Adding Expenses? What’s your SALES MULTIPLE?

Knowing when your firm is able to add expenses is a tricky situation and clients ask me all the time – “Do you think I can afford to ………?” After reading this blog you should be able to answer (at least in ballpark terms) the question of how much additional revenue you need to generate to cover each dollar of new cost (i.e. adding an employee, renting new office space, etc.).

The next time you meet with your accountant or business manager take a look at your income statement and divide your Gross Sales (which includes item sales, time billings and Design Fees) by your Gross Profit (which equals Gross Sales less Cost of Sales) on goods and services. The resulting number tells you how many dollars in Gross Sales you need to cover one dollar of expense without increasing or decreasing your existing Net Profit.

Below is a simplified income statement:

         Sales                                                        $ 675,000

         Less: Cost of Sales                                $ 500,000

         Equals: Gross Profit                               $ 175,000

         Less: Operating Expenses                    $ 125,000

         Equals: Net Profit                                    $   50,000

  

If we divide Gross Sales ($675,000) by the Gross Profit ($175,000) we end up with the number 3.86. This business will need to generate on average $3.86 in Sales for every $1.00 it wants to spend on new Operating Expenses, without increasing or decreasing its Net Profit of $50,000.

Let’s look at two examples of how this can be applied to real business settings.

Example 1:

The firm wants to hire a new employee that would be paid $40,000 in Salary and maybe require them to pay an additional $5,000 in health insurance and $3,000 or so in Payroll Taxes per year totaling $48,000 in additional expenses per year. If we multiply this cost by the multiple of 3.86 we find that in order for the firm to afford this new employee, they will need to generate approximately $185,280 (3.86 x $48,000) more in gross sales!  To make it scarier, this number will surely increase if they add in the costs of a new computer, software licenses, desk space, telephone, and anything else that must be purchased for this new employee. So the question is, will adding this employee allow them to generate $185,280 in additional revenues? If not – than they probably reconsider hiring this person.

Example 2:

The firm’s principal wants to move the office out of her home and finds a space to rent for $1,800 per month. With other expenses (utilities, insurance, internet connection, garbage, etc.) she expects total costs of the office to be around $2,500 per month. Using the multiple of 3.86 and multiplying it by $2,500 per month we see that her company needs to bring in approximately $9,650 more in Gross Sales per month (or $115,800 for the year) to pay for the new office space. Will the move to the new office bring her enough new business or allow her to work more efficiently that she will be able to earn another $115,800 in Gross Sales to afford it? If not, she needs to reconsider her reasons for wanting to move the office from her home.

After determining YOUR sales multiple  - keep it in mind before making major expenditures or even everyday purchases that cannot be billed back to the clients. It’s better to only raise your overhead costs when you feel comfortable that your revenue stream will increase enough to cover these costs on a regular basis.