Successful Founders Understand Their Business’s Costs

Earlier this week, I shared how Pat Farrah became a Home Depot cofounder. Farrah was an entrepreneur who started Homeco, a concept similar to what Home Depot would become.

The language of business (i.e., accounting) is critical for entrepreneurs, but Farrah didn’t speak it. Equally as important, Farrah didn’t know what his costs were. His bank accounts had money in them, so he thought he was doing well. He and his top lieutenants even bought Porsches and Cadillacs. While Homeco was going through due diligence to be acquired, Farrah shared that he had no idea what his margins were or how much money he was making. When his suitors asked him, he guessed that his margins were 23% and he was solidly profitable. After the suitors cleaned up his books and audited them, they learned that the true margin was half Farrah’s estimate. And Homeco wasn’t just unprofitable, it was bleeding so much money that it was already insolvent by the conclusion of the audit. The acquisition was canceled. Homeco failed. Farrah was forced to file for personal and business bankruptcy.

The most successful entrepreneurs running profitable companies have the wisdom to get a handle on costs. Their focus on generating a profit usually leads them to learn basic accounting concepts (or hire someone knowledgeable about them). Their understanding of their costs leads to better decision-making and a company that generates cash (i.e., profits) instead of consuming cash.

Understanding costs served me well as a bootstrapped entrepreneur. I remember watching a competitor sell a popular automotive part for less than our cost. Customers loved the item, and it drove a significant amount of revenue to this competitor. Our team wanted me to compete on price so we could capture some of that revenue, but I declined. It didn’t make sense to lose a material amount of money on each transaction. Selling below cost is unsustainable. We didn’t have outside investors, so every dollar mattered. I reasoned, Why play a game we know we can’t win? Over time, I started to see other decisions this competitor made, and I suspected its leaders didn’t have a good grasp of its costs. A year or so later, it went out of business. I suspect that not tracking its costs caught up with it.