Before assuming business growth is the answer, a little research can save you from working hard for no additional profitability.
A beaver trap uses the beaver’s instincts to kill it. When a beaver senses danger, its instinct is to go to deeper water. The trap scares the beaver when it latches on. Deeper water is usually safer for beavers than shallow water or dry land. Instinct drives the beaver to deeper water but the trap is heavy, so it drags the beaver down and drowns it.
The instinctual solution for many business owners is growth. But growth can drown them under an increased workload with smaller margins. Instinct drove them into the clutches of the trap. The perceived instinctual drive toward the “safety” of growth is the very thing that can kill a company.
A classic thinking error is called substitution. Daniel Kahneman, in his book Thinking Fast and Slow, defines substitution as “answering one question in place of another. Our minds frequently replace the assessment of the question we want to answer with a simpler answer to another question.
An example is when a business owner lands a big deal, a big customer, or has high growth and thinks they have higher returns. In this case, the owner answers the question “Am I increasing my profitability?” with “Am I growing sales?” Bigger isn’t always better. Growth does not always equal profit.
Kicking the Business Growth Addiction
A classic anti-drug ad from the ’90s shows a person doing cocaine. They explain that they do coke so they can work longer… so they can do more coke… so they can work longer… It was a vicious circle that could only end in their demise. Business owners can get into the same circle of addiction, but the drug of choice is business growth.
The circle starts by always believing growth is the best way to more profitability. The growth brings unexpected expenses, which reduces income, so the answer once again is growth which brings more expenses. It’s the same vicious circle.
Niche Retail was a company that many would consider a fast-growing successful company. Gino Wickman, in Traction, quotes Tyler Smith of Niche Retail as saying “We got addicted to the money and the size”. Smith had started a lifestyle company but Wickman concluded the company had “grown too fast and they couldn’t get out of their own way.” (Check out my post on Authentic Goals to learn how to avoid this loss of strategic focus). Smith and his company later shut down Niche Retail.
How do you escape the addiction? The answer lies in clearly weighing the benefits and costs of growth. You don’t know whether growth is the right strategy until you do the analysis.
One way to assess whether growth is the right strategy for you and that you are ready for growth is to check out my free business growth checklist.
Benefits of Business Growth
Any business growth addict can list the opportunities and benefits of growth:
- More income can be earned on fixed costs, which increases profits
- Excess capacity can be put to profitable work
- Growth excites and motivates staff
- New markets and customers provide revenue diversification and reduce risk
- Inventory can be purchased in larger quantities to get lower costs
Growth can bring all these things. There is also a list of costs, which can outweigh these benefits.
The anti-drug ad shows the addict realizing their assumptions had led them into a downward spiral. The first step of quitting an addiction is ending the denial. For growth addicts, this means realizing growth isn’t always good. Let’s dig into that idea a little more.
The Problems of Business Growth
Growth can only increase your profits if it is achieved with a positive marginal return on investment. This is not easy to predict because both revenue and costs shift with growth.
The easiest way to increase sales is to reduce prices. If your margin is tight now, it may be tighter or negative at the lower price. You only know your marginal cost and profit from a well-constructed profitability analysis.
Lowering prices doesn’t guarantee increased sales. Your competitors may match your lower price to maintain their market share. Your competitors took away your growth, leaving you with only the losses of a reduced margin. Welcome to a price war where everyone loses. Chasing volume with price reductions may be a race to the bottom in a war of attrition. The few survivors end up very weak.
The much bigger margin problem is cannibalization. Cannibalization is reducing your price to existing customers when you could have sold to them at your old price or a higher price.
For example, let’s say you usually sell your widgets at $100 but you lower the price to $90 to drive growth. If you normally sell 1,000 widgets, your profit dropped $10,000 ($100-$90=$10 X 1,000). Do you know how many more widgets you need to sell at the lower price just to recoup this lost profit?
The only way to know is to know your marginal profit per widget. Otherwise, you are guessing or blindly running on instinct. Pricing decisions require this analysis. I’ve developed a free price change analysis template you can download to estimate your profit changes.
Sales staff are painfully aware of the deals they are losing and reducing the price seems like the easy solution. They may not be aware of the loss in revenue on all existing deals by lowering the price and may not know the marginal costs. You have to run the numbers.
You also want to model the growth’s effects on your compensation to sales staff and referral sources. This compensation is often based on production and not profit. Your average profit per unit will drop by any promotional price cuts and you’re paying much more in total commissions because sales are up.
Growth can also cause operating inefficiencies to go unaddressed. Growing more revenue is more inspiring than cutting costs. Cutting costs causes stress and arguments. Inefficiencies then build up over time. Many people finally deal with the inefficiencies during a recession when it’s hard to make the cost savings fast enough.
Morale and Customer Satisfaction
Sales promotions can often be demoralizing to employees that aren’t commissioned. Sales staff are working hard but they feel like it’s worth it when they receive their commission check. “Best year ever” they’ll say.
Production, processing, and other back-office staff have also been working really hard and know the sales side is making a killing. If back-office staff have no upside from all the new volume, they feel overworked and underappreciated. This stresses morale. Their workload must be reduced back to normal through additional staff or process efficiencies. Increasing their pay would also help their morale, at least temporarily.
Closely related to morale is customer satisfaction. Customers can sense reduced morale. Resources to handle the growth must be in place before in advance or customer service suffers. This hurts the brand, which has long-term implications.
Cash Flow Pressure
An owner who has a good chance of executing a high growth strategy must prepare for it to ensure employee and customer satisfaction. Once high growth is unleashed, operations can have a hard time catching up. Growth takes a pool of capital to prepare for growth.
Capital is needed for the timing difference between expenses and sales. Cash outflows for expenses often precede cash inflows from sales. Pushing for sales growth without the capital to support it leads to a cash crunch.
One of the biggest things to watch out for is hitting your production capacity and needing to make big investments. Growth often requires new employees, new equipment, and increased inventory. Does that growth trigger another cost? Have we entered the growth spiral again?
Putting it All Together
Let’s put all this together now. Growth may increase profits or it may decrease them. You don’t know without marginal profitability analysis. The investment needed to produce growth will likely decrease cash flow, at least in the short term.
It’s easy to overestimate profits because revenues are easy to measure but capturing all the costs isn’t easy. Smart businesses think fully through the growth to identify all the costs and changes to those costs.
Beyond the costs, companies often don’t prepare for the growth, whether from lack of foresight or lack of capital. Employee morale and customer service then suffer. It’s better to prepare for the growth before it occurs than hoping infrastructure will “catch up” once you have enough cash.
There are many reasons why you should pursue a growth strategy. Many people pursue a growth strategy without considering its costs, the market reaction, and other strategies. You can avoid the pain of unprofitable growth by analyzing both benefits and costs before committing to growth.
Growth is exciting. It feels like success, even when it’s unprofitable. Don’t trust instinct. Do the work to make sure growth is the right strategy for you. Download my business growth checklist to make sure growth is the right strategy for you and that you are ready for growth.