Growth is the goal for most, if not all businesses. Growth of revenue, but more importantly, growth in profit. To grow your business effectively, you need to fully appreciate its ability to scale. Understanding the scalability of your business requires deep knowledge of your unit economics. In financial terminology, you want to know your profit margin on a unit basis. Or to put it another way, how much profit would you earn if you sold just one more product.
Averages
In exploration calls, as I try to figure out the lay of the land, I’ll often ask questions like, what is the average revenue for a deal? Frequently I’ll get the answer, “it depends.” Let me state unequivocally that it does not depend. There is without question an average revenue for your product. That’s not to say that there aren’t complexities to your business model. Different product types produce vastly different revenue streams. Some engagements might be project based and others are recurring revenue. None of these details change the fact that averages exist. Know each relevant average, overall and specific. Know the average revenue and cost across all products and also know the segmented averages. Performing this exercise will enhance your visibility into the inner workings of your business’s financials. Understanding this will enable you to come up with a strategy to both maximize revenue and profit.
Cost of Goods Sold
There are different approaches to selecting the expenses to include in Cost of Goods Sold. My preferred approach is to include only expenses directly attributable to the revenue. To put it another way, if an expense would not exist but for the revenue being produced, it belongs in Cost of Goods. While some like to include employee expense in Cost of Goods, I prefer a different solution.
Employee Expense
You may have employees whose work should directly contribute to revenue. If your typical invoice includes a line item that charges a specific rate to time spent on the job, then employee expense is a consideration to your unit economics. But don’t take the short cut and attribute all employee expense to the unit economics model. Whether your employees are attorneys, therapists or mechanics, it is highly unlikely that all of the time you pay them for translates directly to revenue. Differentiate their salaries between revenue generation and overhead, only attributing revenue generating time to your unit economics. Isolating the portion of employee expense that is overhead can allow you to optimize their time more effectively. That increased visibility can potentially lead to more billable hours through improved operational controls, better pipeline management or employee incentive programs.
Client Acquisition Cost
Your client acquisition cost is the amount you need to spend on marketing and sales to acquire one more customer. This includes advertising dollars, commissions to salespeople and potentially software expenses. Just as important as your current client acquisition cost is knowing what your maximum acceptable client acquisition cost is. This target is the most you would be willing to spend if you knew it would guarantee another client. Anything below and up to that target, you should be willing to spend on more marketing, as it will translate to more profit.
Complete knowledge of your unit economics is critical to maximizing profit and creating a scalable business. Understanding the different components of your revenue and cost structure will help you determine where to invest your time to gain efficiencies, where to cut costs and increase prices and at what point you’ve reached diminishing returns on your marketing and sales investments.
