The basic criteria for a viable business: gross margin and unit economics

In the previous sections we learned that for every market demand, there are usually many possible business models that could be created to meet that demand. We also learned that each business model could accommodate a variety of potential organization designs. The possibilities are endless, it seems.

But not all of these business models and organizational models are successful. We discussed in the previous section, the metrics that owners, managers and the outside world can use to measure the success of the business.

In this section we will identify an important criteria for a viable business: The ability to  generate gross margins.

A refresher: The profit motive, and the need for margin

To get started, let's remind ourselves what the essence of a business is. Let's return to our very high-level headers, under which we grouped the value-creating activities that make up a company's business model:

  1. Choosing your target customers and identifying the product or service you will provide to them
  2. Selecting and sourcing inputs
  3. Transforming the inputs into outputs
  4. Delivering the outputs to customers

Now wait a minute! What makes this different from a government agency or a charity? After all, a government can source coal, turn it into electricity, and provide it to users. A charity can source flour and water, bake bread, and distribute it to the needy. When we drafted this list of activities, we clearly missed something that is unique about business.

That missing dimension is the crucial profit motive. The profit motive introduces a binding constraint, namely that the outputs should be sold, and they should be sold for price that exceeds the cost of production. 1 In other words, the business needs to earn a positive margin on what it sells. Actually, it’s probably better to say that the business needs to earn a positive gross margin on what it sells.

A super quick refresher: Gross Profit versus Net Profit

Let’s revisit the basics of the income statement: The income statement starts with revenues on the first line (or lines), and then lists out expenses, and at the bottom we subtract all the expenses from the revenue to get the net profit.

Let’s add just a tiny bit more structure. Among the expenses, we can list out the direct costs first, and provide a halfway stopping point where we subtract the direct costs from the revenue to get gross profit. Then, as a second step, we can list out the rest of the costs. We then take the gross profit and subtract all these other costs, to get to our final destination, which is net profit.

From Gross Profit and Net profit to Gross Margin and Net Margin

OK: Ready for the big reveal?

Gross margin is just gross profit expressed as a percentage of revenue.

Net margin is just net profit expressed as a percentage of revenue.

You must be joking

Nope. That’s it.

Why is this such a big deal?

Because it’s an efficient measure of efficiency. It tells me, in a single number, how much money the business burns through in order to generate revenue. Viewed from another perspective, it tells me how much bang the company gets for every buck it spends. A company with 70% margins can take 30 bizcoins from an investor, and spend it to generate 100 bizcoins in revenue. A company with 20% margins will need 80 bizcoins to get the same result.

Conversely, if a business generates no gross margin, that implies that every bizcoin it receives can be used to generate exactly that amount of revenue - there will be nothing left over for research or expansion, or to return to shareholders.

And to take the point even further, if the business generates negative margin, it means that the more activity the business undertakes, the more money it loses! Any infusion of funds will be end up being spent in ways that eat up even more funds! In most circumstances this is the sign of a company that is destroying value.

Now, there is certainly a place for audacious plans, for high-risk strategies, and for for playing the long game - all of which require money and patience. But you, as a lawyer, should remain suspicious, critical and cautious when dealing with businesses that do not make money. Indeed, one of the first things you should do is engage in some sort of analysis to figure out if a business that does not make money, is in fact a business that cannot ever make money.

A very useful analytical tool for thinking about profitability: Unit economics

So how do you figure this out? You won't necessarily have access to a company's financial statements. Even if you do, the real money-making engine might be buried inside a larger set of group accounts, or obscured by some large and artificial accounting conventions. So another powerful way to estimate profitability is to look at the unit economics of the business: How much does the compamy earn, and how much does it cost, per unit of a product or service.

Let's look at the unit economics of a cup of coffee (for now I am excluding the cost of the entrepreneur's labour):

Price per cup 10.0
Cost of coffee beans 1.0
Cost of milk 1.0
Cost of sugar 1.0
Cost of cup 0.6
Cost of fuel 0.4
Gross Profit per cup 6.0

This should give you the confidence that this business is generating plenty of margin. The more coffee the business sells, the more money will be generated to either invest in the business, or be returned to the owner. The added benefit of representing the costs like this is that you can now also see, line by line, what will affect the core economics of the business: If the price of coffee beans goes up then margin goes down. If the cost of labour goes down then margin goes up, and so on.

One final note on margins: A low margin business is not necessarily a bad business! In fact, many large, mature businesses are built on delivering commoditized products with razor-thin margins. Just understand that such companies typically need to sell huge volumes in order to generate the returns they need to reinvest in the business or generate returns for the shareholders.