You helped me before, and I'm hoping you can help me again with a problem I have in the branding and package-design company I own with my husband. We need to bring on a new designer to take over some of what I'm doing. The sooner we do it, the better. The workload is more than I can handle, and it's increasing every month. The problem is, I'm not sure we can afford an additional person. To figure it out, I think I need to determine our cost of goods sold, but I don't know how to calculate it for a service business like ours.
—Yael Miller, co-owner, Miller Creative Lakewood, New Jersey
When we last heard from Yael Miller, she was concerned that she wasn't doing a good enough job of turning prospects into paying customers, but the numbers told a different story. (See "The Figures Don't Lie," March.) In fact, she was doing quite well in that department. The issue she's confronting now is one that most business owners run into sooner or later, so I decided to give her an encore.
From her email, I could see that Yael and her husband were focused on the right question: How much in new sales is required to cover the cost of bringing on an additional employee? To answer it, they need to know their gross profit margin, which means that they have to know their cost of goods sold, or COGS, as well. Gross profit equals sales minus COGS. Gross profit margin is simply gross profit as a percentage of sales.
Yael said she understood all that. She just wasn't sure what to include in COGS. I suggested that she think of COGS as direct costs--that is, the amount she spends directly on producing the service she sells. I told her she shouldn't worry too much, however, about whether to include this or that specific item. In privately owned businesses, everybody does it a little differently. What's important is to be consistent. She should decide what costs she considers to be direct and then stick with that definition whenever she calculates her gross margin. At first, the percentage will probably fluctuate from month to month, but over time she'll see the average emerge.
Once you know your gross margin, it's easy to figure out the new sales you'll need in order to break even on the addition of another employee to the payroll. You simply add up all the new costs associated with that new person--salary, benefits, extra phone usage, travel and entertainment, whatever--and divide by your gross margin.
The resulting figure is the amount of new sales that will give you the gross profit required to cover those new costs. But you have to remember: Sales and gross profit are not the same as cash flow. It may take some time for the new person to contribute all that you're expecting from him or her, and you need to be sure you don't run out of cash during that period. Yael and her husband said they understood.