A Tale of Two Businesses: Sales Channels and Profitability

As any manager of a (successful) business will tell you, the two most important factors are:

  • Cash – as in “cash is king”. You need cash to pay your payables. If you do not have enough cash, you cannot meet basic obligations, let alone invest in expansion. Cash generally comes from sales, particularly from converting receivables to cash. Never confuse the accounts receivable asset with the cash asset. Although there are receivable-based financing options, most of which are quite expensive, you normally cannot pay your bills with a receivable. Try telling your engineer that, this week, instead of direct deposit of her paycheck, she will receive a receivable from customer X! Additionally, cash can come from investors, to support expansion or growth in a time of negative profitability, until profitability is reached.
  • Gross margins – gross margins provide the excess over costs of sales (for services) or costs of goods sold (for products) to cover fixed costs, not to mention create operating profit for the owner(s).

Norm Brodsky, in his columns in Inc magazine as well as his book “The Knack” hammers home, again and again, how important gross margins are. As an aside, one of my favourite lines is the story of the manager who, upon being told that each product is being sold at a loss, i.e. negative gross margins, says, “no problem, we will make it up in volume!”

The two major factors that go into COGS (in the rest of this article, we will use COGS and COS interchangeably) are:

  • Product costs – materials, labour, transportation, etc.
  • Sales – commissions, channel costs, etc.

Assume Linksys sells a router for $100. If the cost of materials (plastic, chips, antenna, power supply, shipping, manufacturing) is $50, and they pay a 30% channel commission, i.e. $30, then gross margins are $20. Obviously, besides increasing prices, the two primary methods of increasing gross margins are:

  1. Reduce manufacturing costs, through one or more of: more efficient processes, lower-cost materials, better economies of scale, etc.
  2. Reduce sales costs, either through having each sales unit (e.g. salesperson) on a fixed cost sell more product, or reduce commissions to sales units, i.e. reduce the commission rates.

Clearly, the choice of sales channel, and its costs, has a significant impact on gross margins and, hence profitability.

This insight is very important when analyzing how to structure a new business. We will analyze two potential similar businesses, both based on actual business plan case studies, to see how these costs impact the choice of channel.

Business Overviews

Both of our businesses sell security software. To protect their privacy, we cannot disclose exactly what are of security, but suffice it to say that it is software that is usable only to businesses. The software is very similar, except that company S sells to small-to-midsize businesses (SMB), while company E sells to enterprises. S’s SMB targets have average revenues of $20-100MM; E’s targets have average revenues of $250MM to $BN+. SMB businesses are likely to have, at most, 1,000 employees. Enterprises will have, at minimum, twice that, and most will have 10,000 or more. Given the value of security at the larger scales, the minimum price point of E’s sales at an enterprise is at least $100k, and maximum sale price of $250k. By contrast, S’s minimum price point is $10k, and maximum sale price of $25k. Given the different market sizes and complexity of usage, it is not surprising that S’s minimum and maximum sales are 10% that of E. Both S and E wish to follow the traditional salesperson model. A salesperson, in both cases, makes direct sales calls, and closes each deal.

Enterprise

Given the complexity of E’s customers – both organizationally and in terms of deployment – it is unsurprising that E prefers the inside sales model. This model actually works quite well for them. Following our assumption of the minimum price point of $100k, our salesperson is earning a 20% commission. In the real world, some earn more, some earn less, but this number works for our purposes, and is close to the average assumed in the actual business studied. Our salesperson, being a star, wishes to earn at least $200k per year. Given that his commission is 20%, that means he needs to bring in $1MM per year in sales. Since the minimum sale size is $100k, he needs to make 10 minimum size sales per year, or just under one per month. For a good salesperson, this is eminently reasonable. 160 hours (4 weeks * 40 hours per week), is a reasonable amount of time to spend on closing a large deal. Additionally, since the maximum sale size is $250k, this salesperson likely will earn significantly more.

Enterprise Summary: Required minimum of $1MM per year in sales, for 10 sales per year.

SMB

S actually would prefer to avoid using a salesperson. S seriously investigated using distributors and other channels. However, these channels generally take 30% (sometimes more), and, more importantly, tend not to stock a product until there is significant customer demand. Given the higher COS (and hence lower gross margins and profitability), as well as the chicken-and-egg problem of distributors not taking product until there is demand, but no ability to generate demand without some sales and reasonable cash flow for marketing, S falls back on the same strategy as E: sales staff.

We follow our above assumption that the minimum price point is $10k. As with E, our salesperson earns a commission of 20%. Our salesperson, of course, also wants to earn at least $200k per year, which means at least $1MM per sales each year. However, since the minimum price point is $10k, our salesperson must make not 10 but 100 sales per year. With 52 weeks in the year, she must sell two products every single week. This gives her 20 hours to sell each product. This is extremely difficult, if not impossible, to do as a salesperson reaching out to customers. Even with the maximum sale at $25k, she would have to make just under a sale a week, if every single sale were at the maximum.

SMB Summary: Required minimum of $1MM per year in sales, for 100 sales per year, an unachievable target.

Alternate Paths

Clearly, our SMB is in a bind. If it uses distributors, it has no viable channel until customers demand the products. If it uses sales staff, it can either (a) increase commission rates to retain staff, thus killing gross margins and profitability or (b) expect to lose sales the staff, with a high turnover rate and an inability to attract savvy salespersons, as a quick analysis shows it to be physically impossible to make enough sales to earn the desired amount of income.

What does the SMB do, then? It has several possibilities:

  • Raise investment funds, which will allow it to unprofitably invest heavily in marketing and inside sales for the first one to two years, at a loss. At that point, sufficient demand should exist in the marketplace to allow it to use other channels that will be more profitable than a dedicated sales staff.
  • Increase prices significantly, essentially moving into E’s turf, or somewhere around the top of its market and the bottom of E’s.
  • Use Web distribution channels. This idea was raised by Mike Baird, author of “Engineering You Start-Up“. Mike’s argument is that in order to reach SMBs, you need to engineer and simplify your product sufficiently that it can be explained – value and installation – on the Web, and thus marketed and sold through Internet channels.

Assuming the SMB does not want to change markets because, for example, it has identified a large enough and strong enough niche, or the E space is already too competitive, and it does not want to or cannot raise investment funds, then the third choice is the best. Additionally, from a market product perspective, this is the best choice. Enterprises have large and complex environments, with advanced and highly-paid IT staff. Enterprises are the ones that need and can use complex products. SMBs rarely have such large staff, and normally have a fairly simple environment. The product from S must meet all of the needs of the customers, but must do so as simply as possible. Thus, not just for sales and distribution reasons, but also for core market reasons, Mike’s point is accurate.

Conclusion

Inside sales is rarely the best choice for a sales channel, unless all of the following are true:

  1. The price-point is at least $100k per sales, and preferably more.
  2. The organization to which you are selling is complex and requires a lot of handholding to get the deal done.
  3. The environment into which your product will be installed is complex technically, with advanced staff, and requires customization and/or advanced features for proper installation.

About Avi Deitcher

Avi Deitcher is a technology business consultant who lives to dramatically improve fast-moving and fast-growing companies. He writes regularly on this blog, and can be reached via Facebook, Twitter and avi@atomicinc.com.
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