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Market Validation

Module 012 | Market Validation

Market validation is a series of interviews of people in your target market.

These interviews are used to test a product concept against a potential target
market.
A market validation should always be done before introducing a product.
Ideally, market validation should start much earlier in the process. A better
understanding of the target market will help build a better, more focused
product. A market validation will take a minimum of four weeks, more likely
take six to eight, depending on the number of interviews and the number of
people performing the interviews.
Pick one objective for your market validation. Either verify the target market,
or verify the positioning and value statements. Trying to do both of these in a
single market validation will create too many variables and weaken the value
of the market validation. Write down your objective and make sure everyone
involved agrees on the objective before proceeding.
Objectives:

1. Know the appropriate way to validate your market.

2. Understand how to choose the right supplier.
3. Build a strategic approach in selecting suppliers.

Starting a Market Validation

Before starting a market validation, you must identify your target market. It is
possible to do a market validation with multiple target markets, but that
makes little sense. Narrow down the target market to one if you are testing
positioning and two or three if you are testing the target market.
Define, as best you can, the target market. Write down the answers to the
following questions:
 What types of companies do your potential clients work for?
 What is their job title?
 How will your product make their lives better?
 How can you find them?
Be sure to narrow down your target market and positioning before launching
your market validation.
Finding the Target Market
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Market validations can be done with as few as three or four interviews, but are
more valid using a larger data set. If you are testing a consumer product, you
may want hundreds of interviews. If you are testing a business-to-business
product, you can often get a good market validation out of 20-30 interviews.
Pick the number of interviews that you want and multiply it by three to get the
number of contacts you will need.
You can find people to interview in your target audience through a number of
methods including the following:
 Cold calling. The most direct method is cold-calling into companies.
Ask for the person with the appropriate title and tell them that you are
seeking their advice on a new product. People are more likely to talk to
you if you are seeking their advice than they will be if you are trying to
sell them a product.
 Advertising. Online advertising is fast and very targeted. To find the
right audience, use advertising in an electronic publication that goes to
your target market. You will need an incentive for people to sign up for
the interview. You can use a small gift or a drawing for a larger prize.
 E-mail. You can rent e-mail lists or use viral marketing to get to the
right audience. If you already know a handful of people well enough, e-
mail them. You might want to try to get people to sign up by passing on
an email. They will need an incentive for passing on the e-mail as well
as for signing up.
Be sure to let your interviewees know when you plans to conduct the
interviews. Set up appointments as soon as possible because any
appointments will end up being rescheduled. Also, be sure to let them know
how much of their time it will take.
It is ideal to do some number of the interviews in person. You will always get
more information from someone who is sitting in front of you than you will get
over the phone. Doing the interviews via a web survey is not recommended.
The type of information that you are trying to get is too subtle and subjective
for multiple-choice answers.
Building the Question Set
The most important part of the market validation is the questions that you ask
and how you ask them. Unlike a scientific survey, you are trying to understand
the emotions of your target market. You will want to ask open-ended
questions that get them to talking about how and why they do things and what
will make them buy your product. Whether you are trying to validate your
target market or your positioning, a fundamental question that you should
always ask is, "What keeps you up at night?" This one question will tell you
where the priorities are for this person now. The answer may have nothing to
do with your product, but it will tell you where their priorities will be when
considering any product or service.
Beyond the basic first question, you will need to construct questions that allow
you to try out your product positioning and/or target market. Here are some
example questions:
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 Are you familiar with [product/service]?

 Use your positioning statement, then ask, "Do you see value in this
[product/service] for your organization?"
 Are you planning to invest in this [product/service] this year? Next
year?
 Who is responsible in your organization for implementing products or
services in this space?
You will want to have many questions that are specific to your product
including questions about their environment (which will tell you how easy it
will be to add your product to their environment), cultural issues (which will
tell you how easy it will be to adopt your product), and budgeting (which will
tell you if people actually have the money to buy your product).
The more time you ask from people the fewer you will get to sign up for your
interview, so it is best to keep the questions to a minimum. Fifteen minutes is
an optimum time for scheduling the interviews, but it is difficult to gain any
real depth in 15 minutes. Twenty to thirty minutes is probably a more realistic
time. If you are asking people for an hour or more, you are going to need a
significant incentive to get them to take that much time with you.
Testing the Question Set
It is important to test the question set. Run three to five test interviews, then
review your questions and make sure that you are getting the results that you
want. The following are some things to consider during this review:
 Are the questions open-ended enough to start a dialog?
 Is this the right target market?
 How long are the interviews taking?
 Are some questions unnecessary?
 Have you uncovered something in the interviews that you need to ask
some more detail about?
 Which questions were misunderstood and how can they be reworded?
Conducting the Interviews
Ideally, you, as the product-marketing manager, should be conducting the
interviews. Since you have the most intimate knowledge of the product and
the market, you gain the most from talking to the interviewees. However, this
may not be possible for a product that will require a large number of
interviews. You should certainly be involved in the first few interviews to
understand if the right questions are being asked. If you cannot conduct the
interviews yourself, try to do at least some of them.
Analyzing the Data

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 Analyzing the data is what you should do personally. If you have an outside
firm do a market validation for you, they may not reach the conclusions you
are looking for, or may neglect some data that they find insignificant but that
may interest you, from your own point of view. If you use an outside firm, be
sure to at least take an active role in analyzing the data, if not doing it yourself.
It is a good idea to create a high-level summary for management that includes
key findings and suggested changes in product positioning, value statement,
and target market.

Supplier Selection Process

Choosing the right supplier involves much more than scanning a series of price
lists. Your choice will depend on a wide range of factors such as value for
money, quality, reliability and service. How you weigh up the importance of
these different factors will be based on your business' priorities and strategy.

A strategic approach to choosing suppliers can also help you to understand

how your own potential customers weigh up their purchasing decisions.
Thinking Strategically When Selecting Suppliers
The most effective suppliers are those who offer products or services that
match - or exceed - the needs of your business. So when you are looking for
suppliers, it's best to be sure of your business needs and what you want to
achieve by buying, rather than simply paying for what suppliers want to sell
you.
For example, if you want to cut down the time it takes you to serve your
customers, suppliers that offer you faster delivery will rate higher than those
that compete on price alone.
For some pointers to help you identify what you want from suppliers, see the
page in this guide on what you should look for in a supplier.
The numbers game
It is well worth examining how many suppliers you really need. Buying from a
carefully targeted group could have a number of benefits:
 It will be easier to control your suppliers
 Your business will become more important to them
 You may be able to make deals that give you an extra competitive
advantage
For example, if you have a rush job for an important customer, your suppliers
will be more likely to go the extra mile if you spend Php10, 000 a month than
if you spend Php2, 500.
However, it is important to have a choice of sources. Buying from only one
supplier can be dangerous -where do you go if they let you down, or even go
out of business?
Equally, while exclusivity may spur some suppliers to offer you a better
service, others may simply become complacent and drop their standards.
What You Should Look For in a Supplier
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Reliability
Remember - if they let you down, you may let your customer down.
Quality
The quality of your supplies needs to be consistent - your customers associate
poor quality with you, not your suppliers.
Value for money
The lowest price is not always the best value for money. If you want reliability
and quality from your suppliers, you will have to decide how much you are
willing to pay for your supplies and the balance you want to strike between
cost, reliability, quality and service.
Strong service and clear communication
You need your suppliers to deliver on time, or to be honest and give you plenty
of warning if they cannot. The best suppliers will want to talk with you
regularly to find out what needs you have and how they can serve you better.
Financial security
It is always worth making sure your supplier has sufficiently strong cash flow
to deliver what you want, when you need it. A credit check will help reassure
you that they will not go out of business when you need them most.
A partnership approach
A strong relationship will benefit both sides. You want your suppliers to
acknowledge how important your business is to them, so they make every
effort to provide the best service possible. Moreover, you are more likely to
create this response by showing your supplier how important they are to your
business.
Identifying Potential Suppliers
You can find suppliers through a variety of channels. It is best to build up a
shortlist of possible suppliers through a combination of sources to give you a
broader base to choose from.
Recommendations
Ask friends and business acquaintances. You are more likely to get an honest
assessment of a business' strengths and weaknesses from someone who has
used its services.
Directories
If you are looking for a supplier in your local area, it is worth trying directories
such as Yellow Pages and Thomson.
Trade associations

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If your needs are specific to a particular trade or industry, there will probably
be a trade association that can match you with suitable suppliers.
Business advisors
Local business-support organizations, such as chambers of commerce, can
often point you in the direction of potential suppliers. You can also contact our
Strategic Information Centre.
Exhibitions
Exhibitions offer a great opportunity to talk with a number of potential
suppliers in the same place at the same time. Before you go to an exhibition, it
is a good idea to check that the exhibitors are relevant and suitable for your
business.
Trade press
Trade magazines feature advertisements from potential suppliers. You can
contact our Strategic Information Centre for a list of specialist trade
magazines.
Drawing Up a Shortlist of Suppliers
Once you have a clear idea of what you need to buy and you have identified
some potential suppliers, you can build a shortlist of sources that meet your
needs.
When considering the firms on your shortlist, ask yourself the following
questions:
 Can these suppliers deliver what you want, when you want it?
 Are they financially secure?
 How long have they been established?
 Do you know anyone who has used and can recommend them?
 Are they on any approved supplier lists from trade associations or
government?
Do some research and try to slim your list down to no more than four or five
candidates. It is a waste of time for you and the potential supplier if you
approach them when there is little chance of them fulfilling your
requirements.
Choosing a Supplier
Once you have a manageable shortlist, you can approach the potential
suppliers and ask for a written quotation and, if appropriate, a sample. It is
best to provide them with a clear brief summarizing what you require, how
frequently you will require it and what level of business you hope to place.
Get a quotation
It is worth asking potential suppliers to give you a firm price in writing for, say,
three months. You can also ask about discounts for long-term or high-volume
contracts.
Compare potential suppliers
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When you have the quotation, compare the potential suppliers in terms of
what matters most to you. For example, the quality of their product or service
may be most important, while their location may not matter.
Price is important, but it should not be the only reason you choose a supplier.
Lower prices may reflect poorer quality goods and services, which, in the end,
may not be the most cost effective option. Be confident that your supplier can
make a sufficient margin at the price quoted for the business to be
commercially viable.
Check that the supplier you employ is the one that will be doing the work.
Some suppliers may outsource work to subcontractors, in which case you
should also investigate the subcontractor to determine if you are happy with
this arrangement.
Wherever possible it is always a good idea to meet a potential supplier face to
face and see how their business operates. Understanding how your supplier
works will give you a better sense of how it can benefit your business.
Moreover, remember that your business' reputation may be judged on the
labor practices of your suppliers. It makes good business sense to consider the
ethical dimensions of your supply chain.
Negotiate terms and conditions
Once you have settled on the suppliers you would like to work with, you can
move on to negotiating terms, conditions, and drawing up a contract. See our
guide on how to negotiate the right deal with suppliers.
Getting the Right Supplier for Your Business
Know your needs
Make sure you know what you need. Do not be tempted by sales pitches that
do not match your requirements. Understand the difference to your business
between a strategic supplier, who provides goods or services that are essential
to your business - such as high-value raw materials - and non-strategic
suppliers who provide low-value supplies such as office stationery. You will
need to spend much more time selecting and managing the former group than
the latter.
Spend time on research
Choosing the right suppliers is essential for your business. Do not try to save
time by buying from the first supplier you find that may be suitable.
Ask around
People or other businesses with first-hand experience of suppliers can give
you useful advice.
Credit check potential suppliers
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 It is always worth making sure your supplier has sufficiently strong cash flow
to deliver what you want, when you need it. A credit check will also help
reassure you that they will not go out of business when you need them most.
Price is not everything
Other factors are equally important when choosing a supplier - reliability and
speed, for example. If you buy cheaply but persistently let down your
customers as a result, they will start to look elsewhere.
Agree on service levels before you start
It is a good idea to agree on service levels before you start trading so you know
what to expect from your supplier - and they know what to expect from you.
See our guide on how to manage your suppliers.
Do not buy from too many suppliers, but do not have just one.
It will be easier for you to manage - and probably more cost-effective - if you
limit the number of sources you buy from. This is particularly the case with
low value-added suppliers.
It is always worth having an alternative supply source ready to help in difficult
times. This is particularly important with regard to suppliers strategic to your
business' success.

Value Chain

A value chain is a set of activities that a firm operating in a specific industry

performs in order to deliver a valuable product or service for the market. The
concept comes through business management and was first described by
Michael Porter in his 1985 best-seller, Competitive Advantage: Creating and
Sustaining Superior Performance.
The idea of the value chain is based on the process view of organizations, the
idea of seeing a manufacturing (or service) organization as a system, made up
of subsystems each with inputs, transformation processes and outputs. Inputs,
transformation processes, and outputs involve the acquisition and
consumption of resources – money, labor, materials, equipment, buildings,
land, administration and management. How value chain activities are carried
out determines costs and affects profits.
The concept of value chains as decision support tools was added onto the
competitive strategies paradigm developed by Porter as early as 1979.In
Porter's value chains, Inbound Logistics, Operations, Outbound Logistics,
Marketing and Sales, and Service are categorized as primary activities.
Secondary activities include Procurement, Human Resource management,
Technological Development and Infrastructure.
Value Chain Business Models
Value chain selling is supported through two business models: demand chain
and a supply chain; WebSphere Commerce supports the transactions through,
and relationship management of both the demand chain business model and
supply chain business model. These models support transactions involving
multiple enterprises or parties. Products, goods, services, or information is
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delivered through the parties of the value chain from producers to end users.
A value chain also has relationship and administrative aspects, that is, you can
manage the relationship of the partners or enterprises in your value chain, as
well as offer some administrative services to those parties.
As a result, value chain business models must manage the two sides of their
businesses: their customers and direct sales, and their channel partners and
suppliers. Each requires its own management channels and practices.
To sell directly to customers (direct sales), value chain models usually include
a storefront, where customers can purchase their goods or services directly.
To manage relationships with partners or suppliers, the demand chain and a
supply chain models within the value chain include a hub. Under these models,
value chain administrators can administer the operational aspects of the value
chain in the hub, including enabling partners or suppliers to participate in the
value chain by registering them, setting them up, and conducting various
operations. Partners and suppliers can also access the hub to complete
administrative tasks such as registering users.
The following diagram provides an overview of the partners and relationships
that can be supported in value chain models.

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Recruiting and Hiring Top-Quality Employees

As all employers quickly learn, there is a world of difference between a worker

who is correctly matched to their job and their organization, and one who is
not.
However, how do you find and match the right people to the right jobs? By
including, in your comprehensive people strategy, a well-structured recruiting
and selection program. The key to successfully developing such a program is
to follow a proven recruiting process for the positions you need to fill. Resist
the temptation to omit steps, because shortcutting the process can
shortchange your results. Here is what you will need to do:
1. Develop accurate job descriptions. Your first step is to make sure you
have an effective job description for each position in your company. Your
job descriptions should reflect careful thought as to the roles the individual
will fill, the skill sets they will need, the personality attributes that are
important to completing their tasks, and any relevant experience that
would differentiate one applicant from another. This may sound basic, but
you would be surprised at how many small companies fail to develop or
maintain updated job descriptions.
2. Compile a "success profile." In addition to creating job descriptions, it is
important to develop a "success profile" of the ideal employee for key
positions in your company that are critical to the execution of your
business plan. These might include such positions as team leaders, district
managers and salespeople. For example, let us say you currently have 20
salespeople. Within that group, you have four that are top performers, 12
that are middle-of-the-road and 4 that are not quite making the grade. If
you could bump the number of folks in the top group from 20 percent to
33 percent, that could have a dramatic impact on your company's
performance.
To accomplish that goal, you need to profile everyone in the sales group to
identify any skills and attributes that are common to the top group but
missing from the other groups. Using this information, you will be able to
develop a profile to help you select the candidates most likely to succeed
in that position. Remember, you cannot tell if you have found a match if you
are not matching candidates against a specific profile.
3. Draft the ad, describing the position and the key qualifications
required. Although some applicants will ignore these requirements and
respond regardless, including this information will help you limit the
number of unqualified applicants.
4. Post the ad in the mediums most likely to reach your potential job
candidates. Of course, the Internet has become the leading venue for
posting job openings, but do not overlook targeted industry publications
and local newspapers.
5. Develop a series of phone-screening questions. Compile a list of
suitable questions you can ask over the phone to help you quickly identify
qualified candidates and eliminate everyone else.
6. Review the resumes you receive and identify your best candidates.
Once you post your ad, you will start receiving resumes...sometimes many
more than you anticipated do. Knowing what you are looking for in terms
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of experience, education and skills will help you weed through these
resumes quickly and identify potential candidates.
7. Screen candidates by phone. Once you have narrowed your stack of
resumes to a handful of potential applicants, call the candidates and use
your phone-screening questions to further narrow the field. Using a
consistent set of questions in both this step and your face-to-face
interviews will help ensure you are evaluating candidates equally.
8. Select candidates for assessment. Based on the responses to your phone
interviews, select the candidates you feel are best qualified for the next
step in the process.
9. Assess your potential candidates for their skills and attributes using
a proven assessment tool. A resume and phone interview can only tell
you so much about a job applicant, so you'll need a dependable assessment
tool to help you analyze the core behavioral traits and cognitive reasoning
speed of your applicants. For example, a good test will provide insights as
to whether the individual is conscientious or lackadaisical, introverted or
extroverted, agreeable or uncompromising, open to new ideas or close-
minded, and emotionally stable or anxious and insecure.
The success profile you created for each position will help you determine
which behavioral traits are important for that position. For example, you
would expect a successful salesperson to be extroverted. On the other
hand, someone filling a clerical position might be more introverted.
These assessment tests can be administered in person or online. Online
testing and submission of results can help you determine whether the
applicant should be invited for a personal interview.
10. Schedule and conduct candidate interviews. Once you have selected
candidates based on the previous steps, schedule and conduct the
interviews. Use a consistent set of 10 or 12 questions to maintain a
structured interview and offer a sound basis for comparing applicants.
11. Select the candidate. Make your selection by matching the best applicant
to the profiled job description.
12. Run a background check on the individual to uncover any potential
problems not revealed by previous testing and interviews.
13. Make your offer to the candidate. The information you collected during
the interview process will provide you with important insights as to
starting compensation levels and training needs.
Additional Pre-Recruiting Tips
Before you start the hiring process, determine your strategy relative to how
people fit into your organization. What is your process for making sure they
are a good fit with your company's culture? Decide whether your approach to
the cultural question should include a second interview. In addition, who else,
if anyone, do you involve in the interviews to help make this selection and
judge the candidate? Your goal is to have a plan that will help you determine
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 whether you have a qualified applicant who will fit into your company's
culture.
In addition, decide whether you are going to conduct pre-employment testing.
How much is it worth for you to know an individual's strengths and
weaknesses, not just as a hire/don't hire test, but as a coaching tool to help you
determine their training needs and the best approach to maximize the
person's productivity? Pre-employment testing is often overlooked, when it
could be a very valuable tool. For example, if you find an applicant who fits the
job description and appears to be the person you want to hire, pre-
employment testing can help you determine how to work with them more
effectively and move them along in your organization.
If you want your business to attract and retain good clients, your
comprehensive people strategy must include a recruiting and selection
strategy that attracts and retains quality employees. Following a well thought
out, structured process will help you best match the right people to the right
jobs in your company.

Develop a Business Model

A business model is the way in which a company generates revenue and makes
a profit from company operations. Analysts use the metric gross profit as a
way to compare the efficiency and effectiveness of a firm's business model.
Gross profit is calculated by subtracting the cost of goods sold from revenues.

The internet is a disruptive technology with the ability to revolutionize certain

industries, but where was the cash flow? When analysts could not find the cash
flow, they settled for the business model to legitimize the industry. Instead of
looking at net income, calculated as gross profit minus operating expenses,
analysts concentrated on gross profit. If the gross profit was high enough,
analysts theorized, the cash flow would come.
The Eight Danger of Channel Sales
Business Model is the category for all posts discussing business models for
startups
Channel sales can be used to create extremely successful business models. The
channel gives powerful advantage to an organization, adding additional sales
resources, and taking advantage of existing customer relationships that the
channel partners bring to the table.
The things to watch out for if you are planning to build a business around a
channel sales model are the following:
1. You should recognize that you will need to figure out the sales model
yourselves before you are ready to start to teach channel partners how to
replicate that model. In other words, you will need to make your first sales
directly using your own direct sales efforts (possibly in association with a
channel partner). This will help you understand if your product/market fit
is right, who you need to involve in the sales process, whether the
messaging is resonating, etc.
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2. Channel sales usually take a long time to get off the ground. The reason for
this is that a reseller has a different set of priorities to yours. You have a
great sense of startup urgency, have total focus only on your product, and
are willing to work long hours. They are usually focused on other products
and deals that are paying the bills, and will usually need a lot of work to
convince them that they will get a return on time invested in your product.
3. Resellers often are lazy, and do not want to do the work to create demand
for a new product. They usually prefer to sell products where the demand
already exists. This means you should still expect to create demand using
your own marketing efforts. Ideally, you should be in a position to feed
those leads, or better still, deals that are close to done in the early days.
4. Resellers need education on how to sell, handle objections, differentiate
your product from the competition, etc. This requires work by your
channel sales team. Nevertheless, they will need backup from channel
marketing people whose job it will be to create the appropriate training
materials, programs, tests, etc.
5. Resellers are notoriously bad at marketing. So in addition to your own
demand creation marketing efforts, you are likely to want your channel
marketing staff to create materials and programs that can be used by the
channel to market to their own customers. They will then need to push the
resellers into committing to running events, webinars, etc. using those
materials.
6. Check to make sure there is a channel that sells similar products to a
similar buyer. For example, there is now a nice ready-made channel that
sells VMWare products to IT, and that channel can be used to sell a variety
of add-on products. However if there is no such channel in place, you will
have a significant uphill slog to create a channel that is suitable for your
own needs. Few startups have the time or funding needed to pull this off.
7. If you decide to use a channel sales model, be prepared to commit to it
entirely, and not take orders directly (unless there are some very clear
rules). If the channel sees you competing against them, it will turn them off,
and lessen their commitment to your products. It will also lead to conflicts
in your own sales organization who will want the short-term gain of
greater commission from taking deals directly. While this might mean
more revenue for you in the short term, it is not going to help you build the
advantage of the channel, where once they have seen how to make money
from one deal, they will replicate that with other customers of theirs.
8. Do not expect sales execs that are used to direct sales to transition easily
to channel sales. There is a different mindset involved in committing to the
long-term effort of building a channel. Sales people used to direct sales
prefer more control, and the faster results that come from doing things
directly with the customer. Channel sales people know that with patience
they can get greater advantage than doing things themselves.

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Given the right channel, the right people, good product/market fit, and a lot of
patience, the channel sales model can be one of the most profitable business
models.
Business Model Components
The two primary levers of a company's business model are pricing and costs.
A company can raise prices and it can find inventory at reduced costs. Both
actions increase gross profit. Gross profit is often considered the first line of
profitability because it only considers costs, not expenses. It focuses strictly on
the way in which a company does business, not the efficiency of management.
Investors that focus on business models are leaving room for an ineffective
management team. They believe the best business models can run themselves.
There are five (5) business model components every entrepreneur needs.
1. Revenue Model
Briefly, this is your strategy to generate revenue. What you plan to sell, and
what will convince people to buy. Value propositions, positioning, effective
messaging, product/market fit. Good or bad you got to have a clear
understanding of your revenue model and communicate it well. Although
most business owners get the importance of this in theory -- why do so
many struggle? Perhaps because they really do not get it after all.
2. Gross Margin Model
Yes -- important for you to know how much of the pie you get to keep from
each sale. Do you know your piece of the pie? For example, Walmart and
Costco know they run low gross margins. Their value game is one of low
pricing, so they cannot mark up their products by an exorbitant amount
and still play the value card. However, let us look at the legal service
industry. It has, on average, a gross margin of 93.22 percent, according to
Butler Consultants. Although I am not advocating you jump into the legal
game, it is critical for you to understand your own gross margin model. Can
you see why?
3. Operating Model
If you are Costco, it has slash and burn the expenses. Which is why they
operate out of huge bare warehouses with pallets stacked high of goods.
No thrills, no frills, stack ‘em high, watch ‘em fly. However, if you are in the
legal service industry, it is all about high style and lavish surroundings.
Ever visited a big law firm on the top floor of a downtown New York high-
rise where both the views and service is breathtaking? Both businesses
operate and make decisions based on the knowledge of their operating
model. Do you have a clear understanding of yours?
4. Working Capital Model
Indeed, ‘cash is king’. Do you understand your cash flow requirements? As
you may or may not know, cash flow is significantly different from
‘revenue’. For example, if you operate a bricks-n-mortar retail store on the
main street in your town, you experience first-hand the need for cash. You
must spend cash to fill your store with product so it is available when a
customer walks in ready to buy. Thus, inventory sucks up a tremendous
amount of your working capital. However, if you are an author who strictly
sells downloadable books online, your need for working capital is
significantly different. Laptop, pair of pajamas and an account with
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Amazon can theoretically produce millions of downloads to create a

significant cash river.
5. Financing (or Investment) Model
Number one roadblock I hear business owners complain about is lack of
capital. Yes -- it sometimes does take money to make money. However, not
always. Therefore, to understand the difference is key. For example, say
you want to build a better hotel chain than Marriott or Hilton. Well, I can
tell you this -- you are going to need some serious upfront financing to even
stand a chance to pull it off. However, let us say you plan to change the
world by teaching people how to play the ukulele. Buy a video camera,
launch a WordPress website and watch your video lesson series at $79 a
pop take off like wildfire. Total capital investment? About 500 bucks.
Your success is greatly dependent on your understanding of these five (5)
components of your business model.
How to Create a Budget for Your Startup
For many small-business owners, the process of budgeting is limited to
figuring out where to get the cash to meet next week’s payroll. There are so
many financial fires to put out in a given week that it is hard to find the time to
do any short- or long-range financial planning. However, failing to plan
financially might mean you are unknowingly planning to fail.
Business budgeting is one of the most powerful financial tools available to any
small-business owner. Put simply, maintaining a good short- and long-range
financial plan enables you to control your cash flow instead of having it control
you.
The most effective financial budget includes both a short-range, month-to-
month plan for at least a calendar year and a long-range, quarter-to-quarter
plan of at least three years that you use for financial statement reporting. It
should be prepared during the two months preceding the fiscal year-end to
allow ample time for sufficient information gathering. The long-term budget
should be updated when the short-range plan is prepared.
Many financial budgets provide a plan only for the income statement;
however, it is important to budget both the income statement and balance
sheet. This enables you to consider potential cash-flow needs for your entire
operation, not just as they pertain to income and expenses. For instance, if you
had already been in business for a few years and were adding a new product
line, you would need to consider the impact of inventory purchases on cash
flow.
Budgeting only the income statement also does not allow a full analysis of the
effect of potential capital expenditures on your financial picture. For instance,
if you are planning to purchase real estate for your operation, you need to
budget the effect the debt service will have on cash flow. In the future, a budget
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can also help you determine the potential effects of expanding your facilities
and the resulting higher rent payments or debt service.
In the startup phase, you will have to make reasonable assumptions about
your business in establishing your budget. You will need to ask questions such
as:
 How much can be sold in Year 1?
 How much will sales grow in the following years?
 How will the products and/or services you are selling be priced?
 How much will it cost to produce your product? How much inventory
will you need?
 What will your operating expenses be?
 How many employees will you need? How much will you pay them?
How much will you pay yourself? What benefits will you offer? What
will your payroll and unemployment taxes be?
 What will the income tax rate be? Will your business be an S
corporation or a C corporation?
 What will your facilities needs be? How much will it cost you in rent or
debt service for these facilities?
 What equipment will be needed to start the business? How much will
it cost? Will there be additional equipment needs in subsequent years?
 What payment terms will you offer customers if you sell on credit?
What payment terms will your suppliers give you?
 How much will you need to borrow?
 What will the collateral be? What will the interest rate be?
As for the actual preparation of the budget, you can create it manually or with
the budgeting function that comes with most bookkeeping software packages.
You can also purchase separate budgeting software such as Quicken or
Microsoft Money. Yes, this seems like a lot of information to forecast. However,
it is not as cumbersome as it looks.
The first step is to set up a plan for the following year on a month-to-month
basis. Starting with the first month, establish specific budgeted dollar levels
for each category of the budget. The sales numbers will be critical since they
will be used to compute gross profit margin and will help determine operating
expenses, as well as the accounts receivable and inventory levels necessary to
support the business. In determining how much of your product or service you
can sell, study the market in which you will operate, your competition,
potential demand that you might already have seen, and economic conditions.
For cost of goods sold, you will need to calculate the actual costs associated
with producing each item on a percentage basis.
For your operating expenses, consider items such as advertising, auto,
depreciation, insurance, etc. Then factor in a tax rate based on actual business
tax rates that you can obtain from your accountant.
On the balance sheet, break down inventory by category. For instance, a
clothing manufacturer has raw materials, work-in-progress, and finished
goods. For inventory, accounts receivable, and accounts payable, you will
figure the total amounts based on a projected number of days on hand.
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Consider each specific item in fixed assets broken out for real estate,
equipment, investments, etc. If your new business requires a franchise fee,
copyrights, or patents, this will be reflected as an intangible asset.
On the liability side, break down each bank loan separately. Do the same for
the stockholders’ equity—common stock, preferred stock, paid-in-capital,
treasury stock, and retained earnings.
Do this for each month for the first 12 months. Then prepare the quarter-to-
quarter budgets for Years 2 and 3. For the first year’s budget, you will want to
consider seasonality factors. For example, most retailers experience heavy
sales from October to December. If your business will be highly seasonal, you
will have wide-ranging changes in cash-flow needs so you will want to
consider seasonality in the budget rather than take your annual projected Year
1 sales level and divide by 12.
As for the process, you need to prepare the income statement budgets first,
then balance sheet, then cash flow. You will need to know the net income figure
before you can prepare a pro forma balance sheet, because the profit number
must be plugged into retained earnings. In addition, for the cash-flow
projection, you will need both income statement and balance sheet numbers.
Whether you budget manually or use software, it is advisable to seek input
from your Certified Public Accountant (CPA) in preparing your initial budget.
Their role will depend on the internal resources available to you and your
background in finance. You may want to hire a CPA to prepare the financial
plan for you, or you may simply involve him or her in an advisory role.
Regardless of the level of involvement, your CPA’s input will prove invaluable
in providing an independent review of your short- and long-term financial
plan.

Income Statement

A financial document generated monthly and/or annually that reports the

earnings of a company by stating all relevant revenues (or gross income) and
expenses in order to calculate net income. Also referred to as a profit and loss
statement.
The income statement is a simple and straightforward report on a business'
cash-generating ability. It is an accounting scorecard on the financial
performance of your business that reflects quantity of sales, expenses incurred
and net profit. It draws information from various financial categories,
including revenue, expenses, capital (in the form of depreciation) and cost of
goods.

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By combining these elements, the income statement illustrates just how much
income your company makes or loses during the year by subtracting cost of
goods and expenses from total revenue to arrive at a net result, which is either
a profit or a loss. An income statement differs from a cash flow statement,
because unlike the latter, the income statement does not show when revenue
is collected or when expenses are paid. It does, however, show the projected
profitability of the business over the period covered by the plan. For a business
plan, the income statement should be generated on a monthly basis during the
first year, quarterly for the second and annually for the third.
An income statement lists financial projections in the following format:
 Income includes all revenue streams generated by the business.
 Cost of goods includes all the costs related to the sale of products in
inventory.
 Gross profit margin is the difference between revenue and cost of
goods. Gross profit margin can be expressed in dollars, as a percentage,
or both. As a percentage, the gross profit margin is always stated as a
percentage of revenue.
 Operating expenses include all overhead and labor expenses associated
with the operations of the business.
 Total expenses are the sum of cost of goods and operating expenses.
 Net profit is the difference between gross profit margin and total
expenses. The net income depicts the business' revenues and debt.
 Depreciation reflects the decrease in value of capital assets used to
generate income. It is also used as the basis for a tax deduction and an
indicator of the flow of money into new capital.
 Earnings before interest and taxes shows the capacity of a business to
repay its obligations.
 Interest includes all interest payable for debts, both short-term and
long-term.
 Taxes includes all taxes on the business.
 Net profit after taxes shows the company's real bottom line.
Although the basics of an income statement are the same from business to
business, there are notable differences between services, merchandisers, and
manufacturers when it comes to the accounting of inventory.
For service businesses, inventory includes supplies or spare parts -- nothing
for manufacture or resale. Retailers and wholesalers, on the other hand,
account for their resale inventory under cost of goods sold, also known as cost
of sales. This refers to the total price paid for the products sold during the
income statement's accounting period. Freight and delivery charges are
customarily included in this figure. Accountants segregate costs of goods on
an operating statement because it provides a measure of gross profit margin
when compared with sales, an important yardstick for measuring the firm's
profitability.
For a retailer or wholesaler, cost of goods sold is equal to total inventory at the
beginning of the accounting period and any merchandise purchased, including
freight costs, minus the inventory present at the end of the accounting period.
This is your total cost of goods sold.
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Although manufacturers account for cost of goods sold in the same manner as
merchandisers by reporting beginning and ending inventories, as well as any
purchases made during the accounting period, their approaches are also
different because they track inventory through three phases.
1. Raw material is purchased to create a finished product.
2. Work-in-progress is inventory that is partially assembled.
3. Finished products are inventory fully assembled and available for
sale.
Associated with this process are other costs, such as direct labor and factory
overhead. To account for all these costs, manufacturers usually report them
on a separate statement called the "cost of goods manufactured." This financial
statement is formed by first listing the work-in-progress inventory at the
beginning of the accounting period. The next listed are raw material and direct
labor. The total cost of materials available for use includes inventory at the
beginning of the accounting period plus new purchases and freight charges.
Subtract the raw material inventory present at the end of the reporting period
from the cost of material available for use to determine the cost of materials
used. Add direct labor and manufacturing overhead to this amount. This
results in your total manufacturing costs. Add the work-in-progress beginning
inventory present at the end of the accounting period. These supplies you with
the cost of goods manufactured.
In the income statement for manufacturers, cost of goods manufactured is
added to the finished goods inventory at the beginning of the inventory,
resulting in total cost of goods available for sale. The finished goods inventory
present at the end of the reporting period is subtracted from this amount to
produce the cost of goods sold.
When comparing the accounting of several income statements over time, you
can chart trends in your operating performance. This helps you chart future
goals and strategies for sales, inventory, and operating overhead.
How to Calculate Gross Profit
One of the most important financial concepts you will need to learn in running
your new business is the computation of gross profit. In addition, the tool that
you use to maintain gross profit is markup.
The gross profit on a product is computed as:
Sales - Cost of Goods Sold = Gross Profit
To understand gross profit, it is important to know the distinction between
variable and fixed costs.
Variable costs are those things that change based on the amount of product
being made and are incurred as a direct result of producing the product.

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Variable costs include:
1. Materials used
2. Direct labor
3. Packaging
4. Freight
5. Plant supervisor salaries
6. Utilities for a plant or a warehouse
7. Depreciation expense on production equipment
8. Machinery
Fixed costs generally are more static in nature. They include:
1. Office expenses such as supplies, utilities, a telephone for the office, etc.
2. Salaries and wages of office staff, salespeople, officers and owners
3. Payroll taxes and employee benefits
4. Advertising, promotional and other sales expenses
5. Insurance
6. Auto expenses for salespeople
7. Professional fees
8. Rent.
Variable expenses are recorded as cost of goods sold. Fixed expenses are
counted as operating expenses (sometimes called selling and general
administrative expenses.
While the gross profit is a dollar amount, the gross profit margin is expressed
as a percentage. It is equally important to track since it allows you to keep an
eye on profitability trends.
This is critical, because many businesses have gotten into financial trouble
with an increasing gross profit that coincides with a declining gross profit
margin.
The gross profit margin is computed as follows:
Gross Profit / Sales = Gross Profit Margin
There are two key ways for you to improve your gross margin. First, you can
increase your prices. Second, you can decrease the costs to produce your
goods. Of course, both are easier said than done.
An increase in prices can cause sales to drop. If sales drop too far, you may not
generate enough gross profit dollars to cover operating expenses. Price
increases require a very careful reading of inflationary rates, competitive
factors, and basic supply and demand for the product you are producing.
The second method of increasing gross profit margin is to lower the variable
costs to produce your product. This can be accomplished by decreasing
material costs or making the product more efficiently.
Volume discounts are a good way to reduce material costs. The more material
you buy from a supplier, the more likely they are to offer you discounts.
Another way to reduce material costs is to find a less costly supplier. However,
you might sacrifice quality if the goods purchased are not made as well.
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Whether you are starting a manufacturing, wholesaling, retailing or service

business, you should always be on the lookout for ways to deliver your product
or service more efficiently.
However, you also must balance efficiency and quality issues to ensure that
they do not get out of balance.
Many business owners often get confused when relating markup to gross
profit margin. They are first cousins in that both computations deal with the
same variables. The difference is that gross profit margin is figured as a
percentage of the selling price, while markup is figured as a percentage of the
seller's cost.
Markup is computed as follows:
(Selling Price - Cost to Produce) / Cost to Produce = Markup Percentage
While computing markup for an entire year for a business is very simple, using
this valuable markup tool daily to work up price quotes is more complicated.
However, it is even more vital.
Computing markup on last year's numbers helps you understand where you
have been and gives you a benchmark for success. However, computing the
markup on individual jobs will affect your business going forward and can
often make the difference in running a profitable operation.
Financial Projections
By definition, financial projections are estimates of the future financial
performance of a business.
Planning and working on your company's financial projections each year could
be one of the most important things you do for your business. The results--the
formal projections--are often less important than the process itself. If nothing
else, strategic planning allows you to "come up for air" from the daily problems
of running the company, take stock of where your company is, and establish a
clear course to follow.
Regular planning also helps your company deal with change, both inside and
outside the company. By constantly reevaluating your company's strengths,
markets and competition, you are better able to recognize problems and
opportunities. You can react to new developments, rather than simply
plugging along.
However, what keeps it from just being a number-crunching exercise? Here
are three good reasons to project your financials:
 First, the financial plan translates your company's goals into
specific targets. It clearly defines what a successfully outcome entails.
The plan is not merely a prediction; it implies a commitment to making

Course Module
 the targeted results happen and establishes milestones for gauging
progress.
 Second, the plan provides you with a vital feedback-and-control
tool. Variances from projections provide early warning of problems. In
addition, when variances occur, the plan can provide a framework for
determining the financial impact and the effects of various corrective
actions.
 Third, the plan can anticipate problems. If rapid growth creates a
cash shortage due to investment in receivables and inventory, the
forecast should show this. If next year's projections depend on certain
milestones this year, the assumptions should spell this out.
Depending on your company's situation and objectives, you will need to
develop several types of projections and budgets:
 A model that projects either the current year or a rolling 12-
month period by month. This type of forecast should be updated at
least monthly and become the main planning and monitoring vehicle.
Information in this model can be the springboard for preparing the
other types of plans discussed below.
 A long-range, strategic plan looking out three to five years. While
the 12-month forecast often reflects short-term expectation and
tactical plans, the long-range projection incorporates the strategic
goals of the company. For startup companies, the initial business plan
should include a month-by-month projection for the first year, followed
by annual projections going out a minimum of three years. Some
investors may prefer to see the second year broken out by quarters. It
is fine to append the projections for years two and beyond to the 12-
month forecast, but the numbers should be more than just a simple
extrapolation of the current year. A strategic planning process should
accompany development of the "out year" projections.
 Budgets, typically covering one year. Budgets translate goals into
detailed actions and interim targets. Budgets should provide details,
such as specific staffing plans and line item expenditures. Given the
detail required, the size of a company may determine whether the same
model used to prepare the 12-month forecast can be appropriate for
budgeting. In any case, unlike the 12-month forecast, budgets should
generally be frozen at the time they are approved. They should also be
consistent with the goals of the long-range plan.
 Cash forecasts. These break down the budget and 12-month forecast
into even further detail. The focus is on cash flow, rather than
accounting profit, and periods may be as short as a week in order to
capture fluctuations within a month.
All projections should be broken out by months for at least one year. If you
choose to include additional years, they generally do not need to be any more
detailed than by quarters for another year and then annually after that.
The projections should include an income statement and a balance sheet.
Department or major expense category can summarize expenses; you can hold
line-item detail for the budget. Cash needs should be clearly identified,
possibly by adding a separate statement of cash flows. If your financial
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Market Validation

statements usually report financial rations or expenses as a percent of sales,

calculate and report these as part of the projections, too.

Glossary
Financial projections: Estimates of the future financial performance of a
business.
Gross profit: A company's total revenue (equivalent to total sales) minus the
cost of goods sold.
Income Statement: A financial document generated monthly and/or annually
that reports the earnings of a company by stating all relevant revenues (or
gross income) and expenses in order to calculate net income.
Revenue: The amount of money that a company actually receives during a
specific period, including discounts and deductions for returned merchandise.
Shortlist: A limited list of important items or individuals; especially: a list of
candidates for final consideration
Supplier: A party that supplies goods or services.
Value chain: A set of activities that a firm operating in a specific industry
performs in order to deliver a valuable product or service for the market.
Variable costs: Those things that change based on the amount of product
being made and are incurred as a direct result of producing the product.

References
1. Market Validation;
http://www.venturechoice.com/articles/market_validation.htm; June 5,
2017
2. Supplier Selection Process;
http://www.infoentrepreneurs.org/en/guides/supplier-selection-
process/; June 5, 2017
3. Value chain business models;
https://www.ibm.com/support/knowledgecenter/en/SSZLC2_7.0.0/com
.ibm.commerce.admin.business.doc/concepts/cbmvaluechain.htm; June
5, 2017
4. Recruiting and Hiring Top-Quality Employees;
https://www.entrepreneur.com/article/76182; June 5, 2017
5. Value chain; https://en.wikipedia.org/wiki/Value_chain; June 5, 2017

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6. Income Statement;
https://www.entrepreneur.com/encyclopedia/income-statement; June 5,
2017
7. How to Calculate Gross Profit;
https://www.entrepreneur.com/article/226158; June 5, 2017
8. Financial Projections;
https://www.entrepreneur.com/encyclopedia/financial-projections;
June 5, 2017
9. Business Model;
http://www.investopedia.com/terms/b/businessmodel.asp; June 5, 2017
10. The 8 Dangers of Channel Sales;
http://www.forentrepreneurs.com/channel-sales/; June 5, 2017
11. 5 Business Model Components Every Entrepreneur Needs;
http://www.forbes.com/sites/ericwagner/2013/05/23/5-key-business-
model-components/#54c974be652a; June 5, 2017
12. How to Create a Budget for Your Startup;
https://www.entrepreneur.com/article/244990; June 5, 2017
13. Effective Product Development Steps;
https://jpkgroupsummits.com/effective-product-development-steps/;
June 5, 2017
14. 5 Tips for Creating a Prototype;
https://www.entrepreneur.com/article/227975; June 5, 2017
15. The 7 Steps of Effective Product Development;
https://www.entrepreneur.com/article/244616; June 5, 2017