“Wait ’til I get my money right.” -Kanye West, Can’t Tell Me Nothin’
At a certain point on the road from idea to product, even before any real money has been spent (to date I’ve spent less than $200 of my own money on this project), the discussion of money starts to loom large, like a distant structure casting a foreboding shadow across the path. The threat of loss, the hope of return. You may not be able to see exactly what they look like from where you’re standing, but if you can take some of your hunches and assumptions and put numbers behind them, you might be able to figure out whether or not you’re going in the right direction, and what you might have to do to get to the land of Profit.
Okay, extended metaphor over. Sorry about that.
Up until now, I haven’t done a whole ton of thinking about about my market’s size and characteristics, what I might charge for my product, how much I might have to spend to get it made, or, heaven forbid, how much I stand to make off this whole deal. I’ve been focused on what I know; the design part. And as far as the business stuff goes, I’ve been operating on a series of hunches. I believe that consumer use of coconut oil is on the rise and will continue to grow, for instance; and that a certain segment of people who use coconut oil daily find the process frustrating; AND that of that segment a significant number is willing to devote a small portion of their kitchen real-estate to my product. How many of those people there are, what they’re willing to pay — I find myself needing to answer some of these questions, so that I can answer other, bigger questions. Like, is this a good idea?
That’s a tricky question, but like many things in this process, it’s made up of many smaller questions, some of which can’t be answered, but some of them can, and others can be guessed. You take all of these inputs and you come up with a handful of numbers, then you square them up against each other and even if you’re off by a few thousand dollars or people or units, you’re hopefully closer to the true picture than you would have been otherwise.
And finding a piece of solid ground to stand on is important in all of this, because you need something solid if you want to launch a rocket. So let’s get into it.
What you want to find out:
- How much will it cost to make?
- How much will I have to charge to make a profit?
- How many units will I have to sell?
- How big is the total market size?
Tool #1: The Break-Even
A Break Even Analysis is probably one of the most powerful tools in the entire MBA arsenal for assessing the state of a business. This is going to sound a little bit like math, and it is, but let me assure you of how empowering this process is
When combined with some details about your market, a picture starts to emerge, which can tell you, more or less, whether or not your hunch about profitability is valid, what kind of marketing (national wholesale? Boutique retail? Geographic concentration?) and fundraising strategies (VC? Crowd-funding? Angels?) you will have to employ if done correctly. This is important. Whenever you do this kind of analysis, you are always making assumptions. Which assumptions you make are critical, and how much of a margin for error each one holds has to be taken into consideration. What you ultimately are looking for is an educated guess that is within a safe margin for error. This is not the place to try and optimize. This is mowing your lawn with a flame thrower.
First you have fixed costs, which in my case are essentially the tooling costs; how much I will have to pay a manufacturer to build a tool that can make my product. This is a huge number, somewhere in the mid to upper five-figures for me, but can be millions depending on the complexity, tolerances, etc.
Then there are the variable costs, like labor and materials, which are very small, but go up with every unit I produce. That might only be a couple of dollars per unit, but if I make 2 million units, the variable cost will eventually eclipse the fixed costs.
Which is not really a bad thing. When you add the fixed and variable costs together, then divide by the number of units, you get a cost per unit which goes down the more you produce. When you talk to fancy business people, you can refer to this as “amortizing” the cost of manufacturing.
So, to review:
Cost of Goods Sold (COGS) = Fixed Cost (tooling, operating costs) + Variable Costs (materials, labor)
Cost Per Unit = Total Cost / Number of Units
So how do you figure out these variables? One way would be to talk with manufacturers. In my case, I’m ball-parking the manufacturing costs using an injection molding cost calculator I found online for now. With the current design, here’s what it’s looking like:
Fixed Costs: $100,000
Variable Cost: $2.50 per unit
Okay, now you have your costs figured out, you need to work on profit. Pick a price, say $15 per unit (this would be the cost directly to the consumer. Normally you’d half and quarter that to represent the cut wholesalers and retailers will take). How many units do you have to sell to surpass your COGS? When you plot it on a graph, it looks like this (courtesy of a BEA calculator):
This is known as the all-powerful Break Even point, when the cost of goods sold overcomes the production costs and you start actually making profit. The two key data points you can get from this are: the total amount of money you will have to raise to start netting a profit, and the number of units you have to sell, and at what price, to overcome the costs of production. This can also give you an idea of how much you’re going to have to get your product manufactured for. By playing with different price points, you can make the Break Even point come sooner or later (Sell at $10 and you break even at a 1000 units, sell at $20 and you break even at 500 units), but at a certain point you’ll need another input to figure out where the Break Even needs to be: market size.
Tool #2: Determining Market Size
So you’ve done the break-even and gotten an idea of how many units you’ll need to sell at what price to start netting profit. Now you need to find out if the number of units you want to sell can be supported by the market.
First you want to find out the maximum number of people who could possibly by your product. You’ll work it down from there to a more realistic figure, but it’s a place to start.
How do you figure something like that out? Well it’s different for every product, and it depends a lot on the availability of information. If you’re designing a product for blind people, for instance, you can readily find statistics on the numbers in the U.S. and then work down from there. If your market segment is a little more difficult to quantify, you have to get creative, but the principle is the same: find some data points that correlate to your market and make a series of assumptions. Here’s an example of how you might calculate something like this:
Question: How many cats are there in the U.S.A?
Start with the US population: about 318 million. The average household is 2.58 people, so that’s 123,255,813 households total. Here’s where the assumptions come in. Let’s say that about 30% of US households have cats, and that on average, each household has 1.5 cats each to account for people with more than 1 cat per household. That’s 55,465,115 domestic cats.
That might be off by a few million, but its a starting point. You could also tweak those figures with further data, such as the number of stray cats, which is apparently also somewhere around 50 million (That’s almost as many as there are cats with homes in the US. Spay or neuter your cats, people.)
Finding Relevant Data
This actually is not as easy as it sounds. In my case, figuring out the number of coconut oil users in the US who could potentially buy my product was surprisingly tricky. I started by looking at annual reports for publicly traded companies which are public record and include all kinds of useful sales data, but I couldn’t find a single sales figure for coconut oil.
I looked at annual imports and consumption figures, but those were misleading because coconut oil gets used in a lot of industrial and commercial applications, and my product is for the domestic retail customer. Someone cooking with coconut oil in their kitchen or using it in their bathroom.
I could have paid for the information and in fact there is a huge research document available online, but it costs a few thousand dollars. So that’s not happening.
Out of desperation, I got creative and said, okay, my target consumer is pretty much the kind of person who shops at Wholefoods. Wholefoods is a publicly traded company, so I can pretty easily figure out how many people shop there. Take the total amount of money spent annually on groceries in the US and compare it with Wholefoods sales report last year to get their percentage of the market. Take that percentage of the US population and you’ve got the very very rough number of people who shopped at Wholefoods last year. Divide that by the number of people per household and you’ve got about 2.5 million users for my product.
Not a bad baseline, but also not a very refined analysis. I ended up consulting with my brother, who does this kind of calculation in his spare time, when he’s not being a badass software developer and international Extraordinary Gentleman, in exchange for a 1% royalty on profits up to a maximum cap of $100, or a ride on my yacht some day (his terms). Here’s his [admittedly very crude analysis]:
So there you have it. A very very ballpark idea of how many people I could potentially sell to, and I like that number a lot more than 2.5 million Wholefoods shoppers. I’ve thrown around words like “ballpark,” “rough,” “crude” a lot in this segment, and for good reason: these numbers don’t have to be exact at this point, and actually that’s totally fine. The idea is that all of this can be refined later, but for now you’ve got a model that you can go forward with and use it to inform your pricing, marketing and manufacturing plans.
In business, as in life, there is no certainty. Just probability.
Tool #3: The Pricing Formula
This is pretty straight forward, but it’s worth stating because it’s a pretty powerful tool:
Cost of Goods Sold x 2 = Wholesale price x 2 = Retail price
To translate, everybody in the chain of distribution wants to double up their money. Say you make your product for $2.50 and sell it to a Wholesaler for $5. They sell it to a retailer for $10, and the retailer sells it to the customer for $20. This is useful because if you want to hit a $15 price point at retail because you know that’s what your customer will buy it for, then you’ve got to rework your manufacturing to get costs down, find a way to add value without increasing costs or negotiate with wholesalers and retailers (and good luck explaining to someone why they should make less than a 100% return on their investment, but it’s not impossible).
These three tools working together should give you a good pricing model to go off of, but it’s still basically a prototype. You will continually refine your numbers as you move through the process, getting more and more precise until the day comes when you actually have to put a price in front of people, and even then you can do a limited release to gauge what people will pay.
Until next time, hustle hard