The Secrets to the Profitable Startup

About The Book

This book is a quick and useful guide to analyse the profitability of any business venture. It  establishes a methodology centred on the break-even analysis to examine a business activity. 

Moreover, it also covers introductory aspects which are related to the break-even analysis  such as pricing, budgeting and investment appraisal. 

Profitability is not always a result of revenues. It is, of course, significant to generate sales,  but businesses should also be analysed on how the balance between revenues and costs impacts on the profits. 

The examples provided in this book are designed to quickly and effectively introduce these  key concepts so that the reader can immediately apply them to any project related to starting  or expanding a business.

What’s inside

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Understanding costs, revenues and margins

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Testing the business feasibility

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How to build a budget

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Investment decisions - to invest or not to invest?

  1. Introduction 

This book is a quick and useful guide to analyse the profitability of any business venture. It  establishes a methodology centred on the break-even analysis to examine a business activity. 

Moreover, it also covers introductory aspects which are related to the break-even analysis  such as pricing, budgeting and investment appraisal. 

Profitability is not always a result of revenues. It is, of course, significant to generate sales,  but businesses should also be analysed on how the balance between revenues and costs impacts on the profits. 

The examples provided in this book are designed to quickly and effectively introduce these  key concepts so that the reader can immediately apply them to any project related to starting  or expanding a business. 

As the book is written in a way that discusses the fundamentals straightaway, it may not be  suitable for someone expecting to gain an in-depth knowledge of aspects related to business  finance and accounting.  

This is also not an academic book. Despite using insights both on the authors’ business  experience and proven academic research, it is written without adopting the formality and  rigidity of academic writing.  

Therefore, its reduced size should fit the needs of speed and effectiveness that most business  leaders nowadays require. 

Adequate knowledge about managing costs is a powerful tool to support firms’ sustainability  in the case of either revenues stagnation or growth. 

Therefore, this book analyses various pathways to success and discusses the relevant issues  from the perspective of how costs should be managed to maximise the profitability of a  business.  

The topics do not cover aspects such as increasing revenues, but instead, focus on how  managing costs are equally (or even more) significant to maintain profitability.  

In short, this book helps the readers to get clear and straightforward answers to questions  such as: 

How to assess whether the business is profitable or not? 

How to manage costs to become profitable faster? 

How to control costs to become more profitable? 

How much should I charge customers?  

How many units of product/service need to be sold to break-even? Should I or should I not invest in a given business project? 

How to identify the upfront investments that I need to make? 

How to prepare budgets for business? 

The book starts with an explanation of key concepts related to costs and revenues, how they  influence the margins of a business and, ultimately, its profitability.  

It also provides some insights on how to establish pricing strategies which, in turn, determine the revenues generated by the firm.

Subsequently, the break-even analysis is adopted to test the economic and financial  feasibility of a business, and extensive examples of how this method can be applied to testing  a business model are employed.  

In the end, the book introduces techniques that are useful towards designing a cash-based  budget that can be used to anticipate cash flows of the business as well as to determine  funding gaps and needs.  

It also provides a practical checklist of actions that a business owner should look at before establishing and committing money into a business venture. 

We are hopeful that readers will find the time spent reading and thinking about the concepts  explored in this book to be worthwhile. We wish you the best of reading and the best of luck in your venture!

  1. Pathways to a Profitable Business 

As a useful start, let us discuss some aspects related to profitability and why it is so  important. Any organisation, regardless of its intent to generate profit or not, needs to be  managed in such a way that at least it makes enough revenue to be able to pay for its costs. 

The sources of revenue can vary depending on the type of organisation, and whether it is  profit-oriented or not. 

For a public sector organisation such as a public service, hospital or university, most of  the revenues are generated by public funding, and secondarily by user fees; For a charity or any other kind of non-governmental organisation, the income would  come from a mix of public funding, private donations and user fees; 

For a business, most of the revenue is generated by selling its products and services to  the market/paying customers. 

This book is focused on profit-oriented organisations; however, the same principles can be  applied to other types of organisations as well because the rationale in the decision-making  process is similar. 

Profitability is the primary goal of a business due to the following principal reasons: 

  1. i) A profitable business tends to be sustainable in the long term; 
  2. ii) A profitable business generates returns to pay for the initial investments made, hence  allowing investors to recover the capital employed in the business; 

iii) A profitable business generates dividends that can be paid to the shareholders (owners),  managers, and employees thereby increasing their commitment towards working and  supporting the firm; 

  1. iv) A profitable business enables the firm to invest in its future growth and depend less on  other sources of money such as lenders or external investors. 

Profitability can be measured by subtracting the costs (of resources used and consumed)  from the revenues generated by the business activities. Hence, to be profitable, a business  must create a surplus, or a positive difference when costs are subtracted from revenues. 

The profitability of a business can be checked from the income statement, which is a  summary statement of revenues and costs during a defined accounting period (usually one  year).  

Accounting techniques can frequently create biases in analysing the profitability of a  business, and transform a profitable business into a non-profitable business, and vice-versa.  

For example, a company would undoubtedly have closing stocks at the end of an accounting  period, and important question would be: 

How to find out the worth of the closing stocks?  

Do we take the market price or the price we paid to acquire such stocks or do we use  some other techniques?  

These choices obviously will affect the profitability of the firm in the income statement. 

Such technical issues might sound complicated, and therefore this book deliberately deviates  away from discussing such technical and intricate matters because we aim to present the  relevant problems straightforwardly to make it accessible to a wide range of readers. 

Therefore, our approach to understanding profitability will be through the analysis of  operational profits, which in turn refers to the difference between operating revenues and  costs (i.e., revenues and costs related to the usual business activity). 

It must be noted at the outset that profitability should not be mistaken with liquidity or the  availability of cash: a business may be profitable according to its income statement but may  not have enough money available to meet its immediate obligations. 

By definition, a firm is profitable if it can generate surpluses from its operational activities  and hence create a gain on top of the costs needed to support its operations.  

In simple mathematical terms, profit can be represented as follows: 

Profit = Total Revenue – Total Costs 

There are two key aspects to this equation, namely, revenue and cost. To generate profit, a  business must generate revenue; and to increase its profitability in absolute terms, it needs  to maximise the difference between revenues and costs. 

It is paramount to keep costs under control because costs tend to increase as sales increase.  Therefore, the costs must be managed so that they do not grow at a faster pace than sales;  otherwise, the benefits of generating more revenues would not compensate for the costs of  resources needed to attain them.  

Otherwise, the consequence would be an unsustainable revenue growth trajectory which  could endanger the future of the business.

  1. Understanding Costs, Revenues and Margins a. What are costs? 

Cost can have multiple meanings depending on the context. Hence, it is usual for the term  cost to be preceded by another associated term; for example, direct costs, indirect costs, fixed  costs, variable costs.  

Cost, in a narrow sense, can be defined as the money spent by a firm to generate operating  revenue.  

A firm may need to pay wages and utility bills which are easily recognisable as costs, whereas  others like depreciation may not be so evident because firms would not usually pay  depreciation.  

At first, it is essential to understand the difference between direct costs and indirect costs.  

Direct costs are those costs that can be exclusively and accurately traced to a particular cost  object.  

Cost object in this sense refers to any activity of interest for which cost needs to be measured:  it could be a product, a service, a mix of products, or a business division, and so forth.  

For example, if business owners are interested in measuring the cost of a product that the business produces – such as a simple T-Shirt (cost object) – the fabric needed to make it can  be considered a direct cost.  

However, the rent paid for the premises where the factory is located would be difficult to  assign to the production of T-Shirts accurately if the firm manufactures other clothing items  as well.  

Hence, the rent in such cases would be an indirect cost as far as the manufacturing cost of  the T-Shirts is concerned.  

While calculating the manufacturing cost of the cost object, such indirect costs also have to  be allocated to the cost object reasonably. 

Let us try to illustrate another concept of costs by explaining the difference between costs  and costs. Imagine that two items have been purchased for the business on a given day: a  writing pad (for £2) and a laptop (for £500), both probably having a similar physical size.  

The writing pad is not expected to last long, and it will probably be used up within the  accounting period of one year.  

Hence, the money paid for the writing pad (£2) is both a cost and an expense (money paid  out) and can simultaneously be considered a cost for the accounting period.  

What this means in accounting terms is that while calculating profit for the period, the £2  will have to be subtracted from the revenue (along with so many other costs) to arrive at the  profit figure for that particular period [Remember, Total Profit = Total Revenue Total Cost]. 

Examples of other operational costs that are also costs in the same accounting period are  wages, labour taxes, social insurance, insurances, utilities, office or vehicle rents, and  supplies of any operating raw materials or services. 

On the other hand, the laptop can be reasonably expected to last at least a few years; hence,  more than one full accounting period.  

Therefore, it would be unfair (and against accounting principles) to try to subtract the full  £500 from the revenue of the year in which it was bought because the utility of the laptop  extends well beyond one year.  

Hence, the £500 paid for the computer is an expense but not a cost related to the accounting  period (year) in which it was bought, but rather an investment.  

If the computer is expected to last for five years (assumption), then it would be prudent to  subtract just one fifth or £100 (=£500÷5) from the total revenue for the year so that the  economic cost of the laptop can be spread over its five-year life.  

The amount of £100 which is subtracted from the yearly revenue (for five years) to arrive at  the profit figure is called the depreciation charge, though no actual annual cash outflow of  £100 takes place as the equipment had already been paid for.  

Even though the business does not pay this £100 as depreciation expenses, such depreciation  charges should be assigned to the cost objects when assessing, for example, the production  costs of the business. 

Regarding how the level of activity influences costs, they can also be divided into fixed or  variable costs.  

Fixed costs tend to remain generally the same in the short term (for example one year)  whereas variable costs tend to change with the level of output (such as sales). In the  following section, we will discuss these differences further.

Chapters

Pages

About the author.

Dr. Nuno Arroteia

Dr. Nuno Arroteia holds a PhD in Management. He has extensive industry experience in managerial roles at multinational companies such as Arthur Andersen, Deloitte, UEFA, and Carglass. He is a serial Angel investor with a portfolio across a diverse range of sectors (ICT, creative industries, life sciences, industrial production). He has held teaching positions in the areas of management accounting and international business for undergraduate and postgraduate programs. His primary research interests are in international business, international entrepreneurship and entrepreneurial finance.

Dr Bibek Bhatta has done PhD in Finance from Strathclyde University, UK and MBA in Banking and Finance from Bangor University (UK). He has held teaching positions in the areas of accounting and finance for undergraduate and postgraduate programs in different universities. Prior to obtaining his doctorate, he has also worked in various commercial banks in emerging and developed markets for more than six years focusing on lending activities.

About the author.

Dr Bibek Bhatta

 

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