The Expert Podcast

So let's say you're a business owner and there is some opportunity for you for a paid project. Let's say it's a programming project. Some company wants to charge you a fee to do a new website or to improve your website or search engine optimization. Maybe it's an advertising contract with an outside provider to maybe do paid search on Google or to produce videos.

One of the questions that comes up is how to determine if that expenditure, if that expense, is going to be worth it. A lot of businesses will do the math and say, well, if it gets me one more sale for a thousand dollars and this thing cost me a thousand dollars, it's worth it. And that's a complete fallacy. You will lose money in your business if you use that method to calculate return on investment for any expense.

So we're going to take a look at a couple ways to actually determine the true profitability of any expense. In fact, in business, in all of our businesses that we run, we don't consider anything to be a business expense. Any money that we pay, any check that we write, any contract we do—the dollar amount that goes out from our company is not a business expense. It's an investment in sales. It's an investment in revenue. And if you define it that way and you state it that way, you will make sure that any dollar you spend ends up being worth it. You're not going to waste money.

Again, we'll do the calculations here in a minute. But when you're talking to a salesperson from a company trying to sell you something, one of the first questions you'll hear come out of their mouth is: What's your budget? How much you got to spend? What's your budget? To try to get an idea of how much you can spend.

There's no legitimate reason for that question. There's no legitimate purpose for that question—for you as a business or even for them as a company. Because again, if what they're selling you or what they're providing you is valuable, it doesn't matter what it costs. If you have a return on investment.

A good answer, a good comeback for that is: "Well, you know, if this thing makes me two million dollars, I'll spend a million dollars. My budget's a million dollars. But if it makes me zero, one dollar’s too much. I can't afford a dollar. I'm too poor to spend one dollar on something that makes me zero. So that's my budget. My budget is: a dollar is too much for something that doesn't make me anything. A million dollars is too cheap for something that makes me two million."

So let's dive into the numbers. Let's suppose that you are a business. First, you have to determine your profit margin. And any business owner will know pretty much offhand your profit margin.

The way you calculate that is you take your revenue—let's say you sell a million dollars worth of product or service in the course of a year. You're a one-million-dollar revenue business. And you take your net profit. So let's say at the end of the year, you look at your tax return and you had a two hundred thousand dollar net profit from your one-million-dollar business. Well, that's an easy calculation. You have a twenty percent profit margin.

Apologies for businesses that this is economics 101—right? It's pretty simple stuff. But it's important to have that number before you go into any kind of negotiation or contract or even just evaluation of a service, a product, a resource contract. It's going to be the most important number to come up with.

So again, you have a million-dollar business. You make two hundred thousand. That's a twenty percent profit margin. Twenty percent profit margin.

Okay, so now this business comes along, this company comes along, and they say: "Look, we have this advertising opportunity, we have this programming opportunity. We want you to hire us to do customer service," or outside contractor, whatever the expense is, whatever the payment is for.

First thing you do is take a look and think about how many more sales, how many more transactions, how much more revenue that thing—do you think—is going to get you? How many more sales it's going to get you?

So if you're going to do advertising and it gets you 10 more sales, and you sell stuff for a hundred bucks a piece—well, that thing's gonna make you a thousand dollars. Ten times one hundred equals a thousand more revenue.

So this is where the trap comes in. A lot of businesses will say, "Well, this service or product or contract only cost me 600, and it's going to make me 10 more sales, so it's good. I'm going to make money off this deal."

Well, not really. Because remember, from that thousand dollars worth of sales, you only keep 200. Because that's your profit margin. You might have materials, cost of sale, servicing, sales commissions—whatever goes into your expenditures—even fixed costs, rent, overhead, lights, all that stuff. You only keep 200.

So in reality, that six-hundred-dollar expense only really netted you two hundred dollars in net profit. So you're already losing 400 on this deal.

So how do you calculate a good ROI? Well, and you can be very transparent about this with the vendor, with the contractor. You can tell them, "Look, your thing cost 600. We have a 20% profit margin, which means we have to net 600 from sales just to break even on your service. Which means we have to sell three thousand dollars more of business, of sales, to get back the 600 we paid you. Right? 600 divided by 20%, or times five, is three thousand dollars."

And that just breaks us even. That means that we did all the work, we did the contract, we did everything, and we're back to square one. We didn't make any extra money off this deal. In fact, the only person who made money off this deal was you—because you got the 600. We just got our 600 back. So we're basically a jobs program for your company.

So in reality, we need to make more than that. We need to make 800 in net profit or 900 in net profit. So we really need to have about 5,000 in sales. 4,500 maybe, 4,700.

So if you sell stuff for 100 bucks, you need to sell 47 new orders from this one thing. So if the service you're buying is 600 a month for advertising, you need 47 more sales every month to make it work.

Right, and here's a more simple way to calculate this. You can do an X factor—not the TV show.

When I threw out the number of 20% profit margin, most businesses operate at about a 20% profit margin. There’s some companies that operate on a little bit thinner margin, like 10%. Some intangible product businesses, or maybe a little higher, maybe 30%. And I'm talking net profit—not gross profit, not revenue, not cost of sales markup—we're talking net net profit.

At the end of the year, what you netted in cash versus your sale—that's your net profit. After all expenses, including your salary, including everything.

So most businesses on a 20% net profit—that's a factor of five to break even. So what we do is we say we need a 10x return or maybe an 8x return to make this a worthwhile consideration, a worthwhile pursuit.

Because if you have 8x or 9x markup on your expense, you'll end up being okay.

So what does that mean? For a thousand dollars worth of expense, you need eight or nine thousand dollars worth of new sales to make that expense not an expense anymore—to make it an investment.

If you don't get 8 or 9x, it is an expense. It's a loss. Something that costs you money. You're never going to get it back—just throw money out the window.

Couple other traps that you run into: people will talk about branding. "It's good for branding." Or they might—or you might—even get into your head: "Well, some of those expenses are fixed and they're not going to go up if we have extra business." You know, "Rent's not going to go up. Our payroll might not go up. Some fixed expenses might not go up. Incremental business has a margin that's at the limit—at the edge of that margin—all profit."

Well, let's talk about those two things. Let's first talk about branding. Or an advertiser, especially, or a website developer might say, "It's going to get you more visitors, more traffic, and it's good for your brand."

Well, the day that your bank allows you to make a deposit of branding—or you can deposit visitors—then you can talk about that. The only thing that your bank allows you to put in your account is dollar bills.

Branding is not cashable. Visits, clicks, visitors, likes, shares—none of that is brand, and none of that is depositable. You can't cash it at the bank.

Now some of that might turn into business—but that's what you have to measure. Not how many more visitors you got, how many more clicks you got, how many more likes or shares. Might be good for your ego, but you can't cash it at the bank.

And if you want to spend a thousand a month for something for your ego, that's fine. But now it is an expense. It's not an investment in future sales.

So make sure that you extend the calculation beyond just visitors. Visitors is a good thing—you might need to know—but then look at: what's your conversion rate on visitors on your website?

If you get a thousand visitors, and from that you get let's say 200 inquiries, and you close 10% of those—you have a 10% closing ratio. That means a thousand visitors, you get 200 inquiries, 10% you get 20 sales.

Okay, now you have a number to talk about—sales. The only number that matters.

So if that thousand-dollar expense gets you 20 more sales, it doesn’t add up—right? It only gives you two thousand dollars in revenue at that hundred-dollar example revenue we talked about.

So you can't cash visitors, clicks, likes, shares. Can't cash anything except for sales.

And that's assuming the sales are as good as you normally get—they're not lower margin, they're not discounted, they don't have higher cost for fulfillment. If your new sales cost you more money to fulfill because of higher customer service, then you have to redo your math.

Now let's talk about fixed expenses. A lot of times people say, "Well, if I get 100 more sales, some of my fixed expenses won’t go up." Yeah, my cost of sale will go up, but my fixed expenses won’t.

Well, that's true in the short run. In the first month that you get a hundred more sales or two hundred more sales, you don't have to add more staff, rent more space, have more—you know—electric bill. You don't have to do that your first month.

But if your business grows and continues with that sales revenue, you're going to have to add expenses. Your insurance might go up. You might need more space. You might need more employees. You're going to need more customer service staff.

So you have to keep that 20% net profit in your calculations until it proves otherwise. Until you've got a year or two with new business and a higher profit margin, 20% is still your benchmark.

You can't change that number just because the dust hasn't settled yet on the new business—because there might be other costs that you're not aware of that show up later because of that new business. Regulatory cost, who knows what it is.

So yeah, the fixed costs don't go up. Look at it as a windfall in the short run. But you're gonna have to work harder too.

If you have a 20% increase in sales, everybody's going to have to work 20% harder. You might have to do overtime. Some people might be stressed out because they have to do one-fifth more work than they were doing the week before. And that might put a strain on your employees.

You might have to give them raises. You might have to give them bonuses. You might lose a good employee if you don't account for their extra workload.

So yeah, in the short run, fixed expenses won't go up, so you might have a little bit of a bump in your margin. But in the long run, you're going to have to make up for it one way or another.

So keep that in mind. Always keep your margin percentage the same until a couple years goes...