(MoneyWatch) Every time I hear someone use the phrase "It paid for itself," I cringe a little. Of course it is possible and desirable for something -- an advertisement, promotion, trade show, machine or display fixture -- to cover its own cost. The problem is that many business people, especially those just starting out, don't really understand what it means for something to pay for itself.
There are two ways something can pay for itself: One is through efficiencies/savings generated, like when you buy a high-efficiency appliance for your home. If the machine cost $500 and saves $50 a month in utilities, all other things being equal, the appliance "pays for itself" in 10 months. The second concept is when an expense is believed to be covered by incremental (immediate or ongoing) sales. This is the notion I'm referring to.
For many this will be the ultimate business 101 "duh," but you'd be surprised at how many people either kid/comfort themselves, or simply don't get it.
A couple of weeks ago I spoke to the owner of a really nice small business who told me he had shown his product at a trade show, and though it didn't go gangbusters, the show "paid for itself," so he was fine with it. He explained that the show cost around $8,000 and he sold about the same amount right out of the booth, so, in his words, it was a wash. And I hear that kind of thing all the time, in all different contexts, even from presumably experienced business people. But they are dangerously missing a critical, basic rule of business:
Presuming a desire to make a profit, the relationship of sales dollars to expense dollars is not one-to-one.
Using the example of my friend and his trade show, again the show cost him $8,000 (probably more, but underestimating true costs is the subject for another column). He sold roughly the same amount. So in his mind he sees $8,000 leaving his checking account and $8,000 coming in. Seems like a break-even, but it fails to factor in the cost of goods: The fact that in a profitable enterprise, expenses are paid with gross margin dollars, not sales dollars.
So in reality, based on a gross margin of 60%, his sales left him with $3,200 to cover expenses, so the show was a loser, to the tune of $4,800. And that doesn't factor intangibles like opportunity cost (what he could have done with the time and money had he not done the show). This doesn't mean he shouldn't have done the show; marketing involves experimentation and risk, and some (many) things don't pay off. It just means he has to understand and be realistic about the real results.
I'm not ignoring the big caveat: Sometimes a lack of upfront payoff is a legitimate investment in a bigger picture. Service companies are a good example: They have variable costs of their own (labor, materials, fuel). So if a landscaper spends $1,000 on a coupon mailing and gets $1,000 in jobs from customers using the coupon, the mailing did not pay for itself in direct response. But if those customers turn into long-term, repeat clients, the cost of the mailing was a customer acquisition expense that probably will more than pay for itself over time.
So a critical element of income/expense thinking is whether a sale is likely/mainly a one-time event (as was the case with the products sold out of the show booth), or the door-opener to repeat business. If the latter is likely, great. But if -- as in that trade show example -- sufficient repeat/residual sales are unlikely or impossible to measure, then it's prudent (especially for a small business) to take a conservative view of whether a given expense was really covered by the direct sales it generated.
Not all things will (or even should) pay for themselves, but it is important for a business person to be realistic about the results so he doesn't get himself into further trouble. Misunderstanding (or fooling yourself) about what it means to break even has both micro and macro implications on the financial health of your business.