Sunday, October 2, 2011

Spending it, not saving it.

So I had a 30% increase in revenue last month, above what I expected.

I turned around and spent every bit of it on more product. Not only that, I borrowed from next month's budget to buy even more.

Before I explain why I did that, I want to throw out a couple of precepts I follow.

A. Demand is not (mostly) created by a single small business.

B. It is easier to lose money than to make money.

Precept A.) This can be argued. What do I mean, small businesses don't create demand?

In my opinion, in most cases Demand comes from larger societal and cultural forces. Sure, there are exceptions. Small businesses who through dent of effort and knowledge and interest and space and time are able to create demand for a product that isn't in demand elsewhere. In fact, probably every small business has one or two items where that is true.

As often as not, this demand creation isn't terribly cost efficient. The store creating the demand either isn't realizing or doesn't care that the amount of effort, time, space and energy they are expending to create that demand is zeroing out the benefits of that increase.

If there was one thing I'd like to get across to beginning businesses, it is to remind them to accurately weigh the actual costs of all the extras they throw in; time, space, energy -- weigh these things carefully and put sufficient importance on them.

Mostly we small businesses are riding the waves, reacting to the ebbs and flows of demand, rather than actually creating demand. For instance, nothing I can do to try to create interest in DC comics will equal all the publicity and demand that DC New 52 has created.

In most cases, if demand is sparse for a product, it will stay sparse no matter what you do. Sure, you can have Sales. Or you can buy more inventory. Or advertise more. In fact, the temptation to do those things to create demand is pretty overwhelming.

It is almost always a mistake. It's building sand castles to hold back the ocean waves. Best to adapt to the 'real' demand; move on, try to sell something else.

Lowering prices or increasing stock or spending money in the face of low demand usually has the effect of pushing a wet noodle.

However -- and this is completely different -- when you see demand increase, you can have a major influence on that increase. By adequately servicing that increase, you can push the increase even higher. You increase inventory and space and energy and time and all the rest to keep that demand going.

You do this to PUSH UP SALES.

Which brings me to: Precept B). It's easier to lose money than make money.

To illustrate this, I'm going to throw out some simplified figures, which are made up, but which accurately reflect the percentages of the actual figures.

Let's say you have a store that has 6k in overhead, and 50% margins. This means, this store has to sell 12K a month to break even.

Let's say, that for six months, you have an increase in demand. Say, for the first month you make 16K.

There are three options.

1.) You take the 4k extra and spend it on yourself.

2.) You spend 2K to replace the inventory and save the other 2K.

3.) You spend all 4K in extra revenue on more of the in-demand product.

Let's look at those three options.

Option#1 sounds great. Woo hee! 4K in profits. Let's spend it on a downpayment for a new car. I've always wanted that Hawaiian vacation!

However, your store now has much less inventory and chances are you'll enter a death spiral; less product= less sales, less sales=less product. You've taken that increase in demand and put a stake through it's heart.

Obviously, I've never done this.

Option #2. This is a much better option, and most people would think it the prudent way to do things. But if you do this, you are only servicing demand, you are not helping increase it.

Let's say you do this for six months. Sales stay at the 16K level, and you've saved up 12K in emergency money.

Sounds good, right?

Option #3 sounds rather foolish in comparison. Spend it all?

But let's say you spend all the extra profits on product for six months, and at the end of that period of time, you've increased sales to 18.5K a month. You may have no extra money, but you have more product for sale.

Remember what I said about ebbs and flows? At least in my store, I've learned that what goes up goes down. You're humming along, and suddenly Costco is selling sports cards cheaper than you can buy it. You're selling the hell out of something, beanie babies, pogs, and suddenly, overnight, everyone loses interest. You're having a damn good decade, and suddenly you face the Great Recession.

So let's go back to those original figures.

6k in overhead, at 50% margins, requiring 12K for break-even.

Under Option #1, any decrease in sales and you're simply dead.

So let's look at Options #2 and 3. Which is wiser?

Most people would pick Option #2. Save the money.

But I would argue for Option #3.

Remember that 6K in overhead? Within that 6K in overhead, let's say that you pay yourself 2500.00 a month. As long as you are protecting that 12K sales level, you can pay yourself every month.

So what happens with a massive downturn? Let's say sales suddenly drop by 25%.

Under Option #1, bye bye, adios, too bad, so sad. Hope you enjoyed your Hawaiian vacation. You can always try to sell your new car for a loss.

Under Option #2, you drop back down to 12K, which is your break-even point. However, if you drop even the slightest bit more than that, you can rapidly use up that 12K in savings. In other words, it isn't the best idea to hover at your break-even point. Too easy to get pushed off the cliff. You have to be ultra careful, ignore risky opportunities --not a great formula for health.

Under Option #3, you drop to roughly 14,000.00 a month in sales. Still comfortably above your break-even point. You have time to adjust, you can cut expenses, or live off all the extra inventory you bought while things were going good. You live to fight another day -- not just surviving, but actually having resources to respond to conditions.

So it's best to get your sales level as high as you can get it, so that you have a cushion to fall back on.

Best of all, you protect that 2500.00 a month that you live on.

Given these options, I will always choose to push demand when the opportunity presents itself.

Let me repeat: It is easier to lose money than to make money.

If anything, I've soft-pedaled the reality of the ebbs and flows. Downturns quickly eat up savings, but if you've built up enough of a sales cushion by pushing demand, you can avoid having to dip below your break-even point.

Under Options #1 and #2, in the face of a drop in sales, you have to respond with a lower level of inventory, so chances are that 25% drop in sales for option #1, might be more like 40%. That 25% drop for Option #2, might be more like 30%.

But your drop in sales for Option #3, where you have brought in sooooo much more inventory -- it might only be a 20% drop.

Compound those differences for any significant amount of time, and the paltry savings you might have made under the first 2 options can quickly disappear.

You run a small business.

Take modest profits.

Spend the rest of it strengthening your business.

Over the course of a career, you might actually earn significantly more money than by earning big profits for a few years.


Duncan McGeary said...

Man, that was wonky and a lot of work, but it might help someone out someday....

RDC said...


Aren't you making the somewhat sketchy assumption that increasing the inventory automatically results in a similar in sales.

If that is true then when the sales dropped the person could use the savings to increase the inventory at any time by whatever he needs to keep the 12k in sales.

You neglected option 4 all the moeny goes into increased inventory but sales remains at 12k. Then when you get the drop you have all your money tied up in inventory and no reserves. In which case you didn't even get the vacation.