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Sep 26, 2011 - 4 minute read - Comments - business planning

How To Quickly Test The Viability Of Your Idea

People come up with ideas for businesses all the time. These ideas need to be tested to see if they have a serious possibility of becoming actual businesses. The first thing I like to do is some rough calculations to see if there is sufficient profit involved to even consider the opportunity.

An idea needs to meet a certain threshold of profitability to even be worth looking into further. We each only have so much time in our day. If you choose to work towards launching a business that has low profit potential, you are giving up the opportunity of doing something more profitable. This profitability threshold will vary from person to person but you should have one based on your own situation.

I usually use a spreadsheet to do these simple profitability calculations but it’s not necessary to go that far. These are the typical “back of a napkin” calculations that business people have been doing for years. Use whatever method works best for you.

The first step is to calculate revenue. Let’s use a hypothetical business idea of selling musical instruments online through a website. Let’s say you think 10 instruments will sell every day at an average price of $75 and you will earn a 10% commission on each sale. That’s 10 x $75 x 10% = $75 per day.

Let say you were also going to run ads on your site using Google’s Adsense ad network. Lets say you are going to get 1,000 visitors to your site a day and 1% of them will click on a Google ad, and that Google pays $0.10 per click. That’s works out to 1,000 x 1% x $0.10 = $1 per day.

Let’s summarize.

Revenue Source Daily Revenue Monthly Revenue Annual Revenue
Commissions $75 $2,281 $27,372
Google Adsense $1 $30 $365
Total $76 $2,311 $27,737

The next step is to figure out what expenses will have to be incurred to generate this revenue. For this hypothetical business, we’ll be using a home office. There will be costs for web hosting, advertising, office supplies, professional services, bank charges and utilities. Notice that I haven’t mentioned any start up costs. For the purposes of this quick calculation, we are only interested in on going expenses that would be listed on a business’s income statement. Let’s assume the following:

Expense Monthly Annually
Advertising $250 $3,000
Bank charges $25 $300
Office supplies $20 $240
Professional Services $208 $2,500
Web hosting $15 $180
Total $518 $6,220
 

This works out to:

Income $27,372
Expense $6,220
Net income $21,152

So our rough calculations show that the business would make about $21,000 per year. Any salary for yourself would have to come out of this number as would any taxes and payroll deductions.

This amount would also have to represent the return on any investment you’ve made to get the business running. You need to get a return on your investment or you’ve just bought yourself a job. How much would that investment be? Fifteen or twenty thousand dollars? A site like this would need to have the ability for people to create accounts and post their items for sale on the website without interacting with a person. This requires advanced website development, which is beyond putting up a simple brochure-style website.

All of the numbers above are estimates and have not been researched. You might dispute that the assumptions I’ve made are accurate. This is where the use of a spreadsheet comes in handy as it is easier to run different scenarios and see the effects of different assumptions. You will have research the variables that go into your quick calculations based on the industry you are entering. The more accurate you can get your assumptions, the more accurate your overall result will be.

Don’t be overly optimistic with your numbers. It will be much harder to achieve a given level of sales or to keep expenses to a low level than you think. Be realistic.

The bottom line is that our hypothetical business appears to be not worth pursuing, given the assumptions that have been made. There is not enough income to pay a reasonable salary and to provide a good return on investment.