ZMP is more than an academic exercise – it has real implications for entrepreneurs.

If we expand the concept of ZMP beyond factors (labor and capital) to include activities (which are bundles of factors) we can begin to see how to apply it to business.  These activities could include items such as geographic expansion, advertising, product features, target markets, back office processes, etc.  Every one of these activities, and scores of others, has a point at which they cease being produce additional returns.

Entrepreneurs Have An Instinctive Feel For ZMP

When it comes to new activities, the entrepreneurs I meet have a feel for the idea that something may not be worthwhile to do.  Comments like: “I don’t now if I’ll get the payoff for adding a new product line.” or “I’m not sure a new sales rep will make sense right now.” are indications the entrepreneur is weighing the costs versus the benefits.

What I don’t see as often is entrepreneurs taking this same approach to the activities their businesses already engage in.  And therein lies the opportunity for profit improvement.

Look For The ZMP and NMP

Eliminating, or cutting back on, the activities that have zero or negative marginal product will result in direct improvement to the bottom line by eliminating costs in excess of any revenue.  And often the entire amount of cost reduction will be added to the bottom line as many ZMP activities are non-revenue-producing back office functions.

A Simple How To

While the goal of eliminating ZMPs is desirable, the process can seem daunting.  Here’s how I go about it with my clients:

Write down the major categories of activities your business engages in: Finding new business (marketing, sales, etc.), Fulfilling customer requirements (delivering product, providing service), and  Keeping the business running (overhead).

For each of these categories list the individual activities that you engage in.  For example:

– Finding new business – newspaper ads, brochures, SEO, PPC, cold calling, CRM, etc.

– Fulfilling customer requirements – ordering product from vendors, warehousing, shipping, travel to customer sites, performing services, etc.

– Keeping the business running – building maintenance, accounting, customer service, management, etc.

From this list of activities, spend a few minutes thinking about which ones might not be pulling their weight.  At this stage you’re using you intuition and your knowledge of the business.  Pick two or three of the most likely candidates.

Take a deeper look into the two or three activities from the previous step.  Gather the expense information, the revenue (if any) and the non-revenue benefits to your business. 

Reflect on the implications of reducing or eliminating any or all of these candidate activities.  If you think there’s a strong chance you’ve identified a ZMP…

Test it out and see what happens.

If you’ve never engaged in this kind of process before, don’t worry too much about making mistakes.  There’s a good bit of low hanging fruit and you stand a good chance of identifying ZMPs.  This is an iterative process – wash, rinse, repeat. 

But keep this in mind, the Law Of Diminishing Returns applies to eliminating ZMPs as well!

It shouldn’t be this way.  Working with a CFO should give you more control over your business.

The key for the entrepreneur is to know what the CFO can and should (as opposed to can’t and shouldn’t) do in their role as a senior business advisor and member of the management team.  This first step is to recognize…

Your CFO Is Not The Same As Your CPA

The CPA (in public practice) has two main responsibilities – to certify your financial statements to third parties and to keep you in compliance with tax laws.  The CPA’s primary focus is on reporting results.

Your CFO (who is often a CPA, but not in public practice) is a member of your management team with responsibility for financial operations of your business.  He or she also analyzes how decisions will effect outcomes.  The CFO’s primary focus is on directing results.

There can be overlap between the two – CPAs will often be trusted advisors and CFOs will often be involved in tax compliance – but no one person can, or should, completely fill both roles at the same time.

You Are The Ultimate Decision Maker

Whether your CFO is full-time, part-time, or outsourced you, as the owner of the company, are the one who makes the big decisions for the business.

Your CFO should bring their knowledge and experience to bear in helping you discover problems, analyze opportunities, model different scenarios and inform you as to probable results for various options.  He or she does not make the decisions for you, and if your CFO ever tries to do so, it’s time to find a new one.  In fact, despite the common belief the CFO is the person who always says “No”, they should not do so unless given express authority to do so by you.

Understanding The Lingo

Like with any industry or profession there’s a great deal of insider jargon associated with finance and accounting, especially acronyms.  You as the business owner are not responsible for learning this lingo.

Your CFO should be able to present information to you in terms a layman can understand.  Being able to effectively communicate technical or specialized knowledge to a non-specialist is a sign of deep understanding of the subject matter AND good communication skills.  It is the CFO’s responsibility to be understood, so if you come away from a meeting with your CFO feeling like you didn’t understand what they were saying it may be time to upgrade.

Having An Effective Partnership

Getting the most out of your relationship with your CFO requires work by both of you.  Your CFO should bring ideas to the table, analyze those ideas AND the ideas you bring, recommend solutions and then let you decide on a course of action.  You need to make decisions and then see that they’re implemented.

Banks are in the business to make a profit and that means they need to count on being paid back in full.  Keep in mind that banks are in the business of reducing risk to the bare minimum, so here are five things they’ll look at in evaluating your request.

 You Have Sufficient Cash Flow

If you’re borrowing money for a business purpose, your banker needs to know your business has the cash flow to make the scheduled payments.  First and foremost, this means your business is profitable.  Don’t expect the bank to lend to you to fund losses unless you have a history of profitability and you can show recent losses are temporary and you’ve already taken the steps to correct them.

Cash flow begins with profitability, but doesn’t end there.  Your banker will also evaluate current debt service, investments in fixed assets, growth in accounts receivable, and other non-P&L items that require cash going out the door.

In addition to your cash flow, your banker will want to see…

You Have Sufficient Collateral

In case your business runs into trouble and can’t pay back the loan, your banker wants to see assets that can be sold to pay it off.  For entrepreneurs this will be both business assets and personal assets – most importantly real estate (your home).

There’s some truth to the old adage that banks only want to lend money to those who don’t need it.  They’re most comfortable lending to those who could fund themselves if they sold all their assets and want to borrow to avoid doing so.

Cash Flow and Collateral are not an either-or.  Both must be sufficient for your banker to feel comfortable lending to you, but they are just the first steps.  Your banker will also want to see…

You’re Asking For The Right Amount

Back in the good old days it was possible to ask for more than you needed “just in case”.  That is no longer true.  You will need to prove how much you need in specific detail.

However, if you’re looking to fund a long-term project in which cash will be used in increments over an extended period of time, you can get approved for the whole amount now (if you can justify it) and have the cash come to you in a series of draws timed with your need to spend it.

Not only do you need to ask for the right amount, but you need to demonstrate…

You’re Asking For The Right Type

A business can get itself into trouble by taking on the wrong kind of loan.

As a rule, lines of credit are used for short-term needs – the most common being to fund accounts receivable during seasonal highs. 

Equipment is financed with term loans or equipment leases – usually with 5-7 year terms.

Long-term working capital needs are generally financed with term loans – often SBA guaranteed.

Real estate is financed with mortgages – usually with 10-20 year terms for commercial property.

Never, ever, buy equipment or other fixed assets with a short-term line of credit.

You Have A Strategic Plan

Bankers have always wanted to see historical results for the last few years as well as a business plan for the future, but more and more they are upping the ante by requesting a more strategic approach to your plan.

Instead of going along with your assumption that revenue is going to increase 10% a year for the next three years, they want to know how you’re going to do so.  Which new customers are you going to acquire?  How are you going to acquire them?  What new capabilities do you need to build in your organization?  Do you need to shore up weaknesses in your roster of key employees?  What is your competition doing that will either hinder you, or assist you, in reaching your goals?  Etc.

In Summary

If you want your banker to say yes to your loan request you must: demonstrate the ability to pay back the loan, show it’s for the right amount and right type, have a plan for the future that makes sense.  Of course, this is good business advice even if you’re not looking to borrow money.

And there’s no time like the present.  You’ll earn bonus points from your banker if you already have these things in place before he or she asks for them.

What the authors of The Limits To Growth neglected to take into account is that human beings are not only consumers of resources, but are sources of innovation as well.  We have a tremendous ability to overcome limitations through creativity, increases in scientific knowledge and the application of technology. 

The real limit to growth is the lack of imagination – both for the world and for our businesses.

What’s Holding Your Business Back?

In my work with entrepreneurs I come across numerous surface reasons for limited growth and I’ll be posting about some of them in the future, but more and more I think there’s a deeper problem: the lack of a repeatable, scalable, sufficiently unique business model.

This is an area I started writing about in Rethinking Your Business Model, but I’ll get down to a more fundamental level here.

What Is a Business Model?

For a thorough background on business models go here, but for our purposes a business model is how you create value for customers in a way that they will be willing to pay a sufficient price, and you can deliver at a cost, that allows you to make a profit.  After all, if you can’t make a consistent profit, you don’t stay in business.

An effective business model will take into account these elements:

– Key Partners – suppliers, logistics, IT, etc.

– Key Resources – intellectual property, raw materials, employees

– Customer Segments – which portion of the entire universe of consumers or businesses you are targeting

– Key Processes – manufacturing, design, marketing, sales, etc.

– Distribution Channels – direct to end-user, retailers, VAR’s

– Pricing and Value Proposition – can you deliver value that a customer can recognize

– Cost Structure – fixed and variable

– Overall Business and Political Environment

An Effective Business Model Is Repeatable

Simply put, an effective business model doesn’t need to be changed constantly.  If you’re doing these:

– Constantly looking for new suppliers

– Always looking for the magic target market that will appreciate your offering

– Experiencing high turnover or chronic underperformance among key employees

– Constantly putting out fires

– Competing on price

– Frequently looking for ways to cut overhead to preserve profitability (or keep losses manageable)

This is evidence your business model is not repeatable.  And it’s not repeatable because it wasn’t adequately designed in the first place.  If you can’t come into work every morning and know what you’re going to do, for whom, with whom and with what resources it’s time to take a good hard look at your business model.

An Effective Business Model Is Scalable

It’s popular in the world of software business to talk about scalability in terms of geometric increases in revenue and linear increases in costs, and that’s appropriate for a business with high upfront development costs and low or negligible marginal costs.  For the rest of us scalability means overhead doesn’t have to grow as fast as revenue. 

The rate of growth in overhead doesn’t have to be dramatically slower than revenue, but it needs to be at least a little.  Unless, of course, you’re building out the infrastructure now to support significant growth in the near future – but that’s a once-in-awhile event and shouldn’t be constant.

If you’re experiencing revenue growth and increases in gross profit but net income is not increasing, this is evidence of a problem with your business model.

An Effective Business Model Is Sufficiently Unique

Being unique doesn’t have to mean you have a bunch of patents like an Apple or Microsoft, but it does mean you can’t be the third coffee shop on the block or the 45th printer in town doing business cards and letterhead.  If you don’t have a value proposition for your customers sufficiently different from your competitors, you will be fighting a constant battle for growth and profits.

So if you don’t have a portfolio of patents, look at these areas for uniqueness:

– Can you get an exclusive relationship with a valuable vendor?

– Can you uncover an underserved customer segment and bring to them your value proposition?

– Can you redesign internal processes to make your cost structure lower than your competition?

– Can you find distribution channels your competitors aren’t using?

– Can you find new value propositions for existing customer segments by bundling and unbundling your offerings?

These are just some of the questions to ask yourself as you look for ways to differentiate your business and create a unique business model.

The ultimate aim for an entrepreneur is to create value for themselves, their shareholders, their customers and their employees.  Ineffective business models destroy value, while effective business models create value.  What can you do today to start on the path to creating value?

What Used To Be Barriers No Longer Are

It’s important to keep in mind that technology is just a tool – it has no magical properties.  An example from the pre-internet days will help illustrate how reducing transaction costs can lead to a disruptive business model.

Those of us of a certain age remember that when your car needed an oil change, you had two options: do it yourself, or make an appointment, drop your car off at the garage or car dealer, and pick it up at the end of the day.  Either get dirty or disrupt your whole day.  Jiffy Lube changed all that with its no appointment, drive in, drive out 15 minutes later oil change.  Consumers were willing to pay a reasonable price to avoid the hassles associated with oil changes because Jiffy Lube removed the non-financial (time and hassle) transaction costs.

And that, in a nutshell, is what technology is doing today to established business models.  What consumers and businesses used to do for themselves (or do without altogether) because the costs in time, hassle, risk, etc. were to too great can now be done by someone else.  And what they used to outsource because the cost of acquiring knowledge, finding suppliers and co-ordinating activity can now be done by themselves.

Finding New Ways Of Creating Value

Technology hasn’t rescinded the laws of economics, but it has changed the calculus.  So here are some questions to ask yourself about your business model and how you create value for your customers.

What are the things I’m doing that my customers can now do for themselves?  If you’re relying on time, hassle and knowledge transaction costs that are being eliminated, your customers will leave you eventually.  Just ask Blockbuster.

What are the things I’m doing that my competition can do faster, cheaper, better?  If your competition isn’t already using new technology tools to better serve your customers, they soon will.  Ask Borders how they feel about Amazon.

What are the things my customers do for themselves, or do without, that I could do for them?  Find out what transaction costs you can eliminate for your customers and that you can do for them profitably.

What are the things my competition does that I could do faster, cheaper, better?  Remember the Golden Rule of competition: Do Unto Others…First!

Signs Of A Broken Business Model

If in the past you didn’t struggle with growth and profitability, but now are, you may be the victim of a broken business model.  You can’t fix the problem by working even harder at the same things you’ve always done.  Now is the time to stop running so hard and do a little thinking about the fundamentals of your business model.

We recently marked the 100th birthday of Ronald Coase, who besides having one of the best first names in the English language, is also a Nobel prize winner in economics and an overall really smart guy.Early in his career, Coase pondered the question of why, in a free market, companies exist.  In other words, why would a company take on the permanent expense of having employees on the payroll instead of contracting with free-agents to work on specific tasks as they were needed?  On the surface, it seemed to him that in an ideal world companies would consist only of the owners and a rotating roster of subcontractors, and the company itself would not necessarily be permanent.  He envisioned the virtual company several decades before the idea became popular.  

Businesses Exist to Reduce transaction costs

Coase’s key insight into the reason for the existence of permanent organizations with employees was transaction costs.  These are all the extra costs, over and above the actual price of a good or service, that are incurred when a buyer and a seller engage in a commercial activity.  They include the time and money expended on acquiring information, the time required to bargain over the terms of the transaction,  the risk of exposing trade secrets, the risk of not being able to obtain supply when needed, and the inability to react quickly to market conditions.  The higher the transaction costs the more likely a business will take a function in-house.  The lower the transaction costs, the more likely a business will outsource (hopefully to your company.) 

Reduce transaction costs for your customers

It’s important to note that Coase’s insight into transaction costs applies to companies as purchasers.  So no matter if your customers are other businesses or individuals this can give us some insight into creating a business model.  How can you reduce the transaction costs for your customers to make their world just a little bit better?  What are the transaction costs that bedevil your customers?: Are their costs too high in terms of time, money, or hassle?

For example, could you:

Make it easier for your customers to buy (iTunes, Netflix, Dominos Pizza)

Offload an undesirable or expensive function to yourself and do it faster and cheaper than the customer can do it (Jiffy Lube, UPS Logistics)

Reduce the time and expense of finding information, suppliers or customers (Google, Ebay)

Reduce or eliminate the risk of making a bad decision (Zappos – free return shipping)

There are as many ways to reduce transaction costs as there are types businesses.  The important thing is to spend some time thinking about your customers’ pain, how that pain is not being addressed adequately in the marketplace, and how you can remove that pain profitably.

This assumes that you can already deliver a quality product or service at a reasonable price.  But since quality and price are no longer competitive advantages (they’re just the price of admission) you need to think deeper about the value you can create for your customers.  A full understanding of their transaction costs will help you get there. 

What transaction costs are you eliminating for your customers?

The traditional formula is: Revenue * Gross Margin = Overhead. 

It’s a simple concept, but in the daily bustle of running a business it can be easy to lose sight of its informative power.

Since this particular business, like a lot of businesses these days, sells services and not products, the idea of gross margin can be a little confusing.  Sure, a service business has a cost-of-goods-sold in the form of salaries and benefits for the employees providing services, but most smaller businesses don’t classify them as such on the P&L.  In that case, a variation on the break-even formula is more useful.

Revenue – Variable Costs = Fixed Costs…or  Revenue – Variable Costs – Fixed Costs = Net Profit or Loss

For most service businesses fixed costs are going to be relatively large and variable costs relatively minor.  The result is that within some range (unique to each business) revenue increases and decreases will have a dramatic impact on the bottom line.

Through the magic of algebra we can re-work the formula so that it can predict the impact to the bottom line of changes in revenue.  If we make Variable Costs a percentage of revenue we get and do a little reworking of the formula we get: 

Revenue * (1 – Variable Cost %) – Fixed Costs = Profit. 

Now with numbers (in thousands or millions – whichever you like better):  $1,000 * (1.0 -.05) – $800 = $150 

If we increase revenue by 5% we see a $47.5, or 31.67%, increase in net income.  $1,050 * (1.0 -.05) – $800 = $197.5 

We would need to cut fixed costs by $47.5, or almost 6%, to get the same bottom line impact.  This isn’t a huge difference, but keep in mind that revenue growth compounds and cost cutting does not. 

This is just one hypothetical example.  Your business will have different Variable Costs and Fixed Costs.  Plug in your numbers and see where the opportunities are to improve profits.  Perhaps it’s revenue.  Maybe it’s cost-of-goods-sold, or overhead – or a combination of the three.

Bootstrapping a business is a perfectly viable (maybe even preferable) path to take, but bootstrapped financing comes with limitations.  You don’t have the money to hire the help you need, so you get into the habit of doing it yourself.  In fact, in the early days it’s not even an option – you MUST do it yourself.  But, there’s danger in learning this lesson too well and thinking that what works for a small business will work for a not-small business.

If you want to grow, you have rely on other people to do important things.  It’s a mistake to think you can accomplish big things by hiring only low-level people to do the grunt work while you fill all the valuable roles.  There are too many different skills required and you don’t possess them all.

What Do You Do Well?

The first step is to be brutally honest with yourself; what is it that you truly excel at? Is it sales? operations? strategy? Next, identify those important roles that require skills you don’t have.  If you’re an ace business developer, you probably need an operations wizard.  If you’re a big thinker you’ll need someone who’s good with details.  Choose the work for yourself that will play off of your own strengths – offload your weaknesses.

What About The Things You Don’t

Now that you’ve decided to concentrate on what you do best, how do you make sure the other important stuff gets done?

1) Look at your current employees.  Do any of them have the raw material to step up?  Since you’ve been keeping them under wraps up to this point, they probably need training – but don’t assume that just because they haven’t been doing something they’re incapable.

2) If you don’t have someone in house that can be brought up to speed you might want to recruit someone new.  Make sure you fully understand what role you’re recruiting for and looks for those skills.

3) Outsource – especially when a role needs very specific experience but you don’t need it full time.  Only very large companies have lawyers, and PR people, and the like on staff – most businesses outsource these on an as-needed basis.  You can do the same with a multitude of roles: marketing, HR, accounting, etc.  Many highly qualified professionals are out of work these days, so hiring a savvy consultant in any number of fields is much easier now than it used to be. Take full advantage of this opportunity to receive quality help from able professionals.

4) Partner up with another company – one that has complementary strengths to yours.  This is a common approach for companies with strong technical or product abilities and weak marketing or distribution.

An Investment That Pays Off

Keep in mind that starting and growing a business is going to cost money.  There are times to be frugal, and there are times to be bold so choose wisely.  Concentrating on your strengths and investing in shoring up your weaknesses is a bold move that will pay dividends in growth and profits.

Going John Galt