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SHOULD YOU INVEST THAT DOLLAR? ? SPEND SMARTER WITH MARGINAL ANALYSIS Many small business owners are gearing up to increase their capital spending in 2014. But how do you invest back into your business to ensure you get the most value for your money and drive new growth? Small businesses looking to expand often need to spend money – on capital equipment, real estate, inventory and labor – before they generate any additional revenue. Whether small business owners pay for these expenses with cash flow from existing operations or borrowed money, they need to spend as efficiently as possible. Their returns depend on their ability to generate the most revenue for the lowest cost. ? “MARGINAL THINKING” is central to making these decisions effectively. When considering expansion, instead of focusing on average costs and revenues, look at marginal ones – the costs and revenues that come from purchasing an additional piece of equipment or hiring an additional worker. LET’S SAY YOU RUN A PIZZERIA. Unfortunately, your current production rate has reached its maximum and you’re losing customers to competitors due to lengthy wait times, although you know that if you produced more pizzas, there would be sufficient demand for them. While the strong demand for your product has you considering adding new equipment to boost production speed or volume, there are several factors you need to evaluate beforehand. The decision to expand shouldn’t be based on your overall profit margin—it should be made on the marginal cost of obtaining new equipment or staff and the marginal revenue that these additions will generate. FOR EXAMPLE If you sell 100 meals per day, at an average price of $15, $1,500 in daily revenue, but your total costs—including raw materials, rent, utilities, advertising, labor, insurance and equipment—reach $1,500 per day, your profits stand at zero. 100 = 1,500 $ MEALS PER DAY DAILY REVENUE LE $ PE AS E 20 FO R RD AY ! You might discover that a new oven would be perfect for your business and it leases for $20 per day from a local restaurant supply company. Adding this second oven won’t change the cost of your rent, advertising, insurance, labor or equipment; and your utilities will only rise by $5 per day. In this scenario, the marginal cost of the new oven is only $25 per day. $ 15 $ 15 As long as you can sell two additional plates per day at $15, leasing a second oven makes financial sense because the $30 in marginal revenue will exceed the marginal $25 cost. IN REALITY The margins for investing in new equipment are typically much wider. If one additional oven could produce as many as 130 more meals per day and there is sufficient demand for that increased supply, marginal revenue from adding an oven would be $450, while the marginal cost remains $25. 130 = = 450 $ MORE MEALS PER DAY NEW OVEN MARGINAL REVENUE IT’S IMPORTANT TO AVOID MAKING SOME COMMON SPENDING MISTAKES. Many growing small businesses overestimate how much added demand they will need to meet. Purchasing an oven that’s too large and buying an excess of inventory that will go into meals that won’t be purchased is an inefficient use of available funds. Companies should extend their marginal analysis toward each set of potential new clients to identify the profit potential in every incremental stage of growth. This constitutes marginal forecasting, and is a necessary step in understanding profit maximization. PROFIT POTENTIAL PIZZA POTENTIAL NEW CLIENTS MARGINAL PROFITS In some cases, adding X number of customers may introduce additional costs per customer that exceed the value of purchasing new equipment or hiring new staff. To prevent this, analyze your company’s demand and cost conditions to determine marginal profits. Marginal profits are greater than zero for all levels of production up to a certain maximum, so you should invest in equipment or new hires that will push output to the maximum level. PRODUCTION LEVELS Most companies have to invest in order to grow. By performing a marginal analysis on each individual investment you hope to make, you can determine exactly how much you can, and should, spend on expansion. IF THE SPENDING MARGINS SEEM FAVORABLE, BUY THAT NEW OVEN AND HIRE THAT NEW CHEF. Scott Shane has written extensively about entrepreneurship. His book, Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By (Yale University Press, 2008), was one of the top ten business books of the year for Amazon.com. Shane was the 2009 winner of the Global Award for Entrepreneurship Research, the most prestigious award in this academic field. He also writes regularly for Bloomberg BusinessWeek, Entrepreneur and Small Business Trends. Disclaimer: See individual products for pricing. Inclusion in this article does not mean American Express endorses non-American Express products. © 2013 American Express Company. All rights reserved.