Not all opportunities are equal
October 15, 2007 By Bill deDecker
Business opportunities that have a high probability of success
It’s a fact that with growth comes opportunity. There certainly is no shortage of growth in our industry at present. And with all the growth come many opportunities. Opportunities to expand in new areas, offer new services, take advantage of new technologies or serve new customers. Opportunities to grow the business and increase profitability. And, unfortunately, opportunities to lose a lot of money. So the question is – how do you pick the winners?
A story is told of two brothers who ran a successful commercial helicopter operation near a large city in North America. Some years ago, they inherited a small but very profitable flower shop located in the same city. To take advantage of this opportunity, they decided that one brother (the one who had been doing the marketing and finances) would run the flower shop and the other (who had been in charge of maintenance and operations) would continue to run the charter business. That way they could reap the profits of both businesses. They figured that since they knew how to run a charter business, running a flower shop should be easy. What actually happened is that after one year, the flower shop had lost most of its customers and the charter business was losing money. After much deliberation, they shut down the flower shop and by focusing all their attention on the helicopter business were able to rebuild it to profitability. The question is how such a good opportunity turned out so poorly. The answer is that it actually never was a good opportunity, and had they analyzed the situation carefully beforehand they would have known this.
The other way to look at opportunities is the approach taken by a former boss of mine. Whenever we came up with what we thought was a good opportunity for the company he would say, “you wouldn’t be talking to me if you didn’t think this was a great opportunity. So what I want to know is all the ways that this opportunity can go wrong!” He would then follow this up with a series of questions. If we didn’t have good answers to all those questions, guess what happened to the opportunity – we would pass it up.
The surprising thing was that the questions he asked were not all that hard to answer, but the record shows they helped the company pick a long string of winners and avoid all but a few losers. Not only would he have exposed the flaws in flower shop adventure related above, but it is also worth noting that some years ago he sold his share in the company that he founded for over $500 million.
These were the questions:
1. How does this opportunity fit with the focus of our company?
Every successful company has a strong focus that helps it excel with its customers. As long as the new opportunity fits into the overall focus of the company, the company can bring most or all of the resources that have allowed it to do well to bear on solving the challenges of the new opportunity. But if the opportunity does not fit the company’s focus, few of its resources are of any use to solve the inevitable problems.
For example, consider a helicopter operator that specializes in external lift work. This operator’s focus covers not only logging and firefighting, but also construction work, transmission tower construction and anything else that involves use of external lift to pick up or place a bulky load. But it doesn’t cover selling parts or operating an airport. Look again at the case of the brothers who tried to run a flower shop. Simply put, almost none of the things they had learned in running a successful commercial helicopter business were applicable in the flower business! No wonder it failed.
So what should you do if there is a great opportunity and it doesn’t fit the focus of your current company? Start another company with its own products, its own customers, its own management, its own expertise and its own focus.
2. What are the risks involved?
On every proposed project, my ex-boss wanted to know the technical risks involved and what we were planning to do to manage them. These risks of course vary for each opportunity. But there are several risks that are common to all new ventures and must be analyzed for each new opportunity.
He wanted to know whether we were selling a new service to our existing customer base, or an existing service to a new group of potential customers, or a new service to new customers. In the first two cases, one half of the selling equation is well known, can be analyzed fairly easily and therefore, the risk of failure is low. But if both the service and the potential customers are new to your operation, the risk is high because without extensive research, you won’t know enough about your customers’ needs and the benefits of your new service to make a convincing marketing case.
Similarly, the competition will have a major impact on the success of the new opportunity. If you are launching your new service or looking for new customers in a very competitive environment, you will be fighting an uphill battle. But if there is little or no competition, the risks are a lot less – your potential customers will have fewer choices and there will be no existing loyalties that need be loosened. They will also be a lot more tolerant of the inevitable problems experienced during the start-up.
Thus, the opportunities with the lowest risk and the highest probability of success involve marketing new services to existing customers (for example, treating vegetable or fruit crops with a new type of herbicide or fungicide for your existing customers). In this case, the customers know and trust you and the only sale you have to make is that you understand how to work with the new chemicals. Next is marketing existing services to new customers (for example, marketing your heli-logging services to customers in another region of the country to increase the utilization on your aircraft). If the competition is weak this will be easy, since you have a good track record to point to. If the competition is strong this will be difficult, since you will have to detach the bonds of customer loyalty plus sell your capabilities. Lastly, experience shows that marketing a new service to new customers can usually only be done in the absence of strong competition. And even then, it may not be successful.
Consider what happened to Federal Express. Here was a new service for new customers and there was no competition. Even so, the first time the service was launched in the early 1970s it was a failure! As hard as this may be to believe, it took many more months and many more millions before it was successfully launched the second time.
3. What are the finances?
The finances in this case are not the kind of numbers that would be found in an annual report or a business plan. Instead, what is needed is the big picture, based on estimates of the major cost and revenue elements associated with the opportunity. No detail is required and amounts can be rounded to the nearest $1,000.
The first area to examine is the operating profit. This is obtained by subtracting the estimated major operating expenses from the estimated revenues. For example, assume the revenues for an opportunity are estimated to be $150,000 per year. The operating expenses, including the cost of operating the helicopter, the pilot, other equipment, the additional personnel that need to be hired and the marketing, are $100,000. This leaves a profit of $50,000. That means the opportunity is potentially very profitable. If, on the other hand, the projected profit is only $7,000, there is almost no room for unexpected expenses and this would indicate it is not a very good opportunity.
The next area to examine is how the ratio of expense to revenue compares with your existing business. This ratio for the example in the preceding paragraph is about 67%. If your existing business has a ratio of greater than 67%, this new opportunity has the potential to help the overall profitability of your company. But if the ratio for the existing business is lower than 67%, this new opportunity will be a drag on your overall profitability!
Another important cost factor is the break-even point. Assume in the example above that the revenues of $150,000 per year are generated by flying 100 hours per year. But what is the profit picture if your best marketing generates only 60 hours? Obviously, this would lower the total cost of fuel, maintenance and maybe the pilot (if he is a contract pilot), but the fixed expenses would remain about the same. The expenses might only reduce to $80,000, yielding a profit of just $10,000. By plotting this, it can be shown that the break-even point is about 50 hours. This shows that there is a margin between break-even and the predicted market of 2:1. By business planning standards this is a very conservative margin and it indicates there are sufficient extra revenues to cover unexpected expenses. This is important, because experience indicates that expenses on a new project almost always exceed the original predictions. So any ratio of less than perhaps 1.5:1 should be cause for further study.
Next is the investment required and the payback period. For example, assume that to provide the new service and get the projected revenue of $150,000 requires an investment of $35,000 in new equipment and training. With the projected profit of $50,000 this investment will be paid back in just under one year. With my former employer a payback period of one year or less was considered good. A payback period of 2-3 years was satisfactory, but any payback period of four years or longer was reason to go back to the drawing board.
The last factor is the size of the loss if the project turns out to be a failure. In the preceding example, this might be $5,000 for sunk marketing expenses and training plus the difference between the purchase price of the equipment and its value as used equipment. It’s not pleasant to think about, but it is important to know the size of this potential cash loss. If it is larger than your company can handle, this indicates it is really important to restudy the risk involved. And what should you do if you can’t afford the potential loss and the risk remains significant, no matter how you look at it? Very simple: don’t get enchanted with the potential profits, as did the brothers in the flower shop story. Instead, walk away from the opportunity, as my former boss would have done.
How long does it take to do this kind of an analysis? Maybe four or five hours and a number of telephone calls spread over several days. Will it cause you to avoid some opportunities that might have worked? Absolutely. Is it worth the effort? Definitely. Because this kind of analysis gives you some assurance that you’ll be putting your limited time and even more limited money into the opportunities that have a high probability of success.
Basic Cost and Revenue Elements
The difference between the estimated operating expenses and the estimated revenues.
Ratio of Expense to Revenue
The relationship between total expenses (X) and total revenues (Y) expressed in the form X:Y.
The point at which estimated expenses and estimated revenues are the same.
The period of time it takes for the initial investment to be returned.
Size of the Loss
The amount of money that would be lost should the project fail.