Capital MONEY! aims to provide
resources to existing and prospective small business owners to help them direct
their energy and resources into opportunities with the highest chance of success.
In Volume I we cover the economics of starting a food truck and provide a general framework
that can be applied to a variety of businesses.
So you think you want to start a business.
To help you determine if it's a promising business idea, answer these questions...
- What product will your business sell?
- Who are your customers and how would you acquire them?
- How is your product different and why would people buy it?
- Who are your competitors?
- How much would you sell your product for?
- What are the Gross Profit Margins on your product?
- What are the upfront and ongoing expenses to this business?
- How much profit does the business need to make in order for it to be worthwhile for you?
- How would you achieve that level of profit?
- What is your margin of safety?
Taconomics:
For this example, let's assume you want to start a food truck that sells Tacos. Furthermore, in addition to your love of tacos, you also love frequenting local breweries and your plan is to partner with some of them by being the food provider on specific nights of the week.
Your answers to the questions above could be..
- What product will your business sell?
- Tacos
- Who are your customers and how would you acquire them?
- Customers at XYZ breweries, acquired through physical branding, signage in the breweries, and an active online presence.
- How is your product different and why would people buy it?
- Fundamentally, the answer for all successful businesses is some mix of price, quality, experience, selection. For this specific case, you could say great service, high quality tacos, and competitive prices served at breweries with limited / no other food options.
- How much would you sell your product for?
- $4
- What are the Gross Profit Margins on your product?
- $2.25
- Who are your competitors?
- Food delivery services, nearby take-out restaurants
- What are the upfront and ongoing expenses to this business?
- (details below)
- How much profit does the business need to make in order for it to be worthwhile for you?
- Assume $50K per year (details below)
- How would you achieve that level of profit?
- (details below)
- What is your margin of safety?
- This is a conclusion you can come to after an analysis like the one below. It will never be exact, but a good business will have a large and obvious margin of safety. Meaning that things can go far from perfect and results will still be pretty good.
- Details on the Small Business loan in our Prelude to Taconomics article
8. (continued)
Suppose you want to earn at least $50,000 a year from running the food truck. Spoiler alert: you'll earn ~$54K a year if you have 10,000 customers with an average ticket of $14.30, average gross profit of $8.00, and average operating profit of $5.38 per customer. We will show and explain how we got to those outcomes, and how you could apply to a similar framework to other businesses.
Create a driver-based framework and a baseline set of assumptions:
- Selling only tacos, our baseline set of assumptions suggests $41K of annual operating profit, which obviously is below the target of $50K. (math!)
We will now provide a few more scenarios to give you an idea of how adding products, increasing margins, adding customers, and increasing hours of operations can impact profitability.
Add Products to Increase Profits:
- For this version we've kept the baseline assumptions but added two products that we assume some % of our customers will purchase
- Assume 60% of customers buy a Soda
- Assume 70% of customers buy Guacamole
- Adding these products reaches an anticipated annual profit of $54K, $4K above your target
Expanding Gross Profit Margins:
- Assumes you can increase your gross profit per taco from $2.25 to $2.40
Add Customers:
- Assume a 20% increase in marketing expense to acquire 20% more customers
- Note - in the real world customers often don't increase in direct relation to marketing spend.
Increase Hours of Operation:
- Open 6 days a week instead of 5
- This assumes that you work all 6 days a week and don't hire an employee. This may or may not be realistic, but that would be your decision.
What we hope you takeaway from the above scenarios, is that by making modest improvements to the inputs, operating profit increased from $41K to $93K (+125%).
Which says two main things...
1. ensure to the best of your ability that you are using realistic and conservative assumptions for your baseline else you risk overly optimistic expectations
2. a real business can be materially improved by a combination of seemingly small changes
The scenarios above illustrate a driver-based framework to understand the business, but it does not guarantee success. Before making a decision to start the business, you would want to test all your assumptions with as much real world information as possible.
The scenarios above illustrate a driver-based framework to understand the business, but it does not guarantee success. Before making a decision to start the business, you would want to test all your assumptions with as much real world information as possible.
Considerations:
- An average of 48 customers per day is the most critical driver of success or failure. In order to determine a level of reasonableness you could speak with the breweries that you hope to partner with and ask them 1. how many customers they have per day; and 2. what % of them purchase food.
- If a brewery only has 30 customers per day and only half of them order food, you know that expecting 48 customers per day to your truck is unrealistic. But if the brewery has 300 guests per day and 40% buy food, then 48 customers to your truck may be very attainable.
- Are you certain that your target breweries will let you be their sole food provider? What would you do if one or all cancelled on you? Are there other business, locations or events as good or better for your food truck?
- After # of customers, average ticket and gross profit per customer are the most critical drivers of success and failure. You can do market research or a pop up shop to help determine average ticket and standard pricing. After that you should get an exact understanding of what your costs will be in the quantities that you would be buying them while running the food truck. Once you have price and cost determined you can calculate what your Gross Profit would be.
- You can look at ways to add more products or further expand margins. As shown in the scenarios above, both can be used to materially increase Operating Profit.
- Ensure you have the capacity to serve 48 customers per day (~150 tacos). Do you have enough grill space, do you toast/steam your tortillas, how much prep work can you do in advance, etc.
- Understand your customer acquisition costs, which is calculated by dividing your marketing expense by the # of customers you have over a given time. List all the areas you plan to spend money on marketing and ensure that their costs and results are aligned with your expectations. For example, if you plan to use Facebook ads, purchase a block of them and count the traffic it drives to your website.
We hope that the examples above have been informative and that you can apply a similar framework to other businesses to help determine if they are potentially viable investment opportunities.
Note - this type of framework applied properly can identify bad businesses with more certainty than it can identify good ones.
Just because a business appears to be profitable in this type of framework does not guarantee that it will be profitable in reality. That is why it is essential to pressure test all your assumptions with as much real world evidence as possible. However this framework can identify bad businesses quite quickly. If a business is barely turning a profit under reasonable baseline assumptions, then there is a good chance you can cross it off your list - saving you time, energy, and money.
Regardless of how attached you may be to a business idea, don't try to navigate to a desired outcome. If a business looks great, try to poke holes in your assumptions. Try to prove yourself wrong and show why the business really wouldn't be as great as it seems. Because if you don't do that now, reality were surely do it for you later but at a much higher cost. Conversely, if a business still looks great after trying to find all its faults, then it may be a winner.
Please let us know if this was helpful and/or if you have any questions!
Thank you,
Capital MONEY!