In a drag race the gas pedal is your friend, just about your only friend until the race is over. In an Indy car race, or on a twisty rally course, the brake pedal is even more important and spending all your time on the gas is a sure recipe for a crash. Now imagine your 16-year-old is taking the car out on his own for the first time. Which pedal do you want him most familiar with?
Business is the same way. Sometimes sales drive success – when you are going the right direction. At other times, sales may actually be driving down your profit or holding your nose to the grindstone for hours with no additional benefits. Sales for the sake of sales will burn you out in no time if they do not generate profits.
So, when is a good time to evaluate the profitability of your business? At the one year mark? After your first quarter? Let me suggest that you do it as you evaluate your business idea, before you spend time and money starting something that may drive itself into the ditch. Don’t worry though, if you are already in business you can always make some adjustments to your prices and costs to right the ship. Profit is king and here’s the math:
Start with the sales price of your product of service
$100 for a killer fruit basket for example.
Subtract the Cost of Goods (what you pay for the item if you are reselling, or your direct materials and direct labor if you are making something yourself or offering a service) to arrive at Gross Profit.
-$40 for fruit, nuts and baskets = $60 GP
Now subtract the variable overhead expenses. These are any costs that aren’t a direct part of what you sell but can be traced to each unit and go reliably up and down as you sell more or fewer units. For example, you might pay a certain fee to Paypal for each sale, or shipping if you include it in the price of your baskets. This gets you to your Contribution per unit.
-$10 variable overhead per basket = $50 contribution per basket.
Contribution to what, you may ask? To fixed expenses and profits. Once each unit pulls its own weight, the contribution margin tells you how much it has left to contribute to covering fixed overhead costs and fill your pockets. Fixed overheads are things like rent, website hosting, advertising, etc. which do not go up or down if you sell more or fewer units. That math means that the more units you sell, the more you spread out the fixed expenses between units. As long as each unit has a positive contribution margin then more sales will equal more profits. Knowing this number lets you see how much each additional sale is worth to you.
Take the contribution margin and divide it by your fixed overhead to get your break-even point. Let’s say that you have a lean business (since you make your fruit baskets at home and don’t have a storefront or rented office) and only have about $500 in overheads per month. Maybe you pay for a website and some local ads. Break-even tells you how much you need to sell to cover your expenses.
$500 / $50 = 10 baskets to reach your break-even point.
Do you see how valuable this is to the planning process? If you know how much you will charge and how much you will spend, you can evaluate exactly how much you need to sell to have a viable business idea. You might need to adjust your prices or find a way to cut costs if you find that your contribution margin is too thin and you doubt you can sell enough to be profitable.
The great thing about this quick math is that you can do the same thing to figure sales for any amount of income you want to make. You get paid from the profit, which is where contribution margin goes after you reach the break-even, so just add your desired profit to the fixed expenses to see how many you need to sell to earn x amount of money. If you want to make $3000 per month, for example:
$3500/ $50 = 70 baskets per month to reach your profit goals.
Now you can play with the numbers. Find a way to save money on your wholesale baskets and you can increase the contribution margin. Increase the price by just a small amount and it will boost your profits, since fixed overhead will not change. For instance, what if you can sell the baskets for $110 but would lose 10 price sensitive customers per month and only sell 60 baskets.
60 x $60 = $3600
You could actually increase your profit while making fewer baskets if your sales estimates were correct. Of course, we don't always know how customers will react but knowing how much your products are contributing to your business is the foundation of planning to successfully make a profit.