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At TGG, we believe in simplifying things whenever possible, especially when it comes to developing a basic business model. Accounting is complicated enough! One area where simplification helps tremendously is benchmarking. While every business has some unique characteristics, businesses within industries share many more similarities than differences with respect to how they make money and what range of profitability can be expected.
Simplifying and comparing to a Basic Business Model provides the benefit of benchmarking any business against the expected industry business performance at any given time.
It’s a summarized look at how your business is performing. It can be broken down into the following five parts; Revenue, Cost of Goods Sold (COGS), Gross Profit, Sales, General and Administrative Expenses (SG&A) and Net Operating Income.
Revenue: How much money you earn
Cost of Goods Sold (COGs): The cost of goods you are selling
Gross Profit: The profit you make after deducting COGs from revenue
Sales, General and Administrative Expenses (SG&A): The costs of running your business. For example, rent, utilities, marketing expenses, etc.
Net Operating Income: All revenue minus all of the operating expenses
The basic business model is a static equation, but the inputs change by industry, making this simplistic model extraordinarily powerful. For example, below is a comparison of the ideal way a sample business should be running versus how the business is actually performing.
As you can see from this example, the business on the right is breaking even. When compared to the ideal business on the left, it’s evident that the area to focus on is Cost of Goods Sold (COGS) and to figure out why it is costing much more than the industry average to make the product. When using the basic business model, it should be viewed as a map to help figure out what to do relative to the rest of the industry and to the ideal business model.
How do you determine your basic business model? You want to first figure out if your business is high price, high value or low price, low value. If you’re either one, you’re in a good spot. If you fall outside of this and have high value and low price, you’re going to drive yourself out of business. Alternatively, if you have low value and high price no one is going to buy from you. The first step is to figure out who you are as a business. To demonstrate, watch as TGG’s Founder & CEO, Matt Garrett uses a high price, high value and low price, low value example also known as the Price Value Matrix.
As you can see from Matt’s example, Neiman Marcus (high price, high value) and Walmart (low price, low value) have the exact same Net Operating Income at the end of the day. Both businesses are just operating in very different ways. Once you’ve determined where your business is relative to price and value, you can then start to dig in and see what your actual and ideal performance should be, so you can find out where you’re hitting or missing and take control of your business performance.
There are many different types of professional services businesses, so this example is representative of most, but not all of them.
|Professional Services||Ex. Your Business|
|Net Operating Income||15-20%||19%|
COGS in a service-based business are your people that are providing the service to your customers and that is around 50%. Your 100% revenue minus COGs results in 50% gross profit. SG&A costs be between 30-35%. This results in a 15-20% net operating income. The next step is to line your business up with this formula to see where you stand.
There are a couple of types of manufacturing we’re going to cover. There is specialty manufacturing for producing highly unique and one-off products. The other is generic manufacturing where you are manufacturing widgets or anything that’s not unique. Depending on which one you are doing, it could have a big impact on your basic business model.
|Net Operating Income||15%|
When you’re doing specialty manufacturing, Your COGs are going to be around 50%, even as high as 60%. Your gross profit should be at or above the 50% level because you’re managing something that’s unique that probably took some advanced knowledge, machine, etc. to produce. SG&A in this space are usually higher at around 35% which leaves you with a 15% net operating income.
|Net Operating Income||15%|
If you are doing generic manufacturing, COGs are usually around 70%, even up to 75% which leaves you with 30% gross profit. Since you don’t have many sales expenses because you are making a commodity-type product, your SG&A is low around 15%.
Even if you are in specialty manufacturing or generic manufacturing, you can still get to the same bottom-line profits. Make sure to put your numbers in to see where you stand so the basic business model can keep you on track.
There are a couple of types of construction. There is construction that is specialty and construction that is general. We break them both down here.
|Net Operating Income||7-8%|
General contractors are usually subbing out the work and are more like project managers for the overall project. COGS are higher around 85%. Since they go out and bid on jobs, their SG&A is usually around 7-8%. This leaves 7-8% in net operating income.
|Net Operating Income||20%|
What about specialty construction? Specialty contractors use unique skills. COGs are around 70% leaving you with 30% gross profit. SG&A is probably around 10% like general contractors. This means you could make as high as 20% net operating income as a specialty contractor. Chances are though, your work is going to be more cyclical, so you want to make a bigger profit to account for those instances.
In the software industry, there are two different types depending on if you make the software and sell it to people or a Software as a Service (SaaS) model where you make the software and are in effect, leasing it out to people over time because they are paying a monthly fee or are on an annual contract.
|Net Operating Income||25-35%|
If you are building the software, your COGs are going to be around 25% because you have a lot of people putting in the work to build this software. This gives you a 75% gross profit. However, you have to put a lot of time and effort into keep your business going, so your SG&A is between 40-50% with as much as 25% of that being in sales expenses. Net operating income is between 25-30% Why is it so high? Software sales are risky. You’re inventing something new so it’s important to be rewarded as a business if it succeeds.
|Net Operating Income||20%|
Once you build the software in a SaaS model, the basic business model is very different. COGs are as low as 10% which means a 90% gross profit. But, in order to keep people on the platform and using the software, there are a lot of expenses that go into SG&A. These expenses can be as high as 70% of your revenue and give you a 20% net operating income.
There are a couple different types of retail that we are going to explore when it comes to the basic business model. One example is Walmart (low price, low value) and Neiman Marcus (high price, high value). Both of these businesses use the basic business model to figure out whether or not they are performing at their peak.
|Net Operating Income||6%|
When it comes to Walmart, sometimes their SG&A expenses go down and when they are operating well, the number can go down to 20% and result in a net operating income as high as 10%.
|Net Operating Income||10-20%|
Neiman Marcus, unlike Walmart, will put a lot of money into SG&A to promote their brand. Those costs can be 50-60%. Walmart and Neiman Marcus are both making 10-20% in net operating income. However, they both choose to promote their brand in different ways. If you’re in retail, think about your brand and the basic business model that appeals to your customers.
Most people believe a restaurant will succeed or fail based on the location, the type of food they sell, the ambiance, etc. Restaurants operate on the basic business model formula.
|Net Operating Income||20%|
In the restaurant industry COGs are broken out between labor costs and food & drink costs. These should be broken out into 30% each which results in 60% COGs and 40% gross profit. Your SG&A costs should be around 20%. In an efficiently run restaurant, your net operating income should be 20%. Most businesses make mistakes in COGs where labor and food costs can get as high as 70%. The other place restaurants make a mistake is paying too much in SG&A with their rent. It’s very important to follow the basic business model to ensure you have a successful restaurant for years to come.
Make sure you are benchmarking your business to ultimately drive more money to your net operating income. The small changes you make today can have a big impact on the future of your business. If you’d like to learn more about benchmarking your business, contact us for a free consultation!
This post was reviewed by our team of accounting and financial experts. TGG’s mission is to make business owners’ lives better through excellent financial management. We strive to provide the most up-to-date and objective information on accounting-related topics so our readers can make informed decisions based on factual content. All posts undergo a review process with at least one member of our Leadership Team to ensure accuracy.
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