Why Some Businesses Make an Easy Profit
Every project manager is familiar with the "Fast, good, cheap. Pick two." conundrum. This question is not only ever present in projects, but in business, too. Why does it appear that some businesses cash flow like crazy, while others struggle to stay afloat, let alone grow? It’s easy to discount entire industries ("Running a restaurant is a terrible business!"), but that’s an easy fallacy to fall into. Some types of business have a more difficult path to sustained profitability, but it’s often the operator themselves who makes running the business unnecessarily hard. So what is going on?
Developing a Sound Business Model
While some entrepreneurs start out with a crystal clear thesis on how a business will generate profit, others develop their business model organically. Business plans often get a bad rep, but the importance of formalizing a solid business model is seldom disputed. In essence the business model captures the economics of a business. It breaks down the expected revenues, costs and ultimately profits. This is helpful in itself, but even more useful are the (implicit) assumptions the model may hold.
The model’s assumptions tell how a business is distinguishing itself from its competitors and how this impacts costs. Does it sell a premium service or product? That typically requires more or higher quality labor or material costs. What makes the business model work is that a higher quality product can demand a higher price. This is the important bit: these different assumptions need to balance out in order to create a sound business model with sufficient margins for continued growth.
A seasoned operator will be able to quickly identify these different assumptions. They are often substantial cost components after all. These include (but are not limited to):
Product mix - Typically restaurants are known for serving meals, but often rely on beverages for a large part of their profits.
Product volume - Large scale grocery stores operate on low single-digit margins. Only the size at which they operate make it a worthwhile model.
Quality of Work - Higher quality of work either requires a high level of standardization or more expensive labor. Does the business have access to a qualified workforce, or is it possible to standardize work (further)?
Sales cycle - Unpredictable or lumpy sales require sufficient margin to cover expenses during periods of lower demand.
Marketing spend - Many online businesses rely on paid traffic to drive sales. Changes like Apple’s improved privacy controls (early 2022) had material impact on these types of businesses.
Geography - Offering service across a large geographic area may be outright unfeasible due to transportation costs compared to more local competitors, but can also compress margins as travel time is often billed at a reduced rate.
None of these underlying business model assumptions are detractors in itself, but the wrong combination can result in a business that is excessively difficult to grow, compared to industry peers.
Cash Cows, Dogs and Questions Marks
Although the term business model implies that the model covers the entire business, it is easy to scale the model to a specific service or product. Some of the characteristics from the overall business model often carry over, like Quality of Work, but how this is achieved in this specific instance might differ substantially. This can lead to different services with different economic models happily coexisting in a single business.
These different products are often in different product life cycles. Many businesses often rely on mature, unsexy offerings that generate a reliable source of work (cash cows), next to services that are untested and might require an unknown amount of investment before finding their growth trajectory (question marks). Such a product portfolio is only natural and allows businesses to stay current without burning bridges.
Even when limiting the number of concurrent services offered, this type of diversification can already severely impact smaller businesses and put excessive strain on the team. A large number of services performed by a small number of people naturally means lower efficiency and/or quality. The overall business model can become even further compromised when the operator does not prune the less profitable offerings (dogs), or even subsidizes one offering with the other. This is increasingly prevalent in lifestyle businesses, which by definition are not after maximizing profit.
Lost in the Messy Middle
Service businesses and other less capital intensive businesses are extremely susceptible to ending up in the "messy middle". This is the place where business can happily exist for years, but are unable to break past their plateau. (Read my article on Transforming Your Lifestyle Business into a Company.) The reason for this is quite simple: because they can. When there is little upfront investment, it is easy to expand into less profitable services. Services that might not be developed if they had been scrutinized by a simple business model for that specific service.
Breaking past this plateau is actually quite easy in theory, but often requires some hard decisions. Understanding where the business is making money (profit, not revenue) is often emphasized, but understanding where the business is missing out on potential profit is even more beneficial. This means investigating:
Whether the costs of a service/products can be easily optimized, either by better procurement of materials or resource allocation. Service businesses often run the habit of staffing overqualified team members on simple projects.
Determining whether the market is able to support a higher price point in order to bring margins in line with expectations. Value-based pricing may result in keeping services otherwise not worth the time.
Simplifying a business’s service offering is often seen as the most impactful decisions that can be made, but may require tremendous restructuring the operator may not be willing to make. The business can typically reside in the "messy middle" for a long time, but the lack of growth and innovation may ultimately result in "death by a thousand cuts".
Wrap up
Having a clear idea what distinguishes a business from another and how this impacts the economics is paramount when trying to grow a business. These attributes are often implicit assumptions in a business model, but have a tremendous impact on the bottom line. Being diligent about the product portfolio gives a better understanding, but ultimately this fundamental truth applies to all: "it’s simple until you make it complicated".