This article is going to deviate a little from my normal posts because I’m not going to just focus on the web but instead give small business owners a few simple pieces of advice that can help you run a successful business both online and in a traditional setting.
What is profit?
First, let’s establish that the goal of every business should be to make money but more importantly, it’s to make a profit and the most profit possible over the life of the business.
If we accept this to be true, then we need to stop and take a deep breath because we need to seperate profit from sales because the amount we sell isn’t actually a reflection of our total profit, in fact a company with high sales can actually be losing money!
Let’s take a look at this in a practical example, of somebody hiring a web designer to help them build a website. In this example let’s say that the website will cost $10,000 to build (it’s a pretty fancy website) plus $10,000 in marketing to successfully launch it. From my experience many people would assume the cost of the website is $20,000 but in reality there is the cost of operating the website and continued marketing so let’s add another $2,000 per month to the website cost plus $1,000 for somebody to look after it each month. In total, our website has a cost of $56,000 for the first year of operation and $36,000 each year after.
N0w, let’s assume that on our website we’re selling something. This could be a monthly membership, physical product which need to be mailed or electronic downloads. Regardless of what type of product you’re selling, there will be costs associated with processing credit cards and delivering the product. In our example, let’s assume we’re selling an item that costs us $10 per unit (each time we sell) and we’re selling that item for $30. At first glance, you may assume that you’re earning $20 per unit but in fact, you’re not since you have to account for your total fixed costs as well. The following chart shows the actual costs per item, assuming the business only operates for one year.
As you can see, you’re actually loosing money for the first 1,750 items sold and only making profit above that point. What that means in real world terms is that while you may have collected $52,500 in income from your new online business you spent $56,000 to build and maintain the website plus $17,500 to sell 1,750 products which means you are still short $3,500 which we call a loss.
To calculate the actual break even point for your online business we need to use a fancy math formula, it looks like this:
Revenue(x) = Cost(x)
Actually, that’s not fancy at all. It’s pretty simple really, so let’s expand it to show the break down.
Revenue(x) = Units Sold x Price
Cost(x) = (Variable Costs(x)) + Fixed Costs
So our final math equation (don’t be scared, it’s actually much easier than it looks) is:
Price(x) = (Variable Costs(x)) + Fixed Costs
We know that our Fixed Costs are $56,000 and our Variable Costs are $10 and that our Price is $30 so we can replace those in the equation:
30x = 10x + 56000
Math is awesome, so I know that I can move the 10x to the right side of the = sign as long as I subtract it. This works because if I said 30 “apples” are worth 10 “apples” plus 56000, I could cancel the 10 “apples” from either side, which would result in:
20x = 56000
Now, if I divide both sides by 20 I convert my x (which is the unknown we’re searching for) into a 1 and 56,000 becomes my required units.
x = 2800
So, in order to break even at our business (that is, to have our total sales be equal to our total costs) we need to sell 2,800 units of our product assuming that our fixed costs are $56,000 and our variable costs are $10 per item on a $30 sale.
Expanding the model over two years
In the first example, the fixed cost of your business startup was assumed to be fully utilized in the first year of your business, but realistically a website could last longer so if we want to spread the cost of that website over two years.
To do this, we need to remember that the fixed cost of the website is $15,000 to start plus $3,000 per month. This means that in year one, the cost to run the website is $56,000 and in year two it is $36,000. The total fixed costs to run the website for two years is $92,000 so let’s take a look at the chart with those numbers.
Now, we can use the equation from before to calculate our break even point.
R(x) = C(x)
30(x) = 10(x) + 92000
20(x) = 92000
x = 4600
So, in order to break even (not profit!) you will need to sell 4,600 units at $30, with a cost of $10 per unit and $92,000 in fixed costs over two years.
If you would like to charge more, simply change the value of R(x). So if you’d prefer to charge $35 per unit:
R(x) = C(x)
35(x) = 10(x) + 92000
25(x) = 92000
x = 3680
If you find a cheaper supplier and still want to charge $35:
R(x) = C(x)
35(x) = 5(x) + 92000
30(x) = 92000
x = 3666.66
Using this basic formula, any business can quickly calculate what it takes to make a profit buy simply determing the value of x (the number of units you must sell to break even) and adding 1.