying expenses.
What about expenses? One of the biggest and often underestimated expenses is personnel expense. Whether full or part time, you will most likely need some help. A factor of 10% of sales would be a minimum and it could be as high as 15% or some cases even 20%. At a minimum, $50,000 per year is a good estimate for this business.
Important note- don’t underestimate the amount of help you will need- at some point you will want to go home. Also, include family members time in the equation because if they aren’t working for you they could be working somewhere else.
Another big expense is rent. At a rent factor of just 6% of sales, rent will be $30,000 per year. Phones, operating systems, utilities, insurance, supplies and other operational expenses will equate to at least another $25,000 per year. Marketing on Facebook, in store events and sponsoring a couple of local organizations would equate to approximately $1200 per month or $14,400 per year.
All together these expenses add up to a total of $119,400. Subtract this from the $175,000 in gross profit and you have a profit of a little over $55,000. Your estimates exceeded your target! But remember, these calculations don’t include theft, products that don’t sell and other unexpected expenses. Nor does it include startup cost like fixtures, store buildout and needed equipment like computers and credit card machines.
I realize this is simplified and revenues and expenses can vary greatly. Regardless, it is imperative you consider these calculations for your line of business. One great thing to do once you have made some assumptions on your particular business is ask other people in your industry, trade organizations or even suppliers to see if your assumptions are legitimate.
Even if your numbers aren’t perfect, don’t fall into the trap that business plans are a waste of time. A realistic sense of what it is going to take to reach your goals is an absolute must. At the least, answering a few simple math questions will help you make a wise decisions when you start or invest in your next business.