Calculating Marginal Revenue: Investing in Cousin Jimmy’s startup
How are we going to use the marginal revenue formula to figure this one out?
Have you taken to heart the old adage, “If you want to be wealthy, be an owner,” and want to fund a startup? Yeah! Me, too.
What tools do we have to help us determine what constitutes a good business?
Let’s talk about marginal revenue (and the marginal revenue formula) and how it can be used to help you determine whether to invest in a small business or startup.
Typing the two words “marginal revenue formula” brings me back to the days of Microeconomics 132. Hoo-boy. Time to dust off my intro books and try to remember what boring ol’ Professor Kauper had to say about analyzing market structures. (I think every time I buckled down and decided I really needed to study for Micro, I usually found that, conveniently, it was also almost always pub crawl time.)
Okay, let’s back up absolutely all the way.
Investing in a Small Business
If you’re looking to invest in a small business with your cousin Jimmy, there’s no doubt: you should be analyzing the business’ earnings or projected earnings, factoring in growth, debt levels, and the economics of the industry the business is in. There are other factors to consider, too:
- Why can’t Cousin Jimmy get the money from the bank? Most of the time, it’s tough to find a start-up that’s credible. A lot of times, it’s a friend or relative looking to start his or her business and he or she needs some seed money. Thousands of dollars could be lost over the simple act of a handshake and a casual handover of a check. Of course, all entrepreneurs think their business is going to be the next best thing. Make sure you’re positive that Cousin Jimmy knows what he’s talking about.
- Figure out the plan, man. Ask Cousin Jimmy for a full business plan, including a marketing plan and SWOT analysis.
- What’s your expected level of involvement? Are you a venture capitalist, or are you an angel investor with more control over the business’s decisions? What are the expectations on both sides?
- What’s your expected time frame? Are you comfortable waiting 10 years for returns, or are you interested in getting your money back, and then some, in five?
- What’s the ROI? Figuring out your projected return on investment can be tough to estimate, but the rate of return is likely going to matter to you!
- What’s your exit strategy? When do you take your shares, sell ‘em, and run? You need to know that ahead of time—both you and Cousin Jimmy need to agree so that you both have a plan that meets your quality world picture.
- There are other people to consider. It’s really important for you to consult with a lawyer, talk to your financial guru and also your other family and friends (especially for those who the particular finances may directly affect), especially if it’s a considerable amount of money.
Marginal Revenue Formula
Remember way back at the beginning of this article, we talked a little bit about something called “marginal revenue?”
Oh, yeah. That.
What’s marginal revenue and why do we need to know about it while we consider investing in a small business or startup?
Let’s put the words “marginal revenue” into terms that anyone can understand by looking at the marginal revenue formula. My best example is a concrete example:
Cousin Jimmy’s company sells cupcakes. It sells 200 cupcakes for $10 each.
Total revenue: $10 x 200 = $2,000 for his cupcakes.
If Cousin Jimmy’s cupcake company decides to drop the price to $9, with an assumption that it will sell 260 cupcakes (the thought process being that Cousin Jimmy will sell more that way) then the alternate revenue is $9 x 260 = $2,340.
Marginal revenue is therefore calculated in this way using the marginal revenue formula:
2,340-2,000 = 340 = $5.67
In essence, this “extra money,” which winds up also being less money for each additional product, is the marginal revenue.
Now, it would be considered negative marginal revenue if Cousin Jimmy’s company sold 220 cupcakes at $9:
(1,980-2,000 = -20)
So, therefore, by lowering the price, selling more products actually results in a negative marginal revenue by using the marginal revenue formula. Selling more doesn’t always equal more money for the till if you’ve dropped the price of each unit.
Slam dunk! Take that, Dr. Kauper. (My old professor would probably say, “Wow, she finally gets it.”)
We still haven’t answered the question about why all of this is relevant to our potential small business or startup investment. What’s all of this complicated marginal revenue (and the marginal revenue formula) stuff got to do with Cousin Jimmy and his casual startup proposal?
Taking into account a company’s overall revenue, plus its marginal revenue (both positive and negative) can give you great insight on whether the company is worth investing in.
You’ll need access to a company’s internal inventory numbers and/or sales reports to figure out whether it’s worth it to invest in that particular company—or, if the company hasn’t been created yet, you’d by golly better be asking these questions for the future.
For example, if a small company, Molly’s Cupcakes, is looking for investors, then it’s wholly possible for you to use marginal revenue calculations to figure out whether Molly’s would be worth the, say, $5,000 investment for you.
You’d use the marginal revenue formula to discern whether Molly’s is handling its marginal revenue appropriately, or if Molly’s is just reducing the cost and ineffectively “selling more.”
It Gets More Complicated With The Marginal Revenue Formula
In the previous situation, we are assuming that Molly’s is a monopoly, but we know that in the real world, there are a bunch of other Molly’s, sometimes in the same city. Indeed, this is not a monopoly. We do happen to have Scratch Cupcakery in the same town as well.
How does Molly’s handle the competition from Scratch Cupcakery?
For example, say that Molly’s, in response to Scratch’s competition, brings its cupcakes down to $3 instead of $5. Molly’s Cupcakes may still receive additional revenue, but ultimately, more customers still may go to Scratch and buy cupcakes for $5 instead.
Unfortunately, in the situation of Molly’s, the market is likely going to dictate the price level of Molly’s cupcakes because of the threat of Scratch’s presence three doors down.
And there you have it, the beauty of the free market, people! (This also showcases why owning a small business—especially when said business is not a monopoly—is so darned frustrating sometimes!)
I’m going to intone very monotonously, just like Dr. Kauper: “All right, everybody, does this make sense to you?”
“No, Dr. Kauper,” the class responds in unison.
“Okay, let’s move on.”
“WAIT!” Yells the class. (Yes. He really was a terrible professor.)
Marginal Revenue Fun
Check this out. We can have even more fun with marginal revenue formula and words that sound made-up, like using market structures to understand how marginal revenue would operate under an oligopoly. (Wouldn’t Oligopoly be a more enjoyable name for the Parker Brothers’ famous Monopoly game? Oligopoly? Ha!)
Just to complicate matters more (and isn’t that what the real world is like?), what would happen if we had three cupcake shops: Molly’s, Scratch, and Jimmy’s Cupcakes?
What if Molly’s and Scratch Cupcakery both see Jimmy coming a mile away? What could they do, knowing full well that Jimmy’s is coming to town? Ultimately, this very real possibility is something you’ll need to fully consider before investing in Jimmy’s.
The technical definition is that Molly’s and Scratch Cupcakery are in an oligopoly (they’re considered two cupcake shops in competition with each other in the market.) At any rate, they could, by agreement, lower their prices to force Jimmy’s out of business and then raise prices together once Jimmy’s is history.
Ultimately, knowing the competitors in the market, doing due diligence to calculate marginal revenue (and all the other things you should be asking about when considering investing in a startup) with the marginal revenue formula and understanding the economics of that particular cupcake market are going to help you decide whether to invest in Cousin Jimmy’s business.
If the market is already saturated (does a town of 10,000 really need another cupcake business?), if you can’t go any lower on price and you fear that undercutting two businesses could wind up putting Jimmy’s Cupcakes out of business—these are all very real considerations.
In addition, knowing absolutely everything you can possibly know about the cupcake industry is going to be important for you. Also, definitely don’t let your emotions cloud your judgment. Even if you and Cousin Jimmy go way back (as in, all the way back to playing in the sandbox together) and even if you love the idea of a cupcake shop, that doesn’t mean it’ll be a great investment. Sometimes it’s just better to take your money and move on—or run!
Or maybe there’s another, a better idea out there, with less competition. Who knows? Maybe you could convince Cousin Jimmy to open up an emu farm instead.
Thank you, Melissa, for such a wonderful guest post! While this may not impact our day to day investment decisions, it can be interested to understand what is going on under the hood with all of these companies that we talk about each and every day.