Growing and running a successful business depends on getting “good enough” in a dozen or more skill areas, but you’ll never have the chance to do any of them without this one foundational skill: business math – the simple, necessary numbers that separate you from bankruptcy. Today let’s look at the numbers you must know; how to measure them; and how to use them to make even more money.
The first number everybody wants to know is revenue. That’s important, sure, but there are lots of bankrupt businesses with great revenue, so let’s look instead on what happens after the sale, and that is entirely about expenses.
Broadly speaking, they are of two types – fixed and variable – but be careful with those “fixed” expenses because they are actually variable too. More on that in a minute, after we cover the obviously-variable-expenses.
The first of these is Cost of Goods Sold (CoGS). This is your cost in the product itself. So if your sales price is P and CoGS is C, your Gross Profit Margin (GPM) is P-C. Every dollar saved on CoGS is a dollar you keep, so look for special incentives from your vendors, price reductions with bigger volumes, or even different packaging. Any or all of these can increase your GPM, but in many cases you may have to plan carefully (in the case of volume commitments for example). Your GPM is also a rough measure of your ability to grow net profit – GPM is the portion of every dollar of revenue that you get to keep internally. Well, almost.
You might have noticed that products don’t just sell themselves. It takes sales people, channel partners, or shopping carts to sell stuff. All of this is in Cost of Sales (CoS) and might be treated as either fixed or variable depending on your business. Frankly, neither treatment is either right or wrong, but one way will usually be more right than the other depending on how exactly you sell stuff.
If Amazon sells it for you, then your CoS is well known and pretty much entirely variable: a percentage off the top. If you have a sales team, your CoS will depend largely on how you compensate them: are they commission based, salaried, or a combination. For a strictly e-commerce site, your CoS is mostly fixed technology and traffic costs. In every case, be very very careful with CoS – most people do not account for it very well, and (as a result?) it can get out of control.
For example, since you are reading this blog, you have probably seen an Internet Marketing Launch. These are done using Joint Venture (JV) partners who get 50% of revenue for sending the traffic. Then you can add the launch manager, copywriting talent, technology, and merchant fees and if you do a great job of the math you can have a 20 – 25 pct GPM … on an info-product that has zero CoGS! Awesome, right?
But CoS doesn’t have to get that out of hand to still be a problem. It’s frankly always a problem. It is also the primary reason that everybody loves “free search traffic”. Paid advertising is an addition to CoS, and therefore a subtraction from profit. Obviously no one wants to do that, but ask yourself this: if your GPM is so slim that you can not afford to buy traffic, just how good is your business?
Regarding paid traffic in particular, the secret is perfect analytics. It is the first thing we look at with every client and we (so far) have never found it done perfectly. The “leaks” will start small at first, but build until the only thing you can do is treat your Adwords budget as a Fixed Cost (see below). This is not good. Not knowing your CoS is just like not knowing your CoGS. Would you even consider setting your product prices without first knowing your product cost? Of course not. The same applies to CoS. This is a real cost that has to be known and managed.
And we’re still not done with expenses. There are some costs that really are fixed – your building if you have one, legal, taxes, licenses, utilities, non-sales labor costs – the list goes on. What do we do with these? We’ll talk about margin vs scale another time, but for now let’s just divide our fixed cost by the number of units we sold and treat it like it was a variable cost in each sale – just like CoS. This is called “allocating fixed costs” and it’s a good number to use in running a business, but not for growing one [that too is a topic for another day]. Also notice that this is what you end up with if you are not tracking PPC correctly – in your books it looks just like your building!
So where does this leave us? Do we have any money left at all? 🙂 Maybe. What we get to keep is Revenue – CoGS – CoS – Allocated Fixed Costs. This is one of the several ways to talk about “Profit”. To be sticky about it, this one is called EBITDA – Earnings Before Interest, Taxes, Depreciation, and Amortization – but that is more acronym than any of us needs, so let’s just call it Net Profit. This is what you have left over to pay yourself. Let’s say it’s not enough. I mean, when is it really ever enough, right?
So, how do we use these numbers to keep more profit and/or create greater revenue? I’ve hinted at a couple of ideas above – here are some more.
Are you carrying invoices? This is all too common in B2B businesses. Can you get your supplier to do the same? Whatever your money cost is in floating an invoice should correctly be allocated to CoGS (or CoS, take you pick). With today’s lower interest rates, this is not as bad as it once was, but at large sales volumes it can add up. Getting businesses to pay early (or even just not late!) can be a challenge, but where you can reduce your carrying charge, it is money to the bottom line. Carrying cost is also generally “invisible” or poorly accounted for, so if you are invoicing now – check your float. For a service business like consulting, look at “providing terms”. I used to do 10/10/Net 30: 10% discount if paid in 30 days, or full price due at 30. At today’s interest rate that would be pretty rich!
For physical products, shipping costs can be a huge percentage of CoGS especially for small dollar items or physically large items. Optimizing this is usually a one-time cost that pays you forever. One of our clients is realizing huge savings from doing precisely this.
Several of our clients started in drop-shipping and then graduated to manufacturing their own products. They have done this overseas at a rate that can not be beat through available drop shipping vendors. This has a dramatic impact on CoGS. Of course, it also increased several Fixed Costs, added a carrying cost (the shipping time from the far east), and made inventory planning far more complex, so you do have to do the math. But do it right, and you could grow your Net Profit by 30% on the same revenue.
For you e-commerce people, check your merchant account fees. Escaping “tiered pricing” will usually cut your fees in half.
If you are running a sales team, look at how you are compensating them. Are they getting the right incentives so it maximizes revenue per CoS dollar? The second rule of management is that you get the behavior that you compensate. The first rule is that you can not manage what you do not measure, so measure first, and then design a compensation plan that causes people to naturally do what is best for you.
Just “lay everybody off” is not your best bet here – unless you really are in sad shape – so look instead for either redundancy (which would be my second choice) or increasing capacity. If you get more done with your existing labor or other resources, then you can grow your “top line” (revenue) while holding your Fixed Costs constant. That is an immediate win that pays you forever. Of course, make sure the capacity you are building is “value add” – don’t gear up to do more of something you should not be doing at all!
Optimize your technology spend. Maybe it’s your hosting, the email plan you are on, or going to an annual rather than monthly billing. If it takes some geek a few hours to make the changes, so be it, that one time cost will pay you back a long time.
Fixed costs are insidious. Every business accumulates them over time and they go largely unnoticed. It’s a good idea to occasionally do “house cleaning” and get rid of expenses that are either unused or under performing.
Consider raising your prices! Yes, I know, crazy talk, but this is almost always not just possible, but very successful as well. The “trick” is that “pricing power” comes from “brand power” and that you only get with good marketing … which obviously pays other dividends as well! In fact, branding is one of the highest leverage activity in most businesses, but that’s a different post.
There are also “stealth” ways to raise prices for physical products by changing to free shipping. Online shopping has so accentuated the “I want it now” response that predictable shipping might be a greater buying trigger than price. Only your testing will tell.
Every business is different, but the math is all the same. Just pay attention to the simple math of business and you are bound to find ways to keep more of the money you earn.