Numbers That Count
The limits of my language mean the limits of my world – Ludwig Wittgenstein
I’ve recently been talking to a lot of clients about financial metrics, which is normally a really dry topic. I’ve written before about why financials are so important, but this is way more specific.
Most social entrepreneurs don’t understand the numbers, or what the numbers are telling them.
This isn’t a financial issue, it’s a financial clarity issue. That is, we don’t understand who our customers are, how they choose what to spend, and how frequently they come back.
This means that you don’t need to be an egghead, you just need to know what you’re looking for.
For example, you check your accounts and see that last month, you made $32,000 in sales, and $31,000 the month before. Is this good news? Is it bad news?
Frankly, it’s not news at all, because these numbers don’t tell us the story.
The story we want to hear is about what is happening in the business; how it’s tracking, what customers are doing, what is popular, what is profitable, which products are cash cows and which ones are losing money.
It’s about how many of our customers are regulars, and how often they come back. It’s about how much customers spend on average, or maybe that we’re gaining more customers but each of them are spending less and less.
It’s about what it takes to break even, and how much margin of safety we have before it’s time to start worrying about payroll.
Your finances are one of your early-warning systems; they highlight the changes that sneak up on you. Problem is, if you’re not looking at the right indicators, you won’t notice until it’s too late.
Worst of all, most entrepreneurs have never even heard of these indicators. How can you track something you don’t have a word for?
Here are a few to get you thinking:
Contribution Margin =Revenue – Variable Costs. This is the amount “left over” to pay for all your fixed costs, like rent and utilities.
“We sold $10,000 worth of coffees, which cost us $2,500, so we have $7,500 left to pay for all our other bills”
Contribution Margin per unit = Contribution Margin / # Units Sold. This tells you how much each item you sell pitches in to cover your fixed costs.
“We sold 3,000 coffees, so each coffee contributed $2.50 towards our rent and bills”
Breakeven Point in units = Total Fixed Costs / Contribution Margin per unit. This tells you how many units you need to sell in order to break even, like a hurdle.
“Our rent and bills are $6,000, so we need to sell 2,400 coffees to break even”.
Margin of Safety = (# Units Sold – Breakeven Point) in units, divided by # Units Sold. This tells you how much breathing room you have, and how much sales can drop before you start losing money.
“We’re selling 600 coffees above Breakeven, so on 3,000 coffees that’s a 20% Margin of Safety”
Volume for Target Profit = Fixed Costs + Target Profit, divided by Contribution Margin per unit. Once you’ve decided on how much profit you’re aiming for, this tells you how many units you need to sell.
“Since we want to earn $2,000 profit, we need to sell 3,200 coffees. That means if we increase our sales by about 7%, we’ll be really happy”
See how useful this is?
This isn’t just accounting; this is about good decision-making.
We now get to make choices based on what they will do to that figure (number of coffees sold to hit target profit).
A) We want to run Spotify Premium in the café, good music makes for a good atmosphere. It costs $12 per month, i.e. 5extra coffees. Is it worth it?
B) We could take on an extra café hand on busy days to speed up orders. That means we need to sell an extra 200 coffees, but since we’re faster we could sell more and our service improves. Would this be worthwhile?
C) What would happen if we raised the price by 10c? We’d need to sell 128 fewer coffees to hit the target, but would sales drop?
D) We want to spend some money on marketing. How many extra coffees does the marketing need to sell in order for it to be a good decision?
As an entrepreneur, you get hit with these questions all day, and they’re often tricky decisions. Nobody is going to directly ask you about your contribution margins or breakeven volumes, but by understanding them you can make good choices that keep your business afloat.
Financials aren’t cool.
You know what is cool? Staying open. That puts you ahead of 80% of new businesses.
Get good at the numbers, and you can do more of the good stuff that inspires you. You also get to pay yourself a fair rate, and can hire awesome people.
Grab a whiteboard and a computer, and start mapping out the numbers that matter.
This is a four-part series on useful financial metrics.
You can jump straight to:
Part Two Market Sizing and Forecasting Sales
Part Three Customer Value, Acquisition and Retention
Part Four Churn Rate and Customer Behaviour