Economy of Scale and a Bad Idea

Most people are well aware of the concept of economy of scale – it’s cheaper to buy the huge box of cereal that could feed a family of 10 for a month than to buy the small box that could feed you and your spouse for two weeks. When you buy a lot, the price per unit is less.

This can apply to business as well. If you have a product that you sell for $10 with a margin of $6, then selling 10 at once would give you a higher margin, since some of your costs would overlap. So your margin might be $65 or $70 in that case.

Unfortunately, it also works in the other direction, and I’ll illustrate with an example (I heard this on a tape of a Jackie Mason show):

My friend bought a new watch, and I asked him how much he paid for it.

“Below cost!” he exclaimed triumphantly.

“Below cost? How does the guy make any money?”

“He sells a lot of watches…”

Sometimes in business this makes sense. A store might offer a product for a price at which they lose money. But the objective there is to get you into the store, where you’ll buy other products at a higher profit.

Sometimes in business this is a sad reality. Take Dale Barker from Hamilton, Ontario, who renovated a building to be a beautiful movie theater. He came on Dragons’ Den last week looking for an investment to add a second screen to his theater. The problem, however, is that he was losing money on the existing theater.

This is a classic case of throwing good money after bad. He had a large debt acquired in order to make the renovations, and was dealing with delinquent tenants. His theater was one of the cheapest in town, despite the extra decor. If he spent more money on adding another screen, he would find himself losing money twice as fast. In other words, his business model was losing him money.

In such cases, where the business is losing money, before acquiring additional investments, you need to take a reality check to see if the model itself is sound. If the model itself is not sound, you need to fix it before giving away part of your business and prolonging the agony.

Balance of Founders

As I’ve mentioned a few times in the past, I spend a significant amount of time on various Q & A sites, mostly on either LinkedIn, or on Answers on Startups. Recently, I’ve noticed a few questions come up where the answers all came down to a very simple point – what is the ideal balance of skills in a set of founders?

Before I can even get into the answer to that, however, there is another question that needs to be answered – what is the ideal number of founders for a company?

Unfortunately, the answer is not simple, and depends heavily on the nature of the business.

As an example, if you make custom jewelery and sell it online, then the ideal number might be one. As an example, my friend Rachel does this, and, as far as I am aware, she is truly a sole proprietor. The limiting factor in her business would be the amount of jewelery she can personally produce or maintain, so adding a second person would only be useful if she had more demand for her jewelery than she could keep up with.

On the other hand, if you’re looking to build a complex piece of electronic equipment, you might need a wide variety of distinct skills just to produce the product. You would also need someone to help you market it, and so your minimum number might be 10.

However, looking at a variety of businesses which have grown to be well-known companies, many of them started off with just 2 or 3 people, and that worked really well for them. Here’s how to determine what those people need to bring into the room:

  • A thinker – someone needs to be thinking about what the product is, what it should do, who might use it.
  • An implementer – someone who can turn the idea into a real product or service, something that actually works.
  • A seller – someone who can take the constructed product or service and find people who will pay for it.

That’s it. There are only three basic components to starting a business – thinking of an idea, converting it to something that can be sold, and selling it. Everything else can wait until you have sales and revenue.

When looking for co-founders, make sure that each one is bringing one of those skills into the company. At the same time, make sure that each person is bringing a skill that you don’t already have. If you think of an idea, and know how to sell it, then the next co-founder needs to be able to implement the idea. Until you have someone who can implement, there’s no need for another salesman.

Rules of Work

When you’re in an employment situation where striking is not an option, what can you do to force negotiations with your employers? If you’re working with a contract, then you can play by the rules, and drive your employer crazy. Just follow the rules.

Many rules are defined as part of any work agreement, but many of them are typically ignored by employees and employers alike. Other rules are not defined, and are likewise ignored by everyone. But when you choose to stick to the rules, it can help push negotiations your way, but be prepared for an amendment to the rules at the end of the bargain.

As an example, if your contract does not stipulate that you may have to fill in for an absent co-worker, you can refuse to do their work. Or, you can show up exactly on time, and leave exactly on time, putting in not one minute extra,

Of course, you can get even more clever than that. If a process that you are supposed to follow includes verification, you can insist on doing a complete verification instead of the superficial one that was intended. Train engineers in France did that whenever a train crossed a bridge, since that was technically part of their job. Australian postal workers weighed each piece of mail to ensure that the proper postage was affixed, even when a visual scan could confirm that many times faster.

The idea is to slow down the system to the point where following the rules (for which you cannot be penalized) becomes so time consuming that the employer needs to put an end to it. You want the employer to have you go back to work as usual, where the inconvenient rules are conveniently ignored or modified so that the job gets done in a reasonable manner.

Site Review: Under 30 CEO

There are many people who are tired of working for someone else. Tired of working for some large corporation. Tired of working in a business built by members of previous generations. We have something in common.

We belong to Generation Y.

I made the discovery of a group of people dedicated to helping members of Generation Y become their own bosses. I first came across the site on Twitter, following Jared O’Toole, one of the founders of http://under30ceo.com. I noticed that he posted links to articles from time to time that I could really relate to, since I write about similar topics on this site, and target a similar audience.

Today, I chatted with Jared on his site, mostly because of a contest that was launched today by BizBreak which he was promoting, in which one lucky entrepreneur will win $3,000 plus half the proceeds of the BizBreak sales over the next 60 days, plus coaching from five successful entrepreneurs. One thing led to the next, and pretty soon I was scanning through the collection of articles, interviews, and resources which Jared and Matt (his co-founder) have collected.

Then I noticed some recent additions to the site (turns out I missed an announcement back in January about the new features).

  • Profiles of various companies. Not big companies. Small ones. The kind that have only been running for a matter of months. Where the founder is the developer, and his cousin is the tester.
  • CEO Interviews. Sure, there’s an interview with Donald Trump right at the top of the page. But there are many more interviews of young CEO’s (under 30) who talk about their stories, their successes, their hard lessons.
  • Consulting – Jared and Matt offer a variety of services, from helping you develop your brand, to polishing your business plan in preparation for a pitch to investors.

If you, like me, are building a business, whether full-time or on the side, consider checking out their site. There’s much to be learned, questions get answered, stories get told.

Who knows? Maybe your story will soon be featured there as well!

Fickle Consumers

That’s right, we consumers are a fickle bunch. Today we buy from company A because we heard some great things about them, and tomorrow we run for the hills and look for the local products, because local is in. We like to follow fads, and we’re actually pretty good at doing that.

Companies are well aware of the consumer attitude and loyalty (or lack thereof). As a result, some companies will go to great lengths to earn the loyalty of their customers, while others assume that the loyalty cannot be acquired. Which attitude is correct? Both and neither.

A few weeks ago, I wrote about one company, with what essentially amounts to a monopoly, and how they handled, or didn’t handle, a major image fiasco. In that case, the attitude was that customer loyalty is not relevant, since the customer has little choice but to use their service.

This article will be looking at another company with an image problem, but a completely different attitude – Toyota.

On account of a faulty design in a component of a car, Toyota was forced to issue a recall of hundreds of thousands of vehicles to address safety issues. The explanation for how such an oversight might have occurred in a company that was formerly known for its quality is quite simple. As the company grew, it exceeded its ability to maintain the same standards that brought it former success.

However, when it came time to deal with the product recall, the company did not look to excuses. The recall began with an apology for having let everyone down. The incident was not downplayed, but was addressed in full. What might have been a valid excuse was not discussed.

At the end of the day, Toyota may have lost some potential clients for the next few years. However, several people I’ve spoken to stated that they would continue to drive Toyota cars, because the company was open about the issue, and took appropriate steps to remedy the problem. I drive a Toyota (not affected by the recall), and would buy another.

What this shows is that the consumer isn’t always fickle. Sure, we change our minds arbitrarily, sometimes without any good reason. But sometimes, we do have loyalty to a particular brand, and so, when that brand makes a mistake, we look at how the mistake was handled before deciding whether or not to jump off the wagon.

Can You Spare Some Time?

A common topic in the programming business is how to avoid doing work for free, or close to it. There are various permutations of this:

  • Job postings offering $50 and “lots more work from my friends” to build a custom built eCommerce site with its own payment processing system
  • Friends asking you to spend an evening fixing their virus infected computer
  • People you meet in the community asking you to donate your time to their favorite program

Buried under workIn all these cases, what is being ignored is the fact that the skills they are requesting took years of training to acquire, and that those same skills are what we use to pay our bills. This is similar to asking a doctor to dispense medical advice for free, or a lawyer to prepare a lengthly hiring contract for $50 when it will take him 3 hours to draft it properly.

At the same time, one must stay aware of maintaining a positive relationship with family and friends. The question is, how and where do you draw the line?

For me, the lines are pretty simple.

First, I have two hourly rates – the rate I want to earn, and the rate I need to earn. The rate I want to earn is the rate that I charge paying clients. This covers my expenses, some contingency billing for any additional time I might have to spend on the project that I cannot bill for, and a bit of profit. The rate I need to earn covers my costs exactly. If I have to pay someone to do the work, it’s the amount I’m paying them. There’s no profit in it for me.

Okay, now what? How do I apply those rates?

For family and friends, or people I run into around the community, if I can answer the question on the spot, I don’t charge. It’s not worth it, trying to charge makes me look like a jerk, and there’s usually no liability issue associated with the advice I dispense (if there is, then I won’t give the advice, and I’ll tell the questioner to give me a call at the office). It’s also a good way to spread my name around, gain some positive reputation, and benefit from word-of-mouth referrals, which are the best kind of referrals.

If the work will take me some time (that is, more than a couple minutes), then a decision must be made. For some members of my family, I really will get quality referrals, and so, I take that into consideration. Others are merely trying to get a free ride – and my taxi doesn’t drive that way. In that case, I charge the rate I need to earn, and explain politely that this is covering my out of pocket expenses, and that if I didn’t charge it, I would actively lose money by doing the work for them.

For anyone else, or if it’s a larger project, the explanation for why I can’t just do them a favor is really simple:

I earn a living by doing exactly the kind of work you asked me to do. In particular, this project you want me to do for you will take me 40 hours to complete. That’s a week. I wouldn’t ask you to work for free for a week, and you shouldn’t ask me to do that either.

If you look up what the going rate is for this type of work, it runs about $1500 to $2000 and that’s what I typically charge. If you cannot afford it, then you cannot have it. I can’t afford to vacation in Aruba all year around, much as I would like to, and so I can’t have that either.

It’s really not up for debate, so any explanation longer than that is not warranted. Just as I cannot spend time building your website for free, I also cannot spend time explaining that to you either.

In regard to the people posting on job boards asking for cheap labor for their complicated project? I don’t need them or their project. Offering pennies for the work is just insulting. Either be ready to pay the going rate, or just ask for the favor. Getting me your 10 closest friends to give me their pet projects isn’t a favor, because if you can’t pay, what makes you think they’ll pay either?

Keep Track of This

The deal on Dragons’ Den from CBC this week showed an unusual level of risk, and not because of the entrepreneur who put forward the idea. Interestingly, all five Dragons thought the product was solid, and the company had sales to back up the valuation. The issue, however, was in the viability of the company as an investment.

Track It BackJason Wagner of Winnipeg, Manitoba, came on the Den asking for $200,000 for 25% of his company, TrackItBack. The product is a label which can be attached to anything, such as portable electronics, and contains an ID which can be used to identify the owner of the object.

His company, which has been around since 2005, is profitable, with $500,000 in sales last year (2008) and projected sales of $800,000 in 2009. With 85% recovery rates on reported lost items, the $800,000 valuation seems to be fair. In addition, Jason stated that Sony was including the label with their Vaio laptops with a one year subscription, which had a conversion rate of about 16% with customers renewing at the end of the first year.

The problem the various Dragons saw with the product was in its life expectancy. With GPS technology available, it is only a matter of time before the label becomes obsolete as the manufacturers add their own tracking systems into the devices. As such, the exit strategy from an investment point of view becomes complicated, since there’s small chance of going public, or someone buying out the company.

Perhaps that’s why Brett Wilson made the following offer – he would give the $200,000 for a 25% stake in the company, but would also require a 4% royalty. With a $20 price tag on the labels, that’s the equivalent of 250,000 units sold to recoup the investment. According to the numbers given by Jason, it would take Brett in the area of 6 years for that to happen, although, with increasing sales each year, that could turn out to be a lot shorter.

Sometimes it’s not how good or bad a product is, or how solid the pitch and the numbers are. Sometimes it’s just about getting a plain return on the investment that will determine whether or not a deal can be struck.

For the Right Price

I was having lunch the other day with an old friend discussing the consulting that I do. He asked me how I come up with prices to quote potential clients, specifically when the work is being done on a project basis, not hourly. After explaining my system to him, I realized that other people likely have the same question, so here’s the basics of what I do.

Calendars and schedulesBefore I get into that, however, there are three things you should know.

First, I’m in the IT consulting business, so some of the sections here won’t apply to you if you’re in a different field. However, the method itself is extensible to other fields with the details of each segment being modified to suit the project.

Second, the method was inspired by a comment from Joel Spolsky regarding evidence-based scheduling:

You have to break your schedule into very small tasks that can be measured in hours.

Third, despite knowing the method, it is still easy to make mistakes, and experience alone can reduce the cost of those errors. As an example, there was one project where my quote was off by so much, I ended up earning less than $10 per hour for my work. That project taught me many things, including how to price certain types of projects better. The method can help you develop your intuition, but at the end of the day, if you don’t have any intuition, the method will only get you so far.

The Process

I try not to spend too much time coming up with a quote, as I’m not paid to do that. Typically, I can produce a quote for a project within a couple hours for larger projects, and in minutes for small projects.

  1. Agree on scope: This can take about an hour for a tiny project to weeks for a project with several months of development anticipated.
  2. Draft requirements and design: Sometimes, this is done as part of the first step, especially for the smaller projects. For larger projects, this could mean as much as 6 months of work (a.k.a. 1000 hours). Experience will help you narrow that range down fairly well.
  3. Development: For this, I try to break down the tasks I need to do into the smallest pieces possible, each one no longer than a week, and preferably less than 10 hours, although for large projects, getting it down to 50 hour pieces can be difficult enough.
  4. Testing: Usually 20-30% of the development time will be spent on testing.
  5. Deployment and Training: This can be anywhere from a few minutes to copy some files and e-mail a document, to a couple days of presentations and creating complex support documentation and procedures.

Now, you add up all the hours you counted in each step. Add 20% to that number. Multiply by the rate you want to get paid for the work. That’s your quote. You can fiddle with the number a bit, but the more you deviate from this, the more risk you take in either quoting too high and losing the project, or quoting too low and not being compensated appropriately.

If you’re worried about the unexpected, realize that you’ve actually already covered it.

The first step will prevent scope creep to some extent, and the better you are at drafting a Statement of Work, the more control you will have over what’s included in each project.

The extra 20% you added at the end is in case something unexpected, but covered by the Statement of Work, comes up during the project. In most projects, this happens, you just don’t know what it will be until it’s too late. If nothing comes up, then your margin on the project is larger.

Last, to determine your hourly rate, I use about two-thirds of my maintenance rate. Since I can dedicate time to the project, and I can schedule it, I don’t mind earning less per hour for that work. In other words, my maintenance rate is 150% of my normal hourly rate because I can’t schedule it and it’s generally for small amounts of work at a time.