The SEVENTH Commandment

Walk Before You Run

Expand methodically from a profitable base toward a balanced business.

Optimism is both the poison and the antidote of the growth company manager. It may be possible to accomplish all things, but not simultaneously. With limited resources, incremental growth over time is the judicious prescription for prosperity. Seek logical, extensions of existing activities, but avoid a growth for growth’s-sake psychology. Bigger is not automatically better; more is not necessarily merrier. Make managing a competitive advantage. Increase customer dependency on the enterprise. Economic success can breed more of the same as well as other returns for the primary participants. Money is the traditional reward; life-style considerations are becoming more widely valued.

Walk before you run. Don’t build your skyscraper on sand. Sometimes you have to bunt to get on first base. Avoid growing into trouble. Measure twice, cut once. All of these aphorisms tend to ring true in the cold light of day. But historically, expanding methodically has proven to be something of an unnatural act for those who grow new companies . . . and even sometimes for experienced entrepreneurs who try to turn around old ones. A few years back, Roy Ash, cofounder of Litton Industries and later director of the Office of Management and Budget in Washington, D.C., was fired as the chairman and chief executive officer of the money-losing AM International (formerly called Addressograph-Multigraph).

In effect what this picture says is that 55 percent out of every sales dollar is available to pay first, for the fixed costs and second, for the profit requirements of the enterprise. In a growth company, profit is indeed a requirement, not a luxury. Think back over the ground that has been covered here in Commandment Seven. The crux of the matter of profitability fundamentals is simply this: An entrepreneurial team can harm, or kill, profitability by trying to do too much, too soon. For what often happens when opportunity-chasing overrules methodical growth is that overhead (fixed costs) goes up and the contribution rate comes down. This is a dangerous turn of events.

The end result may well be greater sales volume for the enterprise, but it is paid for with eroding profitability. The combination of higher fixed costs and dropping contribution margin is typically not a formula for long-term happiness in terms of economic vitality.  “Look at our 300 percent growth over last year.” But in the process, the fixed costs tripled, and perhaps more importantly, the contribution rate was allowed to drop precipitously from forty cents per sales dollar to ten cents. By 1992, Widgetronics had to sell $10 million of business just to break even at year end. Unless there are compelling strategic reasons to do so and plenty of money in reserve, such performance is unacceptable if the enterprise is operating in a competitive industry.

An even more detailed analysis of how Widgetronics grew itself into trouble indicates that between 1990 and 1992 the management added two major new product lines, one closely related to the main business and one not. Here are the highlights of the impact the additions had on the contribution rate and the fixed costs. Note carefully what the new, unrelated product line brought to Widgetronics.

In this example, a combination of factors hurt profitability. New, unrelated product lines are not categorically troublemakers. But they should be approached with caution. This is even more true now in the 2000s with the advent of the Internet and surprise competitors. If you personally are not comfortable working with and manipulating numbers in the way illustrated above, make sure at least one of the primary participants on your entrepreneurial team is.

As in any business, Widgetronics management has but three basic ways to increase the profitability of the enterprise. They can seek to increase sales volume (of products with positive contribution rates), reduce fixed costs, or increase the contribution rate. And there are also three specific ways to increase the contribution rate:

• Increase selling prices.

• Decrease variable costs.

• Change the product mix being sold so as to increase the net contribution rate for all products being sold.

Of course, in the Widgetronics example, as in real life, a combination of actions is probably required. Profits don’t just happen. Like sales, they typically have to be made to happen. Entrepreneurs must have sensitivity to the dynamics involved. Profitability isn’t a luxury; it is a necessity in a growth company. Without it there are no earnings to “retain.” Without earnings on today’s business it is usually difficult to attract either equity or debt capital to finance tomorrow’s business.

Profitability is the progenitor of cash, and when you are out of cash, you increasingly tend to be out for good in our undulating, economic times. Entrepreneurs are naturally disposed toward spotting opportunities in the form of new product possibilities, additional markets to pursue, processes to initiate, exciting shortcuts to take, etc. Entrepreneurs move society from the old to the new. By definition, entrepreneurs are supposed to have the ability to see around corners!

But a fragile new enterprise will be lucky if the people in it can do a single thing exceptionally well and consistently during the early years. It may be possible to accomplish all things, but not simultaneously. As one weary president put it, “We can do anything, but we can’t do everything.” With limited resources, incremental growth over time is the judicious prescription for prosperity.