Download invest that dollar? spend smarter with

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.
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