Know Your Numbers: Business Math for the Non-Math Whiz
July 03, 2018
Knowing your numbers is one of the most important aspects of starting and running a business. As tempting as it is for some of us to just feel things out or give only momentary attention to the numbers, this is a mistake. The good news is that you don’t need to be a math whiz to know and understand your most important numbers and what they mean for your business.
First, realize is that not every number matters to every business in every industry. For instance, if your business is service-based and not physical product-based, you won’t need to worry about shipping costs, so that’s not a cost you’d factor in. There are, however, some calculations that every company must make, because they matter across the board.
Identifying and Calculating Critical Startup Numbers
Pricing. What is the appropriate price point or pricing matrix for your product? Many entrepreneurs make the mistake of just adding a little bit of cushion over the material or other obvious costs of creating a product, without factoring in all the other less obvious expenses, the market, and the value their innovation brings to customers.
Here are the 3 main pricing strategies, and their pros and cons:
Cost-based pricing: This, as mentioned above, is where you calculate your price by adding a percentage or flat amount on top of your costs. The benefit of this pricing model is that it’s simple and straightforward. Say you determine that, all told, your product costs $100 to produce, maintain, support, etc. and decide to make the cost of it 50% higher ($150). Easy, right?
Not so fast! The problem is that this strategy misses a lot of value. Even when you do fully take into account all of the costs involved (not just production or maintenance), you still don’t factor in the market, consumers, or competitors. Saying you want to make 50%/$50 on every product you sell is great, if the market will support that. If the products you’re competing with are all priced at or around $100, then you have a problem because few people are going to jump to buy your product instead of a comparable, less expensive one. Similarly, if similar products are being sold for $200 across the board, you might have trouble convincing customers that your product is just as good as those that cost $50 more.
Competition-based pricing: Using this strategy, you’re looking much more at what the other companies in your space are doing and setting your pricing either below or above theirs (depending on the specific kind of benefit you want to communicate — savings or quality). The plus side to this kind of strategy is that it does take into account the market and what people are already paying for products similar to yours, and it’s easy enough to compile data about the competitors you want to use as benchmarks.
But, just like cost-based pricing, this option also misses some value. Surely your product is slightly different, and therefore offers slightly different incentives, than that of your competitors (or else why are you in business, if you’re just copycatting?). You miss the nuances of that and what it could mean for your revenue potential when you only look at it as strictly competing on the basis of the price tag the customer sees.
Value-based pricing: This strategy involves looking at the unique value of your specific offering, both for your customers and for your company and basing your price on that. It’s the preferred method of determining what your pricing should be, but it’s the most difficult to calculate. To come to this number, you’ll need to bring together 2 separate figures:
Price of the next best alternative to your product + Value of your product’s differentiators from the “next best” option (additional features, lighter weight, longer lifespan, etc.).
Let’s imagine you’ve created a gadget in the wearables space. The existing products most like yours are priced around $250, but yours is 10% slimmer, half an ounce lighter, made partially of recycled materials, and has 2 hours of extra battery life. You’ll need to figure out what the added value of those improvements is worth to your customers, which you can do using focus groups or surveys/polls. If 80% of people you poll say they would pay an extra $50 for a product that did all or most of the additional things yours does, then pricing at $300 is not a stretch.
The next number you’ll need to look at is your Gross Margin. In simplest terms, if your company has a single product (which is the case for most startups), Gross Margin represents your revenue minus your production costs (materials, manufacturing, etc.). Many companies mistakenly think this figure represents “profit”. In fact, you still need to account for many expenses (staff salaries, building rent, marketing and other spend) in order to actually understand what you’re left with when all your bills have been paid. For example, the average Gross Margin for companies in the apparel (clothing) industry was close to 50% in 2017, but their Net Margin (aka Net Profit or Net Profit Margin) was only 3.43%, according to data collected by NYU’s Stern School of Business.
Once you’ve got a handle on your Gross Margin, you can calculate your Break Even Quantity (BEQ). This figure will be the number of units you need to sell of your product, in order to not be operating at a loss when you’ve factored in all of your startup costs and Gross Margin. Once again, we’re not yet talking about profit, but just staying out of the red.
Startup costs include everything from getting off the ground with manufacturing or coding, to forming your legal entity, to initial marketing spend at trade shows. Some costs will be fixed, while others will be variable. To calculate BEQ, use the following equation:
Fixed cost / (Price per unit – Variable costs per unit) = BEQ (in units).
Say your total startup costs (including setting up production, rent for the first year, legal and financial setup, etc.) amounts to $100,000. If you price your product $40, and it takes $20 to produce and market, each one, then you’re looking at $20 in “profit” from each individual product. You then divide this into $100,000 and find you need to sell 5,000 units of what you make in order to break even. You can also plug your numbers into an easy online calculator.
Using your Numbers – Revenue and Financial Projections
Once you know your BEQ, Gross Margin, and have a Pricing strategy in place, you can use these three numbers to make financial projections and understand your startup’s revenue potential. That, in turn, should inform your overall business strategy.
Don’t be afraid to play around with these three figures to determine how you might get more out of them. Look at what happens when you raise the price (your BEQ should go down). But that’s not your only option. Many startups (and full-fledged businesses) make the mistake of thinking that if their numbers and projections are turning out unfavorably, their only recourse is to raise prices, make it the customer’s burden. But this is a limited (and limiting) view. Here are a few other things you might consider to bring your numbers to a better place:
- Lowering your overhead. Do you need a full-time marketing person/team, or can you get by with hiring someone part-time to do a little blogging and check in on social media at the start?
- Less expensive production alternatives that won’t compromise quality. Can you find a different manufacturer that will give you comparable turnaround and quality but costs less?
- A larger initial investment. Consider whether one or two more investors might bring you to a point where you don’t need to worry
Once you have your numbers in balance and you’re steady on your feet, you’ll want to start projecting how slowly or quickly you’ll be able to hit your milestones and reach your optimal state of operations over time. It’s important to understand your top numbers and their interplay well by this point. As you begin to grow, you’ll spend more on marketing and customer acquisition, so get to know what that will mean. Certain costs will shift and vary over time, so make sure you’re budgeting well and checking and adjusting projections as needed.
For instance, customer growth numbers, strategies, and spend will vary over time. At the start, you’ll likely take a bottom-up approach, wherein you’re capturing end-users of your product directly, and therefore you’re spending on things like content marketing, social media, and anything that gets the word out without costing a ton. This is in contrast to a top-down down approach, where you’d be selling to large entities by convincing the key decision makers who then buy however much of the product is needed for everyone at their organization. That comes with costlier strategies like having a sales team, advertising, PR, and more. Some companies use a bottom-up approach for the life of their businesses, because it works best in their industry and for reaching their target customer. But some do find the need to shift as they grow, as top-down may be more conducive to scaling and rapid growth.
When you’re forecasting, it’s crucial to use the right tools and methods for the data you have on hand. Even though some forecasting models may be more accurate and nuanced, any model you use is only as good as the data you have. You can’t get very granular and super accurate projections with the wrong kinds of data, and it may be too tedious and time-consuming to gather what you need for that perfect forecasting model. Early on especially, it’s better to get rougher forecasts using the data you do have, than to go scrambling for what’s not readily available.
While all this may seem daunting, especially if math isn’t your best friend, there are lots of templates and calculators available online to help you get a view into your costs, both at the startup stage and beyond. There’s a very simple startup cost calculator Entrepreneur and a more in-depth one from Business Know-How. Finally, SCORE has a great and thorough template you can download.