Growth is a sexy word in business, but creating profits is the key to turning a small business into a much larger one.
Growth is a sexy word in business, and it's what drives all entrepreneurs.
When building a business plan, most management teams build a classic hockey stick: invest in the near term, which will result in negative cash flows in the early years, and count on growth to drive the business to scale.
But what about profits? A common joke is, "We lose money on every sale, but we'll make it up on volume." Unfortunately, that joke is reality for many growing companies that quickly discover that profitability can be far more elusive than sales.
This notion is driven by the realities of building a small business into a large business. Many businesses have an inherent fixed cost base that can only be overcome at some level of margin. Take the ice cream company that we work with. They may make a fixed margin on each pint of ice cream, but it takes a lot of margin dollars to cover the fixed costs of advertising and office overhead.
Many companies realize that growth creates more growth.
Our ice cream company benefits greatly from their rapid sales growth in Whole Foods. Their healthy sales numbers will easily get the attention of other food retailers, and Whole Foods will give them better positioning in the freezer case and more in-store promotion if they perform. All of this should accelerate growth.
We started thinking along these lines because one reader with a growing business recently asked us a simple question: How should I think about profits vs. growth? When should I reinvest profits in the business vs. paying myself or shareholders?
We like to live by a simple rule of thumb: Growth is about creating profits, not revenue. If you shift your aim from revenue growth to profit growth, the right choices start to come into focus.
In order to fuel growth, especially profitable growth, you need to invest in a competitive advantage that gives you the entitlement to future growth. It's relatively easy to grow in a competitive market by cutting price or increasing promotions. These actions don't change your competitive advantage, and therefore don't lead to profitable growth. You are trading off margin, in the cost of the price cut or promotion, for revenue growth.
It's important to estimate the likely return on investment from growth investments you make in your business. The general rule is that if you don't invest to improve your competitive position, you will lose that position over time. We recently talked to a leader of a business that once brought in $300 million in annual revenue and was the leader in its marketplace. It didn't invest in profitable growth, and now it's less than half the size it once was and a laggard in its market. Increasing competitive advantage leads to profitable growth.
Take a look at the way Gatorade was built from a small business in the 1970s to a billion-dollar brand in the '90s. Gatorade continued to invest its profits in building the Gatorade brand image year after year. When Coke launched Powerade to compete, Gatorade had an insurmountable advantage that persists to this day.
Creating profits is the key to driving growth in businesses. Driving revenue growth for its own sake rarely creates the huge successes that entrepreneurs dream of.
KARL STARK AND BILL STEWART are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark