Why is it so hard to start a profitable business? 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:

It isn't hard to start a profitable business. However, it is very hard to scale one.

Let me explain.

Without all the structure and overhead of a formal business (an office, employees, etc), you can launch a business tomorrow for less than $100, pick a common commodity product or service, sell it for twice your cost, and technically you would have a profitable business. You can even repeat that every weekend while holding down a full time job. To the IRS (and according to basic accounting rules) you are profitable. But in order to scale that business and generate the income you'll need to do it full time, you will run into additional costs that are hidden at a small scale.

Let me start with a common example:

I have a friend that is starting a landscaping business. He still has a full time job, and does the work on the weekends. His plan is to grow a large enough customer base that he can hire people to do the work for him while he "runs the business". He charges $35 to mow and edge a 1/2 acre residential lot and has about a dozen customers with gross revenue of about $1600 a month, with some additional revenue from mulching, weeding, and hedge trimming. Technically, he is profitable - today.

However, he isn't (yet) fully aware of the costs of his business.

  • As he is working from his home, and using most of his own personal equipment, he has no equipment storage, office, or other back office costs. When he has to support several landscaping crews, this will change.
  • He uses his personal vehicle and a trailer to haul around his equipment. Today, he isn't counting the costs of the vehicle and trailer into his net profit equation. (Gas, vehicle mileage depreciation, maintenance, insurance etc.) If he has more than one crew, he will need to buy or lease several thousand dollars of equipment to support that crew, as well as account for maintenance and depreciation of the landscaping tools.
  • His current customer base is local - all in a moderately sized gated community. This limits his unbillable travel time between customers, load/unload time, and fuel costs. But this will change as his business grows and his job sites are more spread out.
  • His current employer covers his health insurance and the majority of his taxes. As he transitions to a full time business, this will change and become a real burden on his bottom line. Not only does he need to provide for his own health insurance, but he will have to provide some medical coverage for his employees in addition to payroll taxes, unemployment insurance, liability insurance, etc. He will also need to account for sick time, vacations, medical leave, etc. All of these employee related expenses are referred to a "fully burdened costs" and are typically around 1.5 times the salary - so a $10 an hour employee is going to actually cost the business about $15 an hour - or more.
  • He has no marketing costs - currently all of his business is word of mouth. That's okay initially, but he will need to budget for this as the business scales if he wants to keep 10 full time landscaping crews busy.
  • He has no management overhead - with just him and his son, he can supervise the work. With multiple crews, there has to be enough margin to support a supervisor to make sure the work is done well, handle customer issues, collect payment, etc.,

So if a two man crew takes an hour to service a half acre lot for $35, and the fully burdened labor costs are $30 an hour, he will quickly discover that he isn't profitable. In time he may begin understand why all of the local pro services charge nearly twice as much and focus on almost exclusively on larger lots and commercial properties.

If he wants to break in to the more profitable commercial market, he will discover the next challenge to profitably - established competitors. In economics, any industry with outsized profits will quickly attract competitors that will drive down rates until all companies are making just enough profit to survive, but not enough to encourage more competitors. In the end, commodity businesses like this one survive on relatively low margins in markets with intense competition. Yes, there are very profitable landscaping companies, but they have very fine tuned operations and focus on the most profitable opportunities.

This is where many entrepreneurs and small business people get into trouble: They never do the proper business planning on paper before starting out to see if what they are doing even makes sense. Every week on Quora I see people ask about opening coffee shops, restaurants, retail stores, etc, based on what they think they want to do and not on actual customer demand. That is a recipe for disaster and bankruptcy, and the landscape is littered with failed businesses that didn't think about how they would scale.

Before you start a business, you need to understand why that business will succeed and what it will take to thrive. If you want to start a small local business that will provide a modest income for yourself, then recognize that you are using your startup capital to literally buy a job. That isn't difficult and there are thousands of people that do it every year, and they are perfectly happy. However if you want to scale that business, you'll need to plan carefully and think through the financial costs of actually running the business.

  • What are your costs to provide the goods or service - including time/costs for acquiring a customer, collecting fees, etc. You'll need to consider fixed costs as well as variable costs and how these change as your business grows.
  • How much do you have to charge to make it worthwhile? This could be a combination of price point and scale. Most entrepreneurs get this wrong and undercharge for their goods services thinking price is their competitive advantage. That is a losing strategy - anyone can sell a dollar for 80 cents. The trick is selling a dollar for $2.
  • Are there enough customers who will pay that price and with enough frequency to make the business viable? You'll need to determine the volume of sales it will take for you to break even, as well as what volume you need to have a viable business that can grow. So if you have aspirations of your business earning X dollars a month/year, you need to really understand how many customers that will take and how you'll reach them. An online business can give you the illusion of having access to "millions of customers", but you'll need to cut through the noise to actually reach them.
  • Is the potential return of your invested capital (your time and money) worth the risk? Any investment must be balanced against risk. If you are going to invest $50,000 in a business, the potential return has to be (at a minimum) higher than what it would earn investing in a Treasury Bond. The higher the risk of the investment, the higher the potential return needs to be.
  • How will you win? This is absolutely crucial for any business. Every major city I've visited has had some amazingly successful local business (usually a restaurant) selling a basic commodity item that every one loves and have lines of customers out the door willing to wait hours for their food. In Cleveland, it's Honey Hut Ice Cream. In Nashville, it's the Pancake Pantry, Jack's BBQ, and Hattie B's Hot Chicken. Toledo has Tony Packo's Cafe. None of these place are fancy, but they have all figured out how to do something basic so well the customers love them and are willing to line up and wait instead of seeking a substitute. If you want to succeed at scale, you'll need to figure out how to get your customers to love your product or service so much that they will line up to get it. If you can do that, it won't be difficult at all to make a profit.

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Published on: Aug 3, 2017