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How to Calculate Whether Your Business Idea is Profitable or Not

by Olufisayo
Calculate Whether Your Business Idea is Profitable or Not

There’s only one real difference between entrepreneurs and daydreamers, and that is profit.  Entrepreneurs are the quintessential daydreamers.

They are idea people, always brainstorming new and innovative business concepts.  However, entrepreneurs also are people of action, of dynamism, who are almost never inert, are always trying something, and not just thinking about it.

You cannot get paid for daydreaming — though if you could, it would be an entrepreneur who made it work.  Any idea, no matter how great, will stay an idea unless you can find a way to monetize it and transform it into a business plan.

Think about it this way: the aim of your idea is not only to help your customers solve a problem but to come up with a way to solve the problem profitably.

How do you do that?  In a word (or two), value proposition.  Translated out of business jargon, your value proposition the formula you use to predict whether or not customers will actually buy your product, and whether they will buy it at a price that is substantially higher than what it cost to produce or provide your product.

The formula looks like something like this: (customer utility) – (production cost) = optimal price

But wait, you say, isn’t that just a way to calculate pricing of your product or service? Yes and no.  On the one hand, this formula will simply tell you what the best price is for your product, but on the other hand, your entire business rests on the assumption that consumers will want to buy it, so really, the equation is about the profitability of your business.

Let’s consider each variable independently, in-depth:

Customer Utility

Of the three variables, this is the hardest to define, but also one of the most important numbers you will ever work with.  The best way to think of customer utility is as the dollar amount your product is worth to your customers.

This will change depending on your product, so don’t be afraid if your customer utility is high — if you’re developing a hybrid vehicle, for example, it’s safe to expect something like $20,000.

The important thing to remember when estimating customer utility is that while it may be an estimate, it is an educated estimate.

You have to conduct market research here before you can decide on the number that most accurately reflects your market.

See what other similar companies are charging for their products, hold focus groups that ask how much a random sample of people in your target market would pay for your product, interview friends, family members, strangers.

If you don’t do the research, your number won’t be based on anything reasonable, and will therefore not provide any realistic output in the equation.

If you assume that the utility will be higher than it actually is, your price will be too high, and no one will buy your product.  So spend some time on this, or your idea will never turn a profit.

Production Cost

This is pretty straightforward and is exactly what it sounds like, ie the dollar amount it costs you to produce your idea.

Again, this will vary according to your end product, but it is much easier to come up with a realistic number here because there is almost nothing that isn’t already being produced, so all you have to do is ask around.

Still, this is a very important part of the equation, because over- or underestimating production cost will affect your optimal selling price, which will, in turn, affect the profitability of your business.

Generally, there are two kinds of costs associated with producing something: direct and indirect.

  • Direct costs relate to anything that goes into the production of your product, such as parts, time, electricity, packaging, etc.  If you were a baker, you’d figure in flour, sugar, ovens, knives, pans, butter, and so forth.
  • Indirect costs relate to those things that don’t go into the production of your product but are necessary in order to run a business, such as tables or chairs, signage, marketing materials and so on.

Add up all your direct and indirect costs, and that’s your total production cost.

Optimal Price

Subtract your production cost from your customer utility, and you’ve got the price point for your product.  It should be higher than production cost so you are actually making money, but lower than customer utility so that your customers feel like they aren’t being cheated.

In terms of the equation, the optimal price is the most important.  Knowing how to price your product will make or break your business.

Do the research, and then a little bit of math, and you’ll have a price point that will turn your idea into a bona fide business that makes you money and graduates you from daydream to entrepreneur.

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