Be Thankful for What We Have

Several days ago, my wife was sworn in as an U.S. citizen in a ceremony in Chicago. Having dealt with the government bureaucracy throughout, we did not have high hopes for the occasion, but were pleasantly surprised by the ceremony that took place. Along with the 140 other new citizens and several hundred friends and families, we sang the national anthem and recited the pledge of allegiance. We watched a video about immigrants and also a music video with the song, “Proud to be an American”. The new citizens recited the oath to their new country.

For me, the highpoint of the ceremony was when the new citizens came forward to receive their certificate of naturalization. Of course, this is the digital age, so there were several new citizens taking selfie-videos of themselves receiving the certificate.

The person that impressed me the most was a gentleman in his 60’s, who really looked the part of an immigrant; neatly dressed but somewhat grizzled, with the rough hands of one who had done manual labor for many years. When he received his certificate, he held it aloft in both hands as high as he could reach to show it to friends and family across the room, and then began jumping up and down in a dance of sheer joy, a wide smile on his face. This was an important moment in this man’s life!

Of course, bureaucracy was on display that day as well. It took longer to check in the 141 prospective citizens than the actual ceremony. The Bulldog noted several quick changes in process that could have cut the time in less than half, but I kept my peace that day.

Afterwards, my wife told me about a comment that one of the bureaucrats made during the checking in lineup. Seeing the long line waiting to check in, she asked how many were there. When she was told that it was 141, she said, “Wow, why so many? Are they giving something away for free? I want some!” My wife had the right thought, but she did not verbalize at the time. I will now, “Ma’am, you’ve already got it, and you don’t even know!”

What the bureaucrat had was the liberty and blessings of being an American citizen. Unfortunately, at least at that moment, she seemed to have forgotten that fact. Many do, including myself from time to time. The freedom to live as I would like, to be an entrepreneur and build a business that supports my family and my community. The freedom to express myself and my ideas. We often take these things for granted, and often it is immigrants who remind about these freedoms.

To quote Churchill, “”Democracy is the worst form of government, except for all those other forms that have been tried from time to time.” (From a House of Commons speech on Nov. 11, 1947).

 

Sustaining Growth

Every business owner wants to be successful; or at least all of the business owners I know do. However, there are a significant number of businesses that do not succeed in the long term because of how well they succeed in the short run. Most often, this is because the business grows more quickly than their cash flow allows (see Its Cash That Counts and A Simple Tool to Calculate and Track Cash Flow). Adequate cash flow is vital to the success of any business, and it is possible to analyze your company’s financials in order to predict the rate of growth that your cash flow allows.

Allowable Growth Rate will tell you how fast your company may grow without changing any external financial inputs, such as increasing equity financing or loans. The lesson here is to know what your company’s allowable growth rate is without such financial adjustments and then be ready to apply the adjustments when needed. Negotiate the additional equity or loan before you need it!

This posting will look at the Allowable Growth Rate Formula, and next week will follow with a practical example. Here is the formula for Allowable Growth Rate:

AGR = Net Profit Margin  X  Rate of Retention  X  Asset Turnover  X  Leverage

Net Profit Margin: The first term of the formula is simply the percentage of your net profit, which is Net Income divided by Revenues. The formula presumes that the first source of operating cash is your company’s profits. Recall that I mentioned above that this formula addresses the allowable growth rate without external financial inputs. If your company does not yet have net profit, you will automatically need external financial inputs in order to operate at all, let alone grow.

Retention Rate: Retention rate refers to the amount of Net Profit that is retained within the company. For example, the company may be obligated to pay a dividend out of profits, or as the owner, you do not take any personal salary until after all other expenses are met. The retention rate is calculated by dividing the amount of profit retained in the company by the total of net profit.

Asset Turnover: Asset turnover refers to the number of times in a year that your company uses a dollar to move its operations forward. It is calculated by dividing the company’s Total Assets from the Balance Sheet by Revenues. Asset Turnover is a way of looking at how efficient your company is with its resources. This is important for determining your company’s growth rate: the more efficient that your company uses its resources, the greater the allowable growth rate.

Leverage: Although not everyone agrees with me when I state it like this, but Leverage basically tells us who owns what in a company (see DuPont Analysis: Capital, Debt and Equity). If the total capital in a company is $150,000, and the owner’s equity is $100,000, then that means that there is also $50,000 in debt (belonging to the bank or other individual or entity). In this case, capital divided by equity equals 1.5. Debt is used as a lever to increase the amount of capital available to operate the company. In many small companies, there is no leverage because the company has not taken on debt.

Next week, a practical application of the formula.

Resolve to Follow Your Cash Flow

I saw an interesting saying on a sign the other day, “New Year’s Resolutions, they go in one year and out the next.” That is my philosophy as well when it comes to New Year’s Resolutions. Yet, as a business owner, there is one resolution that ought to be made for the coming year: pay attention to your cash flow.

Most small business owners review their Profit and Loss Statement (hereafter P&L) more or less regularly, but often forget that the bottom line of a P&L is an accounting number. That is, the net profit on a P&L does not take into consideration the timing of cash flows. The business owner will look at the P&L and see a great number, then look at their bank account and say, “Where’s the money?” There are a number of reasons why those numbers may be different.

First, take into account the credit you extend to your customers, also known as receivables. If you have booked sales in a given month, but the actual payment is coming 30, 60 or 90 days in the future, your bank account will not reflect that fact. If you picture your sales as coins flowing into a bucket, any sale made on credit actually has an IOU on it instead of a dollar sign.

Secondly, take into account the credit your suppliers and vendors extend to you, also known as payables. For example, If you look at a P&L that contains cash that will not be paid until 30, 60 or 90 days into the future and do not take that into account, your cash on hand will be inflated beyond what it really is. If you spend those committed dollars on something else, such as payroll, and then have a problem with cash inflow, you might not be able to meet those supplier and vendor obligations when they come around.

The best way to avoid this problem is with a Cash Flow document that takes into account the timing of cash flows. The cash flow document will not register sales for a given month, but the actual cash inflow. The document will not register purchases of goods or services, but the actual cash outflow in a given month. The Cash Flow document should also show the recurring monthly cash outflows for payroll, rent and other expenses. By creating a cash flow document that moves into the future at least 6 months, you will be much better able to predict what cash you will need in any given month in order to cover all of the cash outflows.

Resolving to follow your cash flow in 2013 is one resolution that you can’t afford not to make!

DuPont Analysis: A Practical Example

The previous Blogs in this series introduced you to the DuPont Analysis; this offering will take up a practical example of how a DuPont Analysis can help you understand the state of a business. The subject of the analysis is a small company that manufactures medical devices of different sorts.  This study uses financials from 2011, at which time the company was about a $1.6 million company. To view or download the DuPont pyramid with pertinent numbers go to this  LINK.

I have discovered that people often feel that financial analysis must be quite complex. Well, yes and no. Large companies with complex business structures can be time consuming to analyze. However, in my experience, small business analysis does not need to be complex at all. As a matter of fact, the problems that a small company may be experiencing are not usually very difficult to pinpoint through financial analysis. The example that follows should give you a feel for the relative simplicity of analysis. Of course, if the numbers themselves are off, so will the analysis, but for the sake of example, the numbers presented in this analysis are accurate.

At the top of the pyramid we have a Return on Equity of 25%. In other words, for every $100 of equity invested in the company, there is a return of $25. Now, how are we to interpret that? There are several aspects to consider. If the company was expecting a 15% return, they are doing quite well. On the other hand, if they were expecting 35%, not so well. The previous year Return on Equity was 26%, which gives you one clue, meaning that the current year is down just a bit. However, the current year’s revenues are up by 16%, so there may be something amiss.

In order to understand better we must go deeper into the pyramid. Return on Capital is 23% with leverage at 1.09, meaning that the small load of debt that the company is carrying is actually improving return on equity (23% X 1.09 = 25%). So the problem is not that the company is over leveraged. As we continue down the left hand side, Net Profit Margin at 23%, Operating Profit margin at 30% and Gross Profit Margin at 72% all seem to indicate that the company has cost under control. On the other hand, perhaps the company could boost returns by increasing leverage. Using debt to increase capital for the purpose of increasing investment might be an option.

When we look at the Total Asset Turnover Ratio (also known as Capital Turnover Ratio), we begin to see the tip of an iceberg peaking above the water. The 1.0 indicates that the company is probably not using capital efficiently. At 1.0, the company is turning each dollar of capital over once a year. So, before the company goes looking for increased debt, they must discover why their use of capital is not more efficient.

We can see that Working Capital Turnover is just over 2, which could be an indication of where the rest of the iceberg is hiding. Working Capital is the amount of investment that is used to keep the company operating. It includes inventory, payables and receivables. Another way that this is expressed is in the Cash Cycle, how many days does it take to circulate a dollar in the process of creating a product, collecting that dollar from clients and paying to vendors.

As we can see, in the pyramid, this company’s cash cycle is 613 days long. Of that cycle, inventory is 554 days. This means that  it takes the company 555 days to circulate a dollar in their production and sales process, including both raw materials and parts purchased from vendors, work in process materials that are unfinished products and inventory both on the company’s shelves waiting to go out  or already on a distributor’s shelf waiting to be sold.

The real problem facing the company is that they are tying up capital in their inventory, making it difficult to deploy that capital for other reasons. For example, if their sales were to create a breakthrough, and they required additional manufacturing capacity, it would be difficult to do without taking on additional loans. But, would they want to take on increased debt when their use of that debt is so inefficient.

The real key is how to shorten their production and sales cycle, so as not to tie up large amounts of capital. The solutions could be improved manufacturing methods such as the use of Just in Time, better forecasting the marketplace for demand and paying closer attention to the inventory on distributor’s shelves. The company would do well to fix this problem before it became an even greater challenge, impeding future growth. In addition to fixing the problem, the company needs to monitor the level of both inventory and working capital closely, to guard against future reoccurrence.

As you can see, understanding the way that financial reports give a vision into the state of a company is not all that difficult. Using the tried and true DuPont Method will afford you that vision into the state of your company, and is well worth the time spent to produce the numbers that “don’t lie”!

The DuPont Method: Profitability Ratios

As I first mentioned in this Blog two weeks ago, a good financial analysis can lead you directly to the source of most problems within your business. Yet, many small business owners and entrepreneurs don’t spend a lot of time on financial analysis, or only do so superficially. The series of Blog posts on the DuPont Method of analyzing financial performance will give the small business owner and entrepreneur an excellent set of tools to begin doing financial analysis on their business. For a diagram of the DuPoint Method, click here.

Net profit is a good thing, although it should never be confused with positive cash flow (see the Blog It’s Cash That Counts).  When your net profit is not where you want it to be, digging deeper into the profitability ratios can help you understand why.  Let’s start with Net Profit Margin which shows the percentage of each dollar of sales remaining after all costs and taxes are paid. The Net Profit Margin formula is pretty straightforward:

Net Profit
Sales

The key to remember here is that the Net Profit Margin is an indicator of how your business is doing, financially, but it does not tell us much about the details. Underneath Net profit Margin are two other ratios that can lead you to understand why you have the net profit that you do. On the one hand, you have direct expenses that your business incurs to create the product or service that you sell, and on the other hand you have operating expenses that your company incurs to support the production of that product or service. If either one is out of line your bottom line will be affected.

Examples of direct expense could be the cost of materials in manufacturing, or the wholesale price of a product that a company distributes. For a service company, the cost of consultants or other employees that create and provide the service is often the largest direct expense. Operating expense might be rent, utilities, and internal company services such as human resources or accounting. Now, there are eternal arguments on what constitutes a direct or operating expense; I am not going to take that up here because it is really the topic for a dozen other Blog postings!

When we decompose Net Profit Margin into its’ constituent parts we are able to see two things clearly, how well the business is operating and how much tax is paid to the government:

Operating Profit Margin X Tax Rate

I will leave it to the lawyers and accountants to take up tax rates, but Operating Profit Margin is the key to understanding how profitable your company is. The constituent parts of this ratio will reveal to you how well your company is doing both with direct expense and operating expense with this formula:

Operating Profit Margin = Gross Profit Margin X Operating Expense Margin

Gross Profit Margin represents the percentage of each dollar amount that remains after paying for the direct expenses. Its formula is:

Gross Profit
Sales

Gross Profit Margin represents the percentage of each dollar of sales that remains after paying  direct costs for providing goods and services. This ratio will tell you how efficiently your company is at creating products and/or services. Knowing the history of this ratio will be helpful, but even more important is the comparison to you industry. If your company cannot provide equivalent products and services at a similar cost, you will have difficulty competing in the marketplace.

Operating Expense Ratio (sometimes called Selling, General and Administrative expenses, or SG&A) represents the percentage of sales that go to the general operations of the company. The Operating Expense Ratio is calculated as follows:

SG&A
Sales

In effect, there are two areas of a company that drive profitability, the cost of the product or service that the company sells and the cost of general operations to run the company. If either one is larger than it should be company profitability will suffer. Some companies have problems with one or the other, and at times some companies have trouble with both.

Next week, we will introduce activity ratios, and the week after, have a complete example of a financial analyisis, including an spreadsheet that you will be able to use as a model for you own company.

DuPont Analysis: Capital, Debt and Equity

Capital equals debt plus equity. We hear this phrase, but do we really understand what it means? The best explanation that I ever head was also the simplest. Capital represents all of the assets of the company. Debt and equity represent who owns those assets.

As an example, if a company has $1,000 in capital assets, and $400 in debt, then equity is equal to $600. The bank, or whoever holds the company’s debt, owns 40% of the capital, and the owner(s) of the company own 60%. The proportion of debt and equity to capital is also known as the company’s capital structure.

We should also note that, although we express these relationships in dollars, we may not be talking about cash in the bank, but about other types of assets that could include buildings or other real estate, equipment, inventory as well as other intangible assets, such as good will (which is another topic completely!).

You will recall from last week that return on equity (ROE) was the ratio at the top of the DuPont pyramid (for an image of the pyramid click here), so let’s start there. ROE represents the earnings that a company makes on each dollar of invested equity. In other words, it is a sign of how each dollar of equity is contributing to the bottom line. The calculation for return on equity is:

Net Income
Equity

So, if a company had net income of $12,000 and equity of $100,000, then ROE would be 12% (ratios are usually expressed as a percentage). In other words, for every dollar of equity, the company returned $.12. One way that the ratio can be useful is to compare it to previous years. For example, if the previous years’ ROE was 8%, you could infer progress.

On the other hand, if the previous year was 16%, you could infer the opposite. Another way to use ROE would be to compare it to your industry’s average. If the industry’s average was 20%, for example, your company could be at a competitive disadvantage.

As we work down the DuPont pyramid, we see that ROE can be broken down into two constituent parts, Return on Capital (ROC) and Leverage. ROC is similar to ROE, in that it expresses the return on each dollar of capital in the company. Its’ formula is:

Net Income
Capital

If the same company as above had $150,000 in capital, then the ROC would be 8% or a return of $.08 on each dollar of capital. As in the previous example, you could compare the ROC to previous years, or to company expectations for this year, or you could compare it to the industry ROC. All would be useful in understanding how your company is performing.

At this point you might exclaim, “Wait a minute, how can ROC be less than ROE!” The answer to the question reveals the power of leverage, as well as the usefulness of the DuPont Analysis. To explain the power of leverage, let’s look at the capital structure of the company, that is, the ratio of Capital, Debt and Equity.

Let’s start out by assuming in a first example, that the company actually had no debt. If that was the case, then there would be no difference between the account of capital (debt + equity) and the amount of equity. Therefore ROE would be $12,000/150,000 = 8% and ROC would also be $12,000/$150,000 = 8%.

In reality, we said that the company had $150,000 of capital. If equity is $100,000 then based on the formula capital equals debt plus equity, then the company has $50,000 in debt. Let’s now look at the formula for Leverage:

Capital
Equity

Based on the formula, our example company has leverage of 150,000/100.000 = 150%., or simply expressed, 1.5 When we apply the principles of the DuPont Analysis, this becomes clear.

Ratios at each level of the DuPont Analysis are equal to the ratio above. So, another formula for ROE is:

ROC x Leverage = ROE

In this case 8% (ROC) x 1.5 (Leverage) = 12%. By using debt to increase the amount of invested equity, the company was able to get a better return. If the company had no debt, they actually would not have had as good a net profit.

We can see then that by deconstructing the top ratio, ROE in to ROC and Leverage, we have a better understanding of the company’s financial structure and why they have made the returns that they have. Next week, we will continue to delve deeper into the DuPont pyramid.

It’s Cash That Counts

Next week I will begin a series about a financial anlysis tool known as the Dupont Analysis. To set the foundation, I am repeating this Blog about cashflow, because it introduces the capital blance sheet, which is integral to a Dupont Analysis.

I was working with an entrepreneur in startup mode, and was once again reminded of the difference between profits and cash. Particularly in startups, but also in more mature companies that achieve a breakthrough of some sort, mistaking profits reported on an income and expense statement with cash in the bank could be a crucial error. How do people make this mistake?

They do so by not taking into account the timing of cash flows. Remember, an income and expense sheet is reporting sales and expenses as they are booked for accounting reasons, but the cash flows that accompany the sales often do not happen at the same time.

For example, unless they are in retail, most companies do work on a credit basis (when retail accepts a credit card payment, they deposit slips like cash, so there is no extended term). You may not think about that way, but terms like Net 30 or Net 60 are nothing more than extending credit to your clients. In other words, your company is financing your customers’ purchases. The longer that it takes to be paid by your customer, the larger the debt that you finance.

Every company has a cash cycle, and depending on the business that you are in, there are more or less components to that cash cycle. Let’s take a company that distributes materials to other businesses. Here is a view of their cash cycle:

1. Purchase materials on credit terms (Net 30, 60, etc.) from suppliers
2. Hold in inventory
3.Repackage and sell to customers on credit terms (Net, 30, 60, etc)
4. Paid by customers
5. Pay suppliers

Now, this is a simplified cash cycle, but you get the idea. Obviously, if your customers are slow to pay you and you must pay your suppliers, you could be in for a shortfall of cash. Actually, one of the greatest risks to a startup or small company that is trying to grow is running out of cash while the business is expanding quickly. We should also note that there are other expenses (salaries, benefits, office space or utilities) that must be paid even if your customers are not quick paying you.

That brings us to the concept of Working Capital. Working Capital is the amount of cash that your company needs to have available in order to keep the cash cycle going or better put, to keep the company going. Working Capital is usually tracked in a type of spreadsheet known as a Capital Balance Sheet (which is a bit different than a Balance Sheet).

In a regular balance sheet, capital is kept above and debt below. In a capital balance sheet, a certain portion of debt is brought above. Here is the outline of a how to calculate Working Capital in a simple capital balance sheet:

Receivables (what your customers owe you)
+ Inventory
+ Current Assets
– Payables (what you owe your suppliers)
= Working Capital

Working capital represents the cash that a company needs to keep on hand to operate with receivables, inventory and payables. Receivables represent the cash that you have invested in materials and financing your clients. Payables are what your suppliers have invested in your company.

If the company sells $10,000 worth of materials in a month, 50% at Net 30 and 50% at Net 60, it means that they will not collect any cash for at least 30 days (if the customer pays on time!), and some of it not for 60. Even so, after expenses they might show a net profit of $1,500. There’s the rub, the net profit is not cash in the bank! If the company has bills to pay this month (or salaries) they must use the cash flow from previous sales to pay.

A startup company, in particular, will have problems if as they grow they do not have adequate cash in the bank to pay for expenses while waiting for cash to flow from sales. Often, a portion of the original investment capital in a new company is put aside for Working Capital; other means of having working capital at the ready could include a line of credit.

This is precisely what is meant by being adequately capitalized. Working with investors, bankers and others, the company’s executives must ensure that they have the cash in the bank to operate or they will literally be “out of business”!

What is a Consulting Executive’s Time Worth?

Quite often, when I am working with an owner or executive of a small consulting company, I find that the person I am working with is hard put to tell me what they are worth. In some cases, the owner or executive is worth everything, as they are doing everything. But even those who are doing everything cannot answer my question because they don’t know.

The fact is, every hour that an owner/executive works is worth something, but the real question is, is the company capturing the value that the owner/executive is creating with every hour of work? Unfortunately, the answer is often no; here is why.

An owner or executive of a consulting company often has 2 roles; the first as a consultant working with clients and secondly as an owner/executive running a company. The consultant is billing hours to the client for work done, but the executive is not, as the client work they are doing is either selling or pre-sales, and the internal company work is simply not billable.

Yet, all of the work that the owner/executive performs creates value for the company. If the owner cannot find a way to monetize that value, the company is losing out on an important revenue stream. The answer on how to capture that value is overhead; bringing us to a discussion on how overhead is handled in many small companies.

When considering the P & L of small consulting company, look at where the cost of providing consulting services is placed; often under General and Administrative Expenses as part of salaries, even if the consultants are contractors paid on an hourly basis. The cost of providing consulting services more properly belongs at the top of the
P & L, under the Cost of Providing Goods and Services, it reflects the direct cost of providing the consulting services.

Any non-billable time then belongs under General and Administrative Services. The key reason for differentiating here is to be able to understand what part of the consultant’s time belongs in overhead. This applies in particular to the non-billable hours of the owner/executive, as including these hours in overhead is the only way to monetize non-billable hours.

Let’s take this one step further. In many small consulting companies, the owner/executive may not even paid a regular salary, simply paying themselves what the company can afford at the end of each month. However, if the owner/executive is truly worth their billing rate, then every hour that they work should be calculated at a cost that is the same as their billable rate. As a result, when the company’s overhead is calculated and added on to the billable rate of each consultant, the true value of the owner/executive will be captured.

As you can see, the value of an owner/executive of a consulting company is worth a lot, but only if that value is properly captured.

On Being a First-Time Small Business COO

Many small companies grow to the size where the owner can no longer run the business entirely by him or herself. In some cases, the owner never realizes that the business is beyond a single executive/manager and the consequences are dire. In others, the owner is cognizant of the need and recruits an experienced COO, or perhaps promotes from within.

In the latter case we have a newly minted COO (or VP Operations, or some other title) who has been with the business for a while and knows it well but is now asked to take on an executive role for which they might not have a great deal of experience.If you are in the latter category, here are four recommendations to help you succeed.

Know the Owner’s Mind: It is crucial in your new role to understand how the owner thinks about the business and what their expectations are for you. The real challenge to the new COO is to become the crucial link between strategy and execution and in order to do so you must understand both. Frequent well-planned meetings are a must. Some of the meetings should focus on strategic subjects and others on operational detail.

If you have been working at the business in a different capacity, then you should be able to leverage your knowledge, but do not presume to understand the owner’s thinking without serious, ongoing discussions.

Know the Business/Financial Model: Understanding the Business/Financial model comes down to a simple concept: do you know how the company makes money? Actually uncovering the model may not be so simple. First, you must understand what your product or service is and why the client buys. In other words, how does the company create value for the client? Second you must have an intimate knowledge of the business processes that create that value. Finally, you must understand how the business process affects business finance, in particular cash flow.

Even if you have been working at the company for an extended period of time, as a new COO you must gain process knowledge. Review any documentation, if it exists. As is often the case with small business, documentation will not exist, so work quickly to document basic processes as soon as possible. In addition, study the company’s financial statements so that you will understand how the financial model is affected by business process.

Set Up Feedback Loops: Once you know the crucial information that you need to understand operations and finance, set up feedback loops that will continuously provide you with the information that you need. In addition to information from operations and finance, the third feedback loop that you will want to establish early on is one that reports to you on what is happening in the marketplace. You need to know how the current economic environment is affecting the business, as well as what your competition is up to.

Find a Mentor: If you are new to the COO role, particularly in a small business, finding a more experienced person to mentor you will help you establish yourself in your role. Use your business contacts and network to find someone with sufficient experience to guide you as you grow into the role. Even if you don’t currently know a COO, you would be surprised how many of them would be willing to serve as a mentor. Work at finding someone with whom you can communicate well and who is willing to work with you on a regular basis.

If you find yourself in the position of being a new COO in a small business, you have exciting times ahead of you, so step up to your new reality with enthusiasm. Welcome to the world of the COO!

Know Your Competitive Advantage

Competitive advantage is what all businesses are seeking: it allows your business to charge higher prices for your products and services or to get more customers. Everyone is seeking competitive advantage in their market.

Gaining and maintaining competitive advantage requires that your business be focused on the proper things; that is simple, but not always easy. There are really only two areas of business focus in order to establish competitive advantage: first, you must be competitive in your industry and secondly your business must differentiate itself from the competition. Sounds like a contradiction to me! Let’s take a closer look at each.

In order to be competitive in your industry your business must do “industry basics” well. For example, if you are Starbucks, you can have the nicest storefront possible, with great music and a cool ambiance. But, if your coffee is not at the right temperature, or tastes bad, you will not be able to compete in your market. For a coffee shop, temperature and taste are basics and the company must focus on them in the right way.

In what might seem to be contradictory, it is also true that you should not exceed your industry basics in the name of competition. That practice can be costly and self-defeating. Take the example of a distribution company that competes in a market where 5 day delivery of goods is the standard and customers do not expect more. If a company were to spend time and money on next day delivery, they would be wasting money creating differentiation that their customers don’t want. Doing so puts the focus in the wrong place and could actually hurt the business.

In many cases, businesses do not always focus on the right places to understand industry basics. For example, a business’ financial results, in comparison with the industry median for that result is often a good place to see where your business stands in your industry.

A software development company might look at their software production cost (Cost of Sales); they may not be competing on price, but if their production costs are significantly higher than others in the market, they will have a hard time competing. Proper focus here will keep them competitive in their industry.

Differentiation, on the other hand, is not about industry basics. It is about how your business can do something differently to distinguish itself in the industry. Of course, what you do differently must also be something that your market wants!

Let’s look at distribution again. Supposing that the company that tried to differentiate with quick delivery took some time to talk to their customers that are retail operations. Perhaps they might discover that their customers spend time breaking down the goods they receive from the distribution company into smaller lots for reshipping. The distribution company might be able to save their customers time and effort by packaging their goods in such a way that the customers would have minimal repackaging to do.

At times, it might be possible to turn an industry standard on it’s’ head in order to gain competitive advantage. Prior to Starbucks, most of the coffee industry was centered on fast food coffee chains such as donut shops. Fast was the operating word. Starbucks created a product that included not just upgraded coffee, but an entire experience.

The company wanted people to stay longer, not leave quickly. Starbucks achieved tremendous success with that strategy; only recently have they made moves that have harmed them (but that’s the topic of another Blog).

The name of the game in competitive advantage is to stay focused on the right things for your industry!