The most common definition of business suggests it is the “organized effort of individuals to produce and sell, for a profit, the goods and services that satisfy society’s needs” (Pride, Hughes, & Kapoor, 2013). In a manufacturing-driven society, this definition might be valid, yet it arguably emphasizes an outward-in approach to product and service development and in doing so has potentially set a generation or more entrepreneurs off on the wrong foot. So many entrepreneurs believe that the “thing”—the product or service—they have created will “satisfy society’s needs” without giving enough thought to understanding what society needs, values, and expects. The focus on the thing poses one of the most significant long-term barriers to success for entrepreneurs.
Entrepreneurs devote too much time and energy to the perfect execution of the product or service at the outset. In fact, many entrepreneurs invest—maybe even over-invest—in the thing before they understand if there’s an actual market for the thing. Not long ago, I spoke with an entrepreneur who had an idea for a new technology product and a pool of funds to develop the product. He was searching for a developer to help get this product off the ground but had not thoroughly researched the market opportunity for what he was about to create. Moreover, he had done little more than cursory research on his target customer. His focus was on product execution, rather than customer understanding. Unfortunately, this approach is all too common with startup entrepreneurs. A good product or service—one that meets a customer's desires—will be far better than a great product or service that misses that mark.
Steve Jobs once said, “Customer’s don’t know what they want until we have shown them” (Isaacson, 2011). To Jobs’ point, when new ideas for products and services are solicited from customers, those ideas tend to mirror competitive products in the marketplace or be derivations of products or services already available (Furnham, 2000). However, this should not suggest that knowledge of the target customer and customer input is without value. In fact, one might argue that Jobs and his team developed their products based on a clear understanding of the needs, values, and expectations of their target customer. Apple’s customers, for example, have come to expect the most innovative products, of the highest quality, that enable a short learning curve, efficient use, and support the simultaneous engagement with other products (Hyungu, 2013). Apple’s focus on delivering products to that target customer, and then taking care of that customer with committed customer service, elicits profound loyalty to the company and its products.
Customers are the only thing that matter to a business. Regardless of the product or service offered, if there are no customers, there is no business. It is surprising how many entrepreneurs start their business with an idea of a product or service and a detailed plan for execution of that offering, without a clear understanding of the customer. The customer’s needs, values, and expectations are never thoroughly researched, and the thing, as developed, misses the mark with the intended audience.
All of this is not to say that the thing—the product or service—is not essential. It is. However, a product or service is only relevant in the context of the customer’s needs, values, and expectations. A product and service placed at the center of the business, particularly in today’s business environment, may work in the near term but is not sustainable. The customer must be at the center of the enterprise for a business to have long-term success.
Perhaps a more appropriate definition of a business for our current environment might be “the organized effort of individuals to satisfy society’s needs, by producing and selling goods and services, for a profit.” Changing this definition might encourage entrepreneurs to focus first on the customer, and make product execution and delivery the second step in the business development process. Putting the prospective customer first might well make all the difference between success and failure of the next entrepreneurial venture.
What do you think? Should the customer needs, values, and expectations trump sheltered product development?
Furnham, A. (2000). The Brainstorming Myth. Business Strategy Review, 11(4), 21-28.
Hyungu, K. (2013, September). To Be A True Industry Leader: Apple Inc. and Microsoft Corporation in Consumer. Leadership & Organizational Management Journal, 2013(3), 114-130.
Isaacson, W. (2011). Steve Jobs. New York, NY, USA: Simon & Schuster.
Pride, W., Hughes, R., & Kapoor, J. (2013). Business (12th ed.). Cengage Learning.
Any business that holds and manages inventory does so with the goal of selling that inventory to produce revenue for the company. The key is to maintain just enough to meet demand, but not so much as to have money tied up in inventory for a period longer than necessary. No business holding inventory desires to have more, or less, inventory than is needed to meet customer demand at any given time because failure to meet customer demand will negatively influence sales and profitability. These factors make inventory management one of the most significant challenges any business, but particularly a small business, can encounter.
Depending on the kind of business, there can be many different types of inventory. For example, manufacturers will likely have an inventory of raw materials, work-in-progress inventory, and finished goods inventory at a minimum. A retailer might have merchandise inventory, a service business might have an inventory of hours available to resell, and a magazine or online publication might have an inventory of space that could be filled with advertisements. How each business type manages its inventory may be a little different, but each has the same purpose in mind: To maximize cash flow.
Demand forecasts are an integral part of inventory management. If the business demand forecasts are incorrect, it can be a significant blow to cash flow. For example, if the business assumes the demand will be high, and the assumption is erroneous, it may have too much cash tied up in inventory assets, which in turn would restrict cash flow because the product on hand is not selling as predicted. Conversely, if the business predicts the demand will be low, and the assumption is incorrect, it may not have enough inventory to meet customer expectations, resulting in lost sales and therefore tighter cash flow.
One of the simplest ways to manage physical inventory is to measure productivity and turnover (Traster, 2007). The idea here is to determine how often during the year the business can convert its inventory assets into cash (learn more about inventory turnover and other financial ratios here). Assessing the most appropriate turnover rates is a factor of a company’s sales volume. The goal is to either turn the inventory more times over the course of the year or reduce the amount of inventory held at any given time to maximize cash availability. If money gets tight, it is smart to evaluate the slower moving inventory and determine how price adjustments might help improve sales and increase cash flow, even if the margin on the sale is lower than desired.
Another way to manage inventory levels to maximize cash is to improve supply chain processes using a just-in-time model. For example, gaining agreement from a supplier of raw goods to hold those items necessary to produce a finished product in the warehouse, but not take them into inventory until manufacturing demand requires it, means raw materials are not in stock before necessary. This is one way to hold on to cash a little longer. Another approach might be to make a process change and to delay final assembly and packaging of the product until just before a customer may need the product, thereby reducing labor costs and inventory levels until the very minute (Anderson, 2010). These are only a couple of ways that small modifications in the supply chain process might reduce inventory levels and improve cash flow.
Service businesses and publishers have a slightly different problem. In these companies, fixed inventory is available, and when it is not used in the defined period, it is revenue lost. A consulting firm or advertising agency might have calculated its available inventory of hours by assuming that every revenue-producing person should bill (to clients) an average of 95% of his or her hours per each week for the firm to be successful. Assuming a 40-hour work week and 30-minutes for lunch each day, each should bill 35.625 hours per week. If less than 35.625 hours are billed, that inventory of hours and the revenue it would have produced is lost. The firm must somehow make up that lost revenue elsewhere. Sometimes, hourly rates are increased over time to help make up the difference. But often the solution means firing those who consistently under-perform.
Publishers allocate and maintain an inventory of advertising space within a publication for a specific time. If the advertising does not sell before the publishing deadlines, the revenue is lost. To offset lost revenue, the publisher might offer deep discounts on the unsold space at the last minute to improve cash flow. The publisher might also increase the inventory availability in subsequent issues in an attempt to recoup revenue lost to unsold advertising space.
Inventory management is an art and science. It requires diligence, a reliable inventory system, and designated staff to maximize cash efficiencies. While different business types have different requirements for inventory levels, all businesses must have a keen understanding of their customer needs and market demands to forecast need. Moreover, companies must have a detailed knowledge and control of cost and production schedule to ramp up, or down, depending on the demand forecast. Striking the proper balance with inventory is vital to maximizing cash flow.
Anderson, L. (2010). Accelerating Cash Flow Through Supply-Chain Innovation. MWorld, 9(1), pp. 36-38.
Traster, T. (2007, May 14). 5 steps to get a grip on inventory. Crain’s New York Business, 23(20).
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In an earlier post, Financial Ratio Analysis and the Entrepreneur, I shared some insights on Financial Ratio Analysis and how investors and lenders may consider and use financial ratios to determine whether to invest or lend to an entrepreneur. Entrepreneurs should also understand how to use financial ratios in the regular course of business operations. Each financial ratio has a purpose, and when compared to industry benchmarks, a ratio can provide insights as to a venture’s performance as well as help set stretch goals for business improvements and growth.
The most common financial ratios used by investors and lenders include:
These ratios indicate the long-term solvency and highlight the extent long-term debt is used to support the venture. Leverage Ratios include:
- Debt-to-Equity Ratio which measures how much debt is used to run the business.
- Debt-to-Asset Ratio which measures the percentage of the company’s assets that are financed by creditors.
Learn more about Leverage Ratios and how to calculate them here.
These ratios measure the businesses ability to cover its debt and provide a high-level overview of financial health. Liquidity Ratios include:
- Current Ratio which estimates the company’s ability to generate cash to meet its short-term commitments.
- Quick Ratio which measures the ability to access cash quickly for immediate demands.
Learn more about Liquidity Ratios and how to calculate them here.
These ratios offer insights into operations and help to spot problem areas related to inventory management, cash flow, and collections. Efficiency Ratios include:
- Inventory Turn-over which examines how long it takes inventory to be sold and replaced within a year.
- Average Collection Period which looks at the average number of days it takes customers to pay for goods or services.
Learn more about Efficiency Ratios and how to calculate them here.
These ratios evaluate the financial viability of a venture and provide a measure of comparison and performance to the venture’s industry. Profitability Ratios include:
- Net Profit Margin which measures how much a company earns after taxes relative to sales.
- Operating Profit Margin which measures earnings before interest and taxes (EBIT).
- Return on Assets which provides insights on how well management is using the company’s resources.
- Return on Equity which measures how much the company is earning for each invested dollar.
Learn more about Profitability Ratios and how to calculate them here.
As I mentioned in the previous post, these are just a few of the ratios used in determining the health and viability of a given business. Together with other factors such as customer acquisition costs, these ratios provide a great set of tools for managing an entrepreneurial venture. Fully understanding these ratios and the implications on the venture will be beneficial for an entrepreneur before he or she seeks additional investment or debt financing.
Here are a few resources that might be beneficial for identifying industry comparisons for your industry:
- RMA Annual Statement Studies. Data on business for comparisons
- Almanac of Business and Financial Ratios ($)
- Financial Studies of Small Business ($ or library)
- Bank Rate Small Business Ratio Calculators
Rogers, S. (2014). Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur. New York: McGraw Hill Education.
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