A Company's Magic Formula

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by Aaron Blackmor
on Thursday, April 23, 2009

Can I hire another employee? Can I afford a new computer? Questions like these come up frequently with small business owners, and the answers are often staring them in the face. Rather than just tell them yes or no, however, I like to sit down with them and give them the tools of decision-making, in a sense, teach them to fish.

What I help them determine is a formula that they can use to determine whether or not to make almost any major business decision. Although it's a much more simplified version of the kinds of planning that would go into similar decisions for a larger client, for small clients, it is a very useful "rule of thumb".

For accountant types, the analysis is a very straightforward one called a "cost-volume-profit" analysis. But for non-accounting types, I call it a "Company's Magic Formula".

Here's the Formula

First, whether they're a product or service type company, we have to determine the expense items that vary with sales. By adding these together and determining how much they average as a percentage of sales over a specific time frame (i.e. 13 months), we can determine a gross margin (even for a service business).

These expenses aren't necessarily just cost of goods sold, as other selling expenses should usually be factored in as well. Then, by subtracting these from sales, we can determine the company's typical gross margin. Let's assume it's 25% of sales.

Then, we determine what their other, indirect expenses are and whether they fluctuate (variable) or are somewhat static (fixed). By dividing their gross margin (25%) into this number, we can then determine their break-even sales for whatever time period they find helpful (monthly, weekly, etc.).

What it Means for Your Business

Now, how does this affect decision-making? Quite simply, if a business owner is considering a purchase that is a one-time event, it's really up to whether or not they have the cash on hand. If, however, the decision will result in additional ongoing monthly expenses, such as a new employee or an equipment lease, then you have to add this expense into the fixed expenses when calculating their break-even. The shortcut, then, it to once again divide the gross margin percentage into the recurring monthly expense amount of their decision, and you have a rough estimate of the additional sales they need to generate to justify the new expense. Voila, done.

From that point forward, the business owner has a simple calculation that they can get their hands around in order to determine whether they can "afford" a certain course of action they may be contemplating (ceteris paribus).

The Magic Formula in Action

As an example, let's say a company would like to hire an additional administrative employee at a cost to the company of $36K per year of additional expense (note: this would not be merely their base salary, but rather all benefits and employer-paid payroll taxes factored in). With a 25% gross margin, they need to maintain an additional $144K of sales income per year more than they do currently in order to generate the same net income.

Of course, there are many assumptions that go into such a figure, but as a ballpark estimate, it works quite well. Also, you can't quite use this same technique for employees or equipment that would increase sales or reduce expenses elsewhere, otherwise those changes must be factored in. More on that to come, but for now, this is a good rule of thumb that every business owner, at a minimum, should understand before they make any large, ongoing decisions.

Content Source: ashevillecfo.wordpress.com

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About the Author - Aaron Blackmor

Contact Aaron Blackmor:
CFO Consultants, LLC
(828) 348-0379
aaron@cfoconsultants.net
cfoconsultants.net

Learn more about Aaron.