The other day I was talking to my school friend and he brought me a business plan he was considering. It was a traditional manufacturing business in engineering industry which was completely being funded by his own money. He was pretty serious about the plan and had all the data relating to the specifications of the product, target market, current competition, business cycle and so on. He just had one question for me:

“Is the business worth it?”

And I couldn’t help but ask him like a character in the Maruti advertisement, “Kitna deti hai?”

We set out to find out an answer to our respective questions.

First, we created a comprehensive list of all the costs his business would incur and segregated them into fixed costs (think rent, labour, interest etc.) and variable costs (think raw material, electricity etc.)

Costs and expenses		Fixed Costs		Variable Costs
Raw Material		Labour		Raw Material
Electricity		Remuneration		Electricity
Labour		Sales & Admin
Remuneration (his own salary)		Rent
Sales & Admin		Interest
Rent		Depreciation
Interest
Depreciation

We considered all the fixed costs at annual basis (how much the business would incur in the whole year). We added a mutually decided lump sum amount as a safety margin to cover any costs that we may have missed. The reason for taking these costs annually is because the business will incur them irrespective of the level of their operations. In fact, they will incur these even if the business doesn’t run at all (I don’t need to explain you this, we know how all businesses were shut during lockdown yet had to pay salaries and rents).

Consider these fixed costs to be ‘Survival cost’ (my wife, an absolute rookie in this field gave me this term. Cheers to her!). This is the bare minimum you need to earn through your sales for the business to survive. How? We’ll see that in a minute.

Then we considered all the variable costs. However these costs were considered on per unit basis. We do so because if you plan to manufacture at certain efficiency, you will order raw material accordingly and your machinery will work for only such number of hours as required. Also, we considered the costs on higher end to cover for inflation / price movements in cost of product through the year.

From what we already know, we prepared the following data:

Cost of Machinery	1,00,00,000
Cost of Working Capital	50,00,000

Fixed Costs	Annual		Variable Costs	Per Unit
Labour	10,00,000		Raw Material	900
Remuneration	6,00,000		Electricity	50
Sales & Admin	10,00,000		TOTAL	950
Rent	6,00,000
Interest	18,00,000
Depreciation	35,00,000
TOTAL	85,00,000

Remuneration is the salary that you deserve to earn from your business for all the efforts you have put in. Of course the business belongs to you and all profits are yours to take. However, fixing remuneration for yourself helps you stay in discipline of how much you withdraw from your business. You could decide what remuneration suits you. Considering my friend’s requirements, this seemed reasonable.

“Why am I charging interest to myself?” my friend asked me. He was right. Which crazy ass person puts money from his left pocket to right pocket and calls it as his earnings? But it is not as plain as it sounds. The interest is calculated as ‘Opportunity cost’.

The concept of ‘Opportunity cost’ asks you one simple question. “If not this, then what?” In this case, if he was not doing this business, then what would he have done with his money? Think of our age old “Is se accha to” remark. “Tune 20,000 me ye company ka phone liya, is se accha to tu 20,000 me dusre company ka phone aur earbuds leta”. It basically tells you to maximize your returns out of your investment. In business or investment context, if your current asset cannot earn above your opportunity costs, it’s not worth it.

Now we had to understand at what price is the product sold. He dialed some numbers and we found a range at which these products could be sold. We took the lowest number from that range in the calculation. (PS: Our Gujarati blood teaches us taking risks, but also teaches us to consider a safety margin at every possible place to cover for any adverse eventualities. That’s also a big reason why you always see us with our trademark theplas and khakhras whenever we leave for vacation. It’s not just about our love for food, it’s about having security in most unthinkable, hostile situations).

The difference between Sale price and sum of variable costs is called ‘Contribution margin’, which in simple words mean what you earn over your raw material and other direct manufacturing costs on sale of each unit.

Selling price	1,150
Variable cost	950
Contribution Margin	200

This contribution margin is then multiplied by the units that will be produced and sold during the year. While discussing with him, we found out that he could produce about 68,000 units of his product throughout the year at a given capacity (of course we considered safety margin here too. You thought we’d forget?)

The answer we get here will then be compared to total fixed costs (remember survival cost) incurred during the year. If my total contribution margin exceeds my total fixed costs, the business is said to be profiting.

Contribution Margin	200
Units	68,000
Total contribution	1,36,00,000
Total fixed cost	(85,00,000)
Profit	51,00,000

The biggest catch here is that his whole plan changed when we did this calculation. Initially, when my friend thought of buying a machine, he was planning to go for a smaller version to play safe in the beginning. However, the smaller machine only produced 32,000 units per year while the costs we calculated above didn’t change much. Think what soup he would have got into by trying to “PLAY SAFE!”

Finally, I got my answer to “Kitna deti hai?” The business would earn Rs. 51,00,000.

But still that was not the answer we were looking for. Because to understand whether the business was really worth it, we needed to understand how much return it gave us and more importantly, how soon it gave us back what we have invested.

We finally calculated the Return on Equity (RoE). RoE is a measure that tells us how much a particular business has earned from its investment. In our case, the investment was 1.5 CR while profit earned was 51 Lakhs hence, RoE was 34%. Considering the business will keep earning this profit each year, we can say that the business will give us our investment back in little under 3 years. I know now you’re thinking how the costs can remain the same each year. Calm down. You’re right. But because of the safety margins we considered at various checkpoints, we have got them all covered.

Return on Equity	34%
Payback period	2.94 years

Please note, besides calculating the ROE and Payback period like we just did, this method also helps you in ascertaining a target (target units to be sold or produced or both). For example, you have a machine which can say, produce 20 lakh units per year. It’s not necessary that you will find a market for all 20 lakh units. What you can do here is get a judgment of how many units you can sell and see if you can still make profits.

To give you another perspective, let’s say you went on to play safe like my friend and bought the machine that can only produce and sell 32,000 units while all the costs remain the same, you would make a loss of Rs. 21 lakhs! This means you will have to bring in extra 21 lakhs just so that your business could survive.

Now it was my turn to ask my friend. You are getting a return of 34% per year and your investment will come back to you in about 3 years. “Is the business worth it?”

Now my same question was trickier to him than his was to me. Why? Because he did not know on what basis he could say a yes or a no. I simply drew this on a rough page to him to make things more clear.

It’s no secret that whether you are starting a business or making an investment, your primary goal is to make profits. If you have some other primary target in your mind, think over your decision to start a business or make an investment.

By the above exercise, what we aim to do is to try and find the best mix through which your business can sustain and grow and also compare it with different opportunities we have apart from this business.

Still not confident of how things need to be done? You can contact us at siddharth@indigenousinvestors.com or jinay@indigenousinvestors.com