Financial Clarity for Entrepreneurs

Profit Improvement – The Magic of Algebra

During a conversation with a business owner recently we were looking for ways to identify profit improvement opportunities.  That got me thinking about an old standby – the break-even formula.

The traditional formula is: Revenue * Gross Margin = Overhead

It’s a simple concept, but in the daily bustle of running a business it can be easy to lose sight of its informative power.

Since this particular business, like a lot of businesses these days, sells services and not products, the idea of gross margin can be a little confusing.  Sure, a service business has a cost-of-goods-sold in the form of salaries and benefits for the employees providing services, but most smaller businesses don’t classify them as such on the P&L.  In that case, a variation on the break-even formula is more useful.

Revenue – Variable Costs = Fixed Costs…or  Revenue – Variable Costs – Fixed Costs = Net Profit or Loss

For most service businesses fixed costs are going to be relatively large and variable costs relatively minor.  The result is that within some range (unique to each business) revenue increases and decreases will have a dramatic impact on the bottom line.

Through the magic of algebra we can re-work the formula so that it can predict the impact to the bottom line of changes in revenue.  If we make Variable Costs a percentage of revenue we get and do a little reworking of the formula we get: 

Revenue * (1 – Variable Cost %) – Fixed Costs = Profit. 

Now with numbers (in thousands or millions – whichever you like better):  $1,000 * (1.0 -.05) – $800 = $150 

If we increase revenue by 5% we see a $47.5, or 31.67%, increase in net income.  $1,050 * (1.0 -.05) – $800 = $197.5 

We would need to cut fixed costs by $47.5, or almost 6%, to get the same bottom line impact.  This isn’t a huge difference, but keep in mind that revenue growth compounds and cost cutting does not. 

This is just one hypothetical example.  Your business will have different Variable Costs and Fixed Costs.  Plug in your numbers and see where the opportunities are to improve profits.  Perhaps it’s revenue.  Maybe it’s cost-of-goods-sold, or overhead – or a combination of the three.