How To Calculate the Revenues You Need To Generate for Any Expense
By: Ruth King
I frequently get asked this question when one of my clients is contemplating making a financial decision to invest in something – generally a marketing investment or sending someone to a class, etc.
My answer is always, “Do the Math.”
What’s the math?
“If you’ve generated enough revenue to at least break even, then it is worth doing.”
First, you must track the results. Without knowing the results of an activity, then the math is useless. It comes down to a gut reaction rather than black and white results.
Let’s take an advertising example. A company has paid $1800 a month for an advertising expense and it is time to renew the contract. Should they do it?
Here are the calculations:
The advertising cost $1800 a month. The company’s gross margin is 30%. Therefore, using Ruth’s Rule #2, the company has to generate $1800/30% or $6,000 a month to break even. Was it doing this?
No, it had NEVER, in a year, generated even $1,000 a month. So, the answer is to discontinue that advertising method. The company gave it a year trial. It didn’t work so it has to be discontinued.
Simple. Black and white. No emotion.
It came down to the numbers.
So, what is Ruth’s Rule #2?
I developed Ruth’s Rules in the 1990’s to help owners decide how much revenue has to be generated for any expense to pay for itself or earn the desired company profit.
Ruth’s Rule #2:
At break even: Sales equals overhead cost divided by gross margin.
Let’s apply it to this advertising cost:
Revenues at break even: $6,000
Cost of goods sold: $4,200 (70% of sales –gross margin is 30%)
Gross profit $1,800
Advertising Overhead: $1,800
Net Profit $0 (the company broke even)
You can use this same formula to calculate the break even revenues needed for any overhead item expense: advertising, your receptionist, legal fees, training, and even your own salary.
I challenge you to take your salary and benefits and divide it by your company’s gross margin to see the revenues needed just to pay you.
I’ll bet the result will surprise you.