Key Concepts for a Feasibility Study
The goal of the feasibility study is to determine whether or not there is a reasonable expectation that the co-op’s business can be financially viable. By financially viable we mean that all the co-op’s expenses can be paid including the members’ required wages and still have enough money left over to pay any loans or make new investments for the development of the co-op. The following outlines some key concepts you need to do this assessment. They will help you develop a basic financial model of the business.
Pricing
There are a number of reasons to start your analysis with pricing. The revenue potential of your co-op is dependent upon the price and number of products/services you sell. Unless you are starting with a completely new product or service in the market place, there will already be an accepted range of prices for the product or service you are going to provide. The price you charge will therefore be a key determinant of market acceptance of your product or service.
One of the key steps in determining what may be a reasonable price for your product/service is to compare it with those who will be your competitors. You need to look at similar products or alternative products to determine who are your competitors and what prices they are charging. In setting the price for your product relative to the competing products you must determine whether or not yours has any unique features, its quality relative to the competitors, etc. It is also important to determine how big the market is for your product and is it a discretionary purchase or something the customer still needs when times are financially tight. Once you have a sense of what price you can charge and an estimate of how many products you can sell, you can go on to the next question – at this particular price will enough customers purchase this particular good or service to pay the wages, expenses and surpluses (profits) which the co-op requires to be viable and meet the members’ needs.
To take this next step you will need to understand some basic financial concepts.
Revenue
Revenue is the money generated by the co-op through sales of goods and/or services. The total revenue is a function of the number of items sold times their price.
Cost of Goods Sold (COGS)
COGS is the amount the co-op must spend to purchase and or produce the products or services so that they are ready to sell. If the co-op is a retailer, COGS includes the cost of the products and the cost of freight to have the goods delivered to the store. For the manufacturer it would include the cost of raw materials with freight and all production inputs such as labour that are required to produce the item ready for sale.
Gross Margin
The gross margin is the difference between the revenue generated from the sales of goods and services and the COGS. It can be expressed in dollars or as a percentage of revenue. The gross margin is the amount of money resulting from sales that the co-op can use to pay their other expenses (see below) with hopefully some left over for a surplus (profit).
Expenses
Expenses are all the day-to-day costs of running the business. However it is important to understand there are different types of expenses and to learn to identify what type of expense a particular cost is. This is important for the later analysis of whether or not you can expect your business to be profitable.
Fixed Expenses
These are expenses for a particular period (say 1 year) which are incurred no matter what the co-op’s level of sales are. Examples include: rent, insurance, telephone, bookkeeping costs, advertising, heat and lights, interest payments on loans*, etc. For the feasibility analysis it is important to include the minimum level of income required for each member so that they can work on the business. This is a simple calculation for a retail operation as all the wages can be included here. However for manufacturing operation this is more complicated, as some of the employee’s necessary income will be included as labour expense in the COGS calculation. The balance of the members’ wages needs to be included in the fixed expenses.
Another expense which requires special mention is depreciation expense. When the co-op buys assets such as equipment, or renovations to its store or offices (any item which has a useful life of many years and that will be used over and over again) the initial cost is not classed as an expense but is classed as an asset (something the co-op owns). However a portion of the cost is allowed to be allocated as an expense each year. This portion is the depreciation expense. The co-op usually follows the amounts set by the Canada Revenue Agency to determine the amounts allowed to be classed as an expense for taxation purposes.
* Note that the principal payments on loans are not an expense,they must be paid from the surplus (profit) of the business or from additional investments (over time) by the members. This is very important because it means that a co-op with loans to repay, in order to be viable, must at least make enough profit to pay its loans.
Variable Expense
These are expenses that are incurred as a function of the volume of sales generated. For example in a construction firm, the more different job sites going that need supervision, the higher the travel cost will be for the supervisor. In a wholesaler, the more sales made, the greater the number of shipping crates will be required. For a small co-op, variable expense can usually be ignored for purposes of the feasibility analysis. Just be sure to make a reasonable estimate of the annual expense for the item and include it in the fixed expense category.
Surplus (Profit)
Profit is the difference between revenue generated less the COGS and the total expenses incurred for a particular period.
Breakeven Calculation
At this stage, if you have been thinking about your co-op business idea you will have a pretty good idea of what price you can get for your product, what it will cost you to buy or manufacture them, and also what the other expenses are that you must pay in order for the business to operate. Now you must take the next step help to determine if the business can be viable. To do this we will start by doing a breakeven analysis.
This analysis can be done by determining the number of units (products) you need to sell, if you are manufacturing, or alternately the total value of the sales (numbers of units time the price) in dollars that are required.
As was noted above the gross margin is the money available to cover your other expenses, the breakeven calculation is based on this fact.
Number of units sold required to breakeven
For this calculation you are first going to determine the gross margin per product,i.e. the price of the product less the COGS for the product. When you divide this amount into the fixed costs, you will find out how many units you need to sell to cover these costs. This is the breakeven number of units that will need to be sold.
Breakeven in dollars of revenue
To determine the breakeven in dollars ($) you take the price of a unit (or the average price of different units) and subtract the COGS and then divide it by the price of a unit. This shows how many cents you receive in gross margin for every one dollar of sales you receive. Since the gross margin pays for the other expenses, you then divide those expenses by the gross margin received.
Required Profit
As noted above, to be viable a co-op is likely going to require a surplus (profit) to pay for its loans and to have money to further develop its business, buy new inventory or equipment, and purchase other assets needed to develop the business. The co-op must determine how much money this is likely to be and add this required profit to the breakeven calculations done above.
Viability Decision
By now you will have a simple model of how your business works. What products or services it will provide, and at what price. You will know who your competitors are and will be getting the feel for whether or not your products have a good chance of being bought by customers. The breakeven analysis has shown how many units you need to sell or what are the total sales required. The key question now is – do think you can achieve those sales? This is the time to be very hard-headed and conservative in your estimates. It is also a time when you face one of the key experiences of business – having to make a decision and judgement about the future based upon your best guesses, with no certainty that you will be right. Ultimately, if you proceed it will be based on the feasibility analysis, your gut reaction in assessing this analysis and your commitment to succeed.