What is the process to test the viability of a business idea? originally appeared on Quora - the place to gain and share knowledge, empowering people to learn from others and better understand the world.

Answer by Bernie Klinder, Entrepreneur, Investor, Consultant, on Quora:

There are two major components for testing an idea: validating demand, and making sure the (accounting) math makes sense.

Validating demand is critical for new, unproven concepts. This can be done via market research, focus groups, and developing a "minimum viable product" to demonstrate the product functionality and get feedback. Passionate entrepreneurs sometimes create a business they wished existed and hope that "if they build it, people will come." For existing products or services in established markets, you'll need to figure out how your concept is going to stand out among the competitors. In either case, sometimes this a huge unknown, and part of the risk of entrepreneurship.

But it's all a wasted effort if the numbers don't make sense and you can't be profitable. Many entrepreneurs never bother to do some basic calculations, or use really ambitious figures in their business plan. They underestimate startup costs and expenses (both fixed and variable), and overestimate sales. While it's generally expected that a business will lose money for the first few years, there should be a road to profitability. After all, your investors want their money back.

Business planning is all about validating the basic assumptions you have in your head about starting your business. As an example, lets say had $500,000 and you wanted to start a mobile car wash and detailing service.

  • Is there demand? Maybe, lets assume you live in a large metropolitan area and there is at least some demand. You'll need to figure out how many real customers exist in that market. How many busy people would use your service, rather than drive through a car wash or wash it themselves? You also need to determine what they are realistically willing to pay for your service. ($25/wash?)

Now you need to determine costs:

  • Start up costs - how much will you need to invest in equipment (specialized trucks), office needs, uniforms, supplies (soap, brushes, pressure washers), marketing, etc.
  • Fixed costs: The monthly costs of running the business. Loan/lease payments on the trucks, buildings, insurance, salary labor etc. - any costs that remains the same whether you wash one vehicle or 100.
  • Variable costs: these are the costs that change per vehicle washed. In simple terms: How much water, soap, fuel, labor hours does it take to wash a single vehicle?
  • Cost of goods sold: The fixed and variable costs estimates will determine how much it costs to provide the service: If you charge $25 and pay an employee $10/hour, with a fully burdened cost of $15/hour (the additional cost of taxes and benefits), you won't make much money if takes an hour to wash a vehicle. Once you add fuel costs and the costs of supplies, you're close to breaking even.

If you know your "costs of goods sold" (what it costs you in time and materials to wash a car) and other variable costs, you can determine the minimum number of daily/weekly/monthly service appointments you need to cover your fixed costs and still be profitable.

With that information, you need to either find a way to be profitable at that price, or determine what you need to charge to be profitable and if enough customers exist that will pay that price. Do you need to alter your approach? Perhaps only offer higher end service that includes detailing? A one-hour service that cost $75-$125? Other premium services? A cheaper option per car, if there are multiple cars?

You'll need to go back and forth creatively and determine how you can reduce waste and lower costs, and what price points make sense for the demand in your area. If you charge $250 per service, the number of customers in your area will drop and narrow.

Thinking through this it should become rapidly obvious that this business could exist under a very specific set of market conditions - high population density of image conscious busy professionals, with mild seasons. Too many rainy or cold snowy days will ruin your business, or make it seasonal. Los Angeles may be a better starting point than Boston or Cleveland, but you may also face more competition in areas with ideal market conditions.

After all that, you still need to determine how profitable you will be and if it still makes sense to invest the $500,000. In short, you need the business investment to pay more than other investment options like simply buying Treasury Bonds that offer less hassle and lower risk. A business investment needs to offer a "risk premium", where the potential profit is worth the risk: the higher the potential, the more risk they are willing to take. Typically, the potential is calculated on a 5 and 10 year schedule based on estimated and probability. If there is an 80% chance that the business will return an annualized average return of 12% over 10 years on the invested capital, than it's likely a good idea to launch. If it's 1% (or negative), you're better off investing in something else or buying Treasury Bonds.

When the numbers make sense, you can go back and re-test the idea using the MVP (minimum viable product) idea and do a soft launch to test assumptions. That is, starting with a bare bones business (a single truck) and a marketing budget and see how much business you can generate and if your cost assumptions are accurate. If you discover that none of this works the way you thought it would, you can either go back to the drawing board and adjust your business process or walk away. It's much better to experiment with $5,000 and fail, than go all in with $500,000 only to discover too late that all of your estimates and assumptions were wrong.

Sometimes the planning process or a failed experiment could lead to insights into a more profitable one. For example, trying to market these services to people who park at airports may lead to an insight that it may make more sense to open your own parking lot nearby where parking is free for up to 7 days with car detailing services (plus free shuttle service to the airport). Again, you won't really know until you do a little research and run through the process. The better your research and the less "guesses" and assumptions you make in your plan, the higher your chance of success.

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Published on: May 22, 2017