Joe can't afford to hire people, but tries to sell more through his own services and partner services. Then he hits a wall. To service the business, he needs to hire more people. Then he needs to sell more. He thought he was only a short distance away, but he has a long way to go. It never seems to get close, but there's no time for sit back. "Just keep pounding away," he says.
I ask, "Well how much do you need to sell to breakeven?"
"Well, I'm losing $20,000 a month, so, uh, $20k," Joe replies.
"Are you sure?" I respond.
Remember algebra, remember y=mx+b. Well that's how business functions. In a product business, it's pretty easy. It cost me a certain amount to buy raw material. Add that to the cost of production and then tack on a profit margin.
It's no different in a services business. There's the cost of providing a service - COGS or cost of goods sold (you can even call it cost of service or COS). This is a variable cost: it includes employee costs directly involved in providing your services and if you have to pay a vendor for a service that becomes part of your offering. In a web development firm, it's the designers and developers. In a technology services firm, its compensation for those that deliver on projects. It goes up as you sell more.
Then there's gross margin or GM. This is what you care about. This matters more than anything else. This is what you get after you take away the cost of offering the service. I t's how you pay for all your other expenses.
Gross Margin = Revenue - COGS
Expressed as a percentage it is:
GM% = (Revenue - COGS)/Revenue
In my friends case, if Revenue is $100,000 and COGS is $60,000, then the Gross Margin is $40,000 or 40%.
Now everything else is a fixed cost, then you know your breakeven. Since this is a stylized example, we will not include variable costs of sales like sales people or advertising in Search Engine Marketing. We are going to pretend the main salesperson is the CEO and he can't hire any more. Nothing new there :)
From Gross Margins or Gross Profits we subtract operating costs like:
- Sales & Marketing (S&M)
- Research & Development (R&D)
- General and Administrative (G&A)
From here we get Net Profits which are also called Net Margins, Profits Before Tax (PBT) or EBIT (Earning Before Interests and Taxes).
PBT = GM - S&M - R&D - G&A
Or expressed as a percentage:
Net Margin% = PBT/Revenues
Now let's get back to my friend, how far should he go before he breaks even?
Gross Margins: 40k or 40%
PBT: - 20k or -20% Net Margins
Again, how much does it take to get profitable?
Well, if your fixed costs are $60k, then you need to receive enough gross margin to get to $0 PBT or:
Operating Expenses => Revenues - COGS => Gross Margins = $60k
He must overcome $60k in fixed expenses. Solving for this can be made easy by using the Gross Margin equation above
Breakeven Revenues = (Operating Expenses)/GM% = $60,000/.40 = $150,000
Given that current sales of $100,000, our CEO friend needs to sell $50,000 more! That's to get to breakeven.
Remember: We are not including cash flow issues or the fact that our CEO probably needs to do a variety of things that probably include going after high value deals, closing more profitable deals, hiring sales help or cutting expenses.