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Finding a way to measure profit at scale, while simultaneously not losing sight of individual customer margins, is an issue when calculating profitability. The traditional profitability equation–once the best practice–has not kept pace with how business has evolved. It is clear that this formula needs to be updated to truly reflect how companies need to operate in the modern age. This article will define the classic profitability equation, explain what an updated formula should look like, and discuss why this new take on an old classic should be the future when it comes to calculating profit at scale."
How to Calculate Profit
This formula, Revenue > Cost, also known as the profitability equation, is the formula accountants use to determine the total net income of a company. Sounds good, but is it too good to be true?
The Profitability Equation is a fundamental principle for business management, but we argue this formula can be updated and refined so it can better calculate profit for more non-traditional businesses. Let’s return to these first principals to contextualize this Business 101 concept in order to update this tool for businesses in the digital age.
How do we define Revenue? Revenue is the capital flowing into your business. It is the oxygen that energizes your operations. Any excess of capital is the profit. And like respiration, it takes energy to make energy. This spent energy is the cost of goods sold (COGS). It is the capital spent on assets like land, labor, or product. Revenue is profit plus the cost of goods sold. Revenue = Profit + COGS
Costs are more nuanced, but in broad brushstrokes, costs are the hours and resources spent in order to obtain revenue. Cost manifests primarily in two ways: operating expenses and the cost of sales. Operating expenses (OpEx) are the costs to create and sell the business’s products and services. Think salaries, materials, and electric bills. Cost of sales (COS) is the capital spent to create a bid to acquire a customer’s contract. Costs = COS + OpEx
You may have discovered already that the profitability equation has its shortcomings, especially if your business specializes in an internet-based service. There is a redundancy in the equation for companies, like software firms, that do not require land or materials to operate. For these businesses their cost of goods sold are essentially equivalent to their operating expenses.
By calculating these two variables, you will determine the bottom line expenses required to operate the business. However, in terms of calculating profit, these variables are going to adjust in tangent and because they are equal, they cancel out each other in the equation.
The updated profitability equation eliminates the cost of goods sold and operating expenses to focus on profit over the cost of sales. The focus of the equation becomes determining what price your business needs to charge your customers in order to be profitable. There's reasons to do something that is not profitable, but you need to know how to calculate the risk.
Scaling Profitability for the Business’s Lifetime
In this updated equation, Profit >COS, profit is the lifetime value of a customer versus the initial acquisition cost to obtain that customer. This is a great way to determine whether or not to pursue a lead. Determining the company’s profitability depends on the team’s ability to close on a lead at a cost that is less than the value they will receive from the customer.
If the lifetime value your company receives is greater than the amount of money it would take to negotiate the initial deal with that customer, that lead is worth pursuing. The formula works both ways, and as a result, marginal changes can determine whether or not to pursue a lead.
For this equation to work, it must be scaled based on the lifetime value of the customer. This updated profitability equation may seem innocent, but it begs a major existential question. How long is the lifetime of your own business?
If the focus for the business is meeting short term revenue goals, then this profitability equation needs to be adjusted to your business’s expected lifetime. The calculation must always calculate the lifetime value of any customer to be less than or equal to your expected lifetime value. You cannot account for the potential value received in five years, if your business only has enough capital to sustain two more years of operations with a negative revenue.
Your key to profitability becomes finding a way to reduce your cost of acquisition to determine an agreeable price to charge your customer that will also offset the cost of the customers that did not close. Afterall, those leads that didn’t buy anything are just costs.
At Novvum, we recognize the variability and complexity inherent in measuring profit. Part of our mission is to help our clients maximize profits by assisting in reducing these marginal variables in order to make intelligent business decisions. Our specialties include development that results in lower client acquisition costs and higher conversions. Let us help you do what you do best, innovating on your operations to drive your success.