Why Business Is A Numbers Game

Last week I wrote an article about business transformation and I had a couple of comments about my apparent priorities and how I might be ignoring the people and culture element.??

I wasn’t ignoring this element as it was included in my list of priorities but I still maintain that you need a strategy, a plan and a DEEP understanding of the numbers before you communicate any planned transformation to the wider business.

Added to this, business transformation decisions also HAVE to be based on facts and figures - sadly emotion and a sense of duty occasionally has to often be sidelined if you are undertaking a major transformation project.

If the business fails - everyone is out of a job and debts will mount further.

Let’s explain this with a typical example:

You are running a software business in the US with $10 million of annual recurring revenue and a seemingly impressive gross margin of 70% - sounds good huh?

You have 50 US based staff and an office that they all work from.

Sound familiar?

… but you are making a $3.8 million annual LOSS - how can this be?

Put simply, it breaks out like this:

• Cost of Goods (or COGS, which are hosting, 3rd party software costs, and 3rd party support etc.) would likely be running at ~$3.0M annually?
• Operating Expenses (or OPEX which includes staff salaries, marketing, R&D, office costs, and general administrative expenses) are running at ~$10.8M annually
• Once you subtract COGS and OPEX from REVENUE you have a figure of minus $3.8M or put simply, a $3.8M NET LOSS

Here's the detail behind those numbers:

Let’s calculate the financials for a typical SaaS software business with $10M in recurring revenue, a 70% gross margin, 50 staff in the USA, and an office cost of $300,000 per year.

Business Overview

? Annual Recurring Revenue (ARR): $10M

? Gross Margin Target: 70%

? Headcount: 50 staff

? Office Cost: $300,000 annually

? Primary Expenses: COGS, Operating Expenses (OPEX), and Taxes

Step 1: Calculate Gross Profit

Gross margin is revenue after deducting Cost of Goods Sold (COGS), which includes hosting, customer support, and third-party software expenses.

COGS (30% of revenue):

? COGS = $10M × 30% = $3M

Gross Profit:

? Gross Profit = Revenue - COGS = $10M - $3M = $7M

? Gross Margin = Gross Profit ÷ Revenue = $7M ÷ $10M = 70%

This is a pretty typical model so why is the business losing money? Read on...

Step 2: Operating Expenses (OPEX)

OPEX includes staff salaries, marketing, R&D, office costs, and general administrative expenses. Here’s the breakdown:

1. Staff Costs:

? Average salary + benefits per employee: $120,000

? Total staff costs: 50 × $120,000 = $6M

2. Marketing and Sales (25% of revenue):

? Estimated at $10M × 25% = $2.5M

3. R&D and Product Development (12% of revenue):

? Estimated at $10M × 12% = $1.2M

4. General and Administrative (G&A) Including Office Cost:

? Original G&A expenses (legal, accounting, etc.): 8% of revenue = $10M × 8% = $0.8M

? Add office cost: $300,000

? Updated G&A = $0.8M + $300,000 = $1.1M

Total OPEX:

$6M (staff) + $2.5M (marketing) + $1.2M (R&D) + $1.1M (G&A with office) = $10.8M

The OPEX is killing this business!!

Step 3: Operating Profit

Operating profit is calculated as Gross Profit - OPEX.

? Operating Profit = $7M (Gross Profit) - $10.8M (OPEX) = -$3.8M (Operating Loss)

Step 4: Net Profit

Let’s assume taxes and interest are negligible since the business is operating at a loss. Therefore, Net Profit = Operating Profit = -$3.8M.

So how do you become profitable?

You basically have to cut costs and delivery efficiencies around your two biggest business costs; which are COGS and OPEX.

Sure you can go and try and sell more to increase revenue but if your cost of delivery is proportional to your turnover you will only end up making the deficit worse if you haven't reduced costs.

Immediate actions to reduce costs:

1. Renegotiate supplier contracts to reduce COGS.
2. Evaluate a more efficient and cost effective method of product delivery
3. Consider moving from an office to a remote working model.
4. Create a more cost effective marketing strategy.
5. Limit R&D to only essential product updates.
6. Reduce admin expenses where possible - potentially outsource.
7. You may be forced to consider moving some roles to a lower cost base, off shore model.

Real transformation only happens when you take bold and positive action

Let’s be realistic, first you need to stem the losses and then you need to turn a profit so you could be looking to find $7.0M from your business and that’s a huge number.

Don’t get me wrong, the people element of any transformation is a huge consideration but in order to start to become profitable, business transformation has to purely be a numbers game..