One big mistake I made in the early years as a small business entrepreneur was to do most of my purchasing from one vendor. It made sense at the time. First, it was much simpler than dealing with two or three. Second, the sales rep was a nice guy, always polite and accommodative. He would check my inventory for me and place the order himself, which saved me a great deal of time. Third, he had plenty of experience in the industry and had been with that distributor for many years. Fourth, he said he was interested in a business relationship whereby in return for getting all my business he would lower his margins and pass the savings on to me. What’s not to like?
I’ll start by sharing with you the fact that I’m paying less for some items today than I did 20 years ago. And that’s not because we have been in a deflationary cycle since then. Rather it’s because I wasn’t shopping before ordering. Think about it. Would you buy anything of value without first checking different sources to make sure you’re getting the best price? You wouldn’t think of it. Yet when it comes to small business purchasing that represents nearly 40% of revenues, we hand that over to the sales rep without asking many questions that might perhaps hurt her feelings. There is of course another very good reason why we do that: shopping among three vendors for 80 or 100 items takes an inordinate amount of time so as to be not humanly possible. We don’t have time efficient operational tools that would empower us to accomplish that task and level the playing field with the vendors. That field is currently tilted dramatically in their favor and they know it, and that’s how we end up with costs that are out of control, paying for items we don’t receive or paying more for items we happened to inquire about before ordering.
Another significant reason why we shouldn’t ever buy from just one vendor is that under the best of circumstances that one vendor will not be getting the best prices himself on all of the items he carries. That’s his problem not yours. By shopping among three vendors, you will quickly see which vendor has the best pricing on what items. Huge savings will result from buying certain items from vendors who are getting a better deal on them, in addition to the savings realized as a byproduct of vendors competing for your business. That is what competition is all about. It’s unfortunate that up to now we small business entrepreneurs didn’t have the tools to easily and effectively shop for inventory the way we do when we shop for a new TV.
When you have a 500-item purchase list and are constantly buying inventory items, there needs to be a system in place for managing each item individually. Doing so saved me $400,000 over the past 16 years. These are savings that went directly to the bottom line, averaging $25,000 per year. That’s a lot of money to a small business especially when you remember the small business high failure rate. More specifically, a savings of $25,000 in one year would prevent many small businesses from shutting down because they ran out of cash. Imagine then the impact of cumulative savings over a 10, 15 or 20 years. All of sudden we’re talking about real money that can be used to make other investments, build a retirement fund, improve one’s lifestyle or all of the above.
I estimate that of the $400,000 in savings mentioned above, about $100,000 (25%) was saved by catching delivery errors, invoicing errors or discrepancies between prices promised and what I was actually charged. Simply shopping among different vendors for each item before placing an order accounted for the balance of savings. One example is invoicing errors. On several occasions over the years I caught a total charge for one item on an invoice that was a multiple of what it should have been. The last one was a $527.60 charge for a produce item that was supposed to be $52.76. That’s one line on one invoice from one vendor accounting for savings of $474.84. Previous similar errors ranged from tens to hundreds of dollars on items such as fresh chicken breast and ground beef.
Another real life problem is price discrepancies. That happened so often with different vendors that it became a priority to me to find a solution effective enough for catching those errors so the vendor reps will decide it’s in their best interest to stop it from happening in the first place. Why? Catching each and every one of those incidents and sending a request to the rep for a credit resulted in a steady stream of extra paperwork for them. They had to first confirm that the price on the invoice was not the one they quoted, then issue a credit to make up for the error and follow up to ensure their accounting department processed the credit. It simply became too much hassle for them especially when they realized that I had a system in place for catching all these errors and following up until I received the credit. It was in their self-interest to guarantee that this problem ceased in my case. And that was OK because to them, I was just one customer out of hundreds.
If you start with the end in mind you will realize why it’s so important to make every effort to capture the savings discussed above. The problem is that existing tools such as accounting programs are not equipped to deal with these day-to-day operational problems. They are concerned only with organizing and accessing data because they assume that entrepreneurs operate in ideal conditions where mistakes don’t happen and vendors do not, on occasion, play games. That’s what Mallet Software is all about: a best practices and automation toolbox that will enable operators to efficiently and easily manage hundreds of tasks in real time. One of those tasks is purchasing and invoices management.
I recently asked a fellow restaurant owner about his purchasing controls practices to glean insights as I build Mallet Software. He summarized his system in two words: spot check. He was proud of the fact that he recently caught an inflated price on one item he buys, communicated that to his vendor, got the salesman in trouble and was assured that that will not happen again. That’s what I used to do in the early years.
A few months into my entrepreneurship experience, I had a conversation with a neighbor who owned a clothing store about checking invoices. He had been in business for 15 years and was trying to be helpful with advice to a novice business operator. He stated that he goes through each and every one of his invoices, line by line, to make sure he’s getting the quality, quantity and price he’s expecting. He strongly suggested I do the same. I thanked him for the advice and as I walked away I thought to myself, “Here’s this wealthy business operator who can sit in his office and examine every line on every invoice because he can afford to have enough employees on the floor to take care of business chores. Obviously, I couldn’t do that. Not while working 70 to 80 hours a week trying to keep up with the constant flow of tasks.” Three years later, as I was trying to find ways to bring the cost of materials down, I remembered that conversation and out of frustration I decided to do a thorough check of a few invoices. What I found was shocking. Prices that are out of control because I wasn’t shopping around, partial deliveries or non-deliveries that were not noted on the invoice which meant I was paying for something I didn’t get and math that didn’t add up on manually written invoices.
That was both eye-opening and a strong enough incentive to do something. But what to do? How was I going to go through approximately 3,400 invoices (annually) line by line to discover and fix hundreds of problems and then follow up to make sure credits were issued? It soon became quite clear to me that that task is not humanly possible to accomplish manually and that spot-checking would not come close to fixing the problem. Not with that many invoices. My neighbor, the clothing storeowner, had a huge advantage in that he had a fraction of that number of invoices to deal with. Why was it vitally important to optimize the purchasing and invoices process? First, the dollar volume consumed by purchases or paid out through invoices was around 40% of revenues, a significant ratio. Second, there was a thousand different points of waste, not a few big ones, that were easy to spot and fix. Just as with small leaks in a boat, money would bleed imperceptibly until it’s too late to do anything about it. Third, any savings accomplished would flow directly to the bottom line and thereby increase the profitability of my business. The result would be ever increasing cumulative savings as revenues increase. It didn’t take long to conclude that the answer of automation would provide, among other things, help in real time. That’s how Mallet Software was born: the first module was Purchasing/Invoices.
What’s amazing is that we, small business entrepreneurs, are still relying on manual processes, memory and hard copies in the twenty first century in the United States of America. Doesn’t that strike you as odd?
Why do entrepreneurs choose marketing over controlling costs?
Marketing is an issue of paramount importance if the purpose is to increase sales. That results in higher profits, which is the reason to be in business. There is, however, one situation where marketing a business can be inimical to its health. As discussed in the previous post, managing costs is tedious and because it is lacking proper automation tools, it is typically not done at all. If, as a result, a business is barely breaking even or losing money, the extra layer of revenues gained from marketing efforts will hasten the demise of that business. For example, let’s look at a business that grosses $500K annually. Its cost of materials is 35% and is suffering losses equal to 5% of revenues, or $25,000 and so it is barely hanging on. Assuming its marketing efforts succeed in increasing revenues by 20%, or $100K, losses will increase by $5,000 to $30,000.
That may not sound like a significant amount of money for a business grossing half a million dollars a year except for a couple of details: First, marketing campaign costs are not yet added to losses. These marketing expenses add to the losses of our hypothetical business. Second, the dollar volume and aging of its accounts payables. Other things being equal, to a business that was already on the edge of failure, these few thousands of dollars in extra losses may very well be enough to cause it to fail. That is why, incidentally, you will sometimes see a popular and busy restaurant close its doors abruptly. Contrast the above scenario with an effort to cut costs by 5 percentage points to industry norms. That same business would be saving $25,000 plus marketing campaign costs that were not incurred. Now it is breaking even and has established a solid foundation to bring in more revenues that are likely to make it profitable, because both cost of materials is optimal and fixed costs are, well, fixed.
Entrepreneurs’ focus on bringing in more revenues while lacking awareness of profitability or lack thereof, is a palliative. More revenues means instant gratification while optimizing costs is tedious work especially when automation is lacking. There is also a numbers illusion at work. Increasing revenues by tens of thousands of dollars annually sounds and feels far more satisfying than reducing costs by 5 percentage points. But in fact it is these few percentage points that really matter because they address the core issue: Making a profit. Add to that the bias on the part of some small business owners to increase revenues to boost the business’ selling price and you can see why it is simpler to expend energy on revenues first and foremost.
Finally, there is the myth about the relationship between dollars spent on marketing and how many units need to be sold to cover that cost. Operators typically ask how many units sold will take to cover the expense. If a campaign costs $10,000, for example, and units for sale are priced at $25, the answer would be 400. In fact that is the wrong question to ask. The correct question: What does it take to make $10,000 in profit in my business? Assuming a business is profitable and its profit margin is 10%, the answer would be $100,000 in revenues. Divide that number by unit price and what you get is 4,000 units sold to cover the cost of the marketing campaign, just to break even, and not 400. Now compare making and selling 4,000 units to the savings achieved as a result of controlling costs as explained earlier and you realize, in stark terms, how lack of awareness impacts small businesses decision making.
Why do some lottery winners go bankrupt?
The answer is lack of awareness. They fall prey to “new friends,” and end up losing their windfall as a direct result of the lack of a template for rational decision-making in a new situation. Not at all unlike new entrepreneurs.
Having taken the time to carefully examine “why” and proceed to solutions, one of the conclusions that became clear to me years ago, as a restaurateur, was that small business operators have to manage hundreds of tasks at all times. That is obviously not humanly possible, and that is where the huge gap in awareness in small businesses opens up. The result is that entrepreneurs often operate without a clear picture of their businesses at any given time, and such lack of awareness leads to faulty decision-making.
Experience and failing at various tasks in the early years at Patisserie Boissiere led me to develop and automate a 20-item list of actions that must be performed on each invoice that my business receives from vendors if we are to control costs and optimize time and profits.
The problem is that last year we handled approximately 3,400 invoices. Multiply 3,400 by 20 and what you get is, for all practical purposes, an unmanageable number that would consume enormous amounts of time if attempted manually.
Many operators try to cope by spot-checking prices of some items as opposed to checking the prices of all items. But doing so without knowing where in the hierarchy of spending items fall is simply a waste of time.
If, on the other hand, an operator does not perform each of those 20 actions on every invoice received, she would be conceding defeat regarding 40 percent of her revenues at the outset. When something that has to be done cannot be done, the result will be catastrophic failure. That is precisely what small businesses suffer from now. Vendors, on the other hand, are very familiar with the state of small business awareness and some of them take full advantage of it.
The key factor here is complexity. Once a business grows beyond a handful of employees and about two dozen inventory items, complexity increases exponentially. That means awareness of what’s happening in one’s business goes down, dramatically.
While big corporations have armies of personnel dedicated to each task, many small business owners try to compensate by being physically present onsite at all times. While that may address some problems, it does not address data volume being simply overwhelming. It is at that point that the process turns from management to a game of whack a mole. Tasks end up being ignored, done poorly or done brush-fire style at the last moment when a deadline is up.
Years ago a comment made by an economist about small businesses resonated with me a great deal: “We don’t know what goes on in small businesses. They are like a black box.” The tragedy is, neither do we in the small business community.