Operating Models

Different businesses adopt different business models in terms of strategies of pricing, volume and service being deployed.

• Walmart and McDonald’s have a Low Price, Low Margin, High Volume model. They sell products at a low price, their profitmargins are low and therefore they must generate high volumes(meaning they must sell a lot of products to a lot of people) toachieve profitability.

• The Ritz Carlton and Neiman Marcus have a High Price, High Margin and High Service model. Their prices are steep, but theyoffer exceptional service which requires high overhead costs. TheRitz Carlton will serve far fewer customers than a Holiday Inn,but they will make a satisfactory profit because of their highermargins.

• Most other models fall somewhere in between.

You must choose a model that best fits what you are offering and what your customers want. You also need to determine which key customers you will focus on. When you try to serve and please everybody, you end up not pleasing anyone.

Let’s look at Costco and Whole Foods to understand their models and financial performance.

For Fiscal Year 2014,Costco has annual sales of $113 billion while Whole Foods ismuch smaller, but still does a very respectable $14 billion.Costco prides itself in providing very attractive prices: hence itkeeps prices low, which result in a low Gross Margin of only 13%. Itmust therefore keep its Operating Expenses very, very, low at 10%. Thisleads to an Operating Margin of 3%. Because it has high sales / store, itsfixed asset / sales ratio is only 13%, which means that it generates $100of sales for $13 of fixed assets. Costco is an excellent example of a lowprice, low margin and high volume business.

Whole Foods provides high quality natural products at a relatively higher price. They earn a Gross Margin of 36%, but they also provide a higher level of service, which costs 29%, resulting in an Operating Margin of 7%. Because it has many smaller stores it needs $21 of fixed capital to support $100 of sales.

Both of these companies are profitable and do a good job meeting the differing needs of their customers. The point to be underscored isthat there are many ways to develop profitable business models.

Let’s look at one more example. Apple is mostly a hardware company, albeit an upscale hardware company. Its Gross Margin is 39%, but because it outsources most of its production, its Operating Expense is only 10%, giving it an Operating Margin of 29%. Microsoft, in contrast, is a software company with a high Gross Margin of 69% despite wasting a ton of money on its extraneous businesses. With its bloated bureaucracy, Operating Expenses are 37%, but this still delivers a very healthy Operating Margin of 32%.

One is a hardware company and the other a software company. Both find ways to serve their customers while making a lot of money in the process. The trick is to find the business model that will work for you, while deeply satisfying your customer.

Verinder Syal, Author:Discover The Entrepreneur Within

Understanding Costs

There are two broad categories of costs: Cost of Goods and Operating Expenses.

Cost of Goods is the cost directly related to the product or service. For example, the cost for a pair of jeans at Costco would be the cost of buying the jeans from the manufacturer plus the labor cost that was incurred in selling it to you.

Operating Expenses are the expenses beyond the above costs. For Costco, this would include advertising, utilities, accounting and legal fees, salaries for its buyers and management, leasing and other costs.

Subtracting Costs of Goods from Revenue gives us the Gross Margin. From this we subtract Operating Expenses to calculate the Profit (before taxes). A business must evaluate each element of cost and try to reduce it wherever possible while providing the level of service that it desires to offer.

 Capital Needed

To start a business, you will need Start Up capital before you have even made your first sale. Money will be needed for several things and this list will vary by type of business. Items may include costs to develop your product, legal and accounting fees, marketing help, website development, getting patents, etc. The business itself may need to be underwritten for some time before it becomes profitable. Additionally, you might need to hire a call center to handle customer inquiries and support. Think of these costs as start up costs.

Once the business gets rolling there are two other key needs for capital.

  1. Working Capital: This is the money that is needed to run the day- to- day business. There are three key components: Receivables, which is money that people owe you, Payables, which is the money that you owe others and Inventory, which can be in theform of finished goods or raw materials.

Let’s start with Receivables. Assume you are a small winery selling to wine distributors and you have to give them 60 day terms, meaning they will pay you 60 days after they receive the wine.(These terms are negotiated between the parties, but size and industry practices often determine such terms.) This is a Receivable on your book because the money is owed to you and you anticipate receiving it.

In turn, you have to pay your suppliers in 30 days for the glass bottles and the grapes you buy from them. This becomes a Payable on your books.

In addition to this, let us assume that you will need to keep 1000 cases of wine in Inventory to be able to fill the orders as they come in. This too will cost money.

In this example, you will receive the cash from receivables in 60 days, but you have to clear up your payables in 30 days. Hence you will need money to fund this gap. In addition, you will need money to fund the inventories that you stock. These are the three main things you will need to monitor and fund on a day-to-day basis. This is called Working Capital.

2. Fixed Assets: You also may need to buy equipment such as computers, cars and perhaps even land to build the winery. This capital is called Fixed Assets.

Admittedly, these components have been simplified, but by and large they are adequate to understand the concepts we are discussing.

Verinder Syal, Author: Discover The Entrepreneur Within