Model Behavior

Details, Details

Your business model describes how your business goes from preparing your product or service to delivering it to your users, and how many of those transactions you need to execute to keep up with your operating costs.

You must include these details when creating or reformulating your business model:

1. Suppliers and the average price of your company's goods

2. Labor costs per each unit your company produces

3. Selling price and the resulting gross profit margin

4. The amount your business needs to ship weekly to break even

5. Your company's annual output and the break-even point as a percentage of total capacity

A strong business model identifies who is buying your product or service and why they choose to do business with you as opposed to your competitors. It then offers a clear rationale for why buyers will pay the price you're charging (say, $50 per unit).

Once you give solid reasons for the buying decision, you need to report how many sales per day you make. If you say daily sales activity averages 250 customers (5,000 each month), then the revenue component of your model at $50 per unit is $12,500 each day. This metric has to make sense with respect to the scale and scope of your operation.

Next, you clarify your labor and materials costs in relation to your expenses. Perhaps your labor and materials costs for each sale are $28, leaving you with $22 per sale in gross profit, a 44 percent margin. If your overhead is $85,000 a month, that $22 profit margin needs to happen about 3,860 times every 30 days to break even with your fixed monthly costs. So the model now rests on whether you have the capability to do that kind of volume. If so, you have a sustainable business model where the first 3,860 customers each month cover all your costs, and the next 1,140 contribute $22 each ($25,000) to your pretax profit.

Take a look at this example of a poorly-thought-out business model: You have a "cool idea" that costs $60 in labor and materials to manufacture, and overhead runs $100,000 per month. You might believe a price of $75 will draw potential buyers, but with a $15 profit margin, you'll need to sell nearly 6,700 units every 30 days--and right now you're doing business at an average rate of less than 125 customers per day. These metrics don't work.

Or maybe you project a price of $100 (a 40 percent margin), which would drop your monthly volume point to 2,500 units. The problem is, there's no way to sustain that price-point given the competitive environment. In both these cases, the numbers don't add up, and the business model is not sustainable. There are many cases where entrepreneurs have come up with poor business models where the volume needed to cover monthly fixed costs would have to be 75 percent of the overall market share. Again, that scenario is unreasonable, and investors won't support it.

David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.

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This article was originally published in the March 2002 print edition of Entrepreneur with the headline: Model Behavior.

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