(Almost) Ten Secret Business Formulas

IN THIS CHAPTER

check Finding the most expensive money you can borrow in two ways

check Figuring out how to break even

check Finding out whether you’re growing too fast

check Using two different formulas to answer those what-if scenarios

check Letting Isaac Newton decide your ordering schedule

check Following the Rule of 72

I have some good news and some bad news. The good news is that you can use some powerful formulas to better your chances of business success and increase your profits. No, I’m not joking. These formulas do exist. You can and should use them. In the pages that follow, I explain the formulas and how to use them.

Now for the bad news: To use these formulas, you need to feel comfortable with a bit of arithmetic. You don’t need to be a serious mathematician or anything, but you do need to feel comfortable using percentages and calculators. By the way, you can use the standard Windows Calculator (available from within QuickBooks by choosing Edit ⇒ Use Calculator) to work with these secret formulas.

Even if you’re not particularly fond of (or all that good at) math, I want to encourage you to skim this chapter. You can pick up some weird insights into the world of finance.

The First “Most Expensive Money You Can Borrow” Formula

Here’s something you may not know: The most expensive money that you can borrow is from vendors who offer cash or early-payment discounts that you don’t take. Perhaps your friendly office-supply store offers a 2 percent discount if you pay cash at the time of purchase instead of paying within the usual 30 days. You don’t pay cash, so you pay the full amount (which is 2 percent more than the cash amount) 30 days later. In effect, you pay a 2 percent monthly interest charge. A 2 percent monthly interest charge works out to a 24 percent annual interest charge — and that’s a great deal of money.

Here’s another example that’s only slightly more complicated. Many, many vendors offer a 2 percent discount if you pay within the first 10 days that an invoice is due rather than 30 days later. (These payment terms are often described and printed at the bottom of the invoice as 2/10, Net 30.)

In this case, you pay 2 percent more by paying 20 days later. (The 20 days later is the difference between 10 days and 30 days.) Two percent for 20 days is roughly equivalent to 3 percent for 30 days (one month). So a 2 percent, 20-day interest charge works out to a 36 percent annual interest charge. Now you’re talking serious money.

Table 20-1 shows how some common early-payment discounts (including cash discounts) translate into annual interest rates. By the way, I’m a bit more precise in my calculations for this table, so these numbers vary slightly from (and are larger than) those given in the preceding paragraph.

TABLE 20-1 Annual Interest Rates for Early-Payment Discounts

Early-Payment Discount	For Paying 20 Days Early	For Paying 30 Days Early
1%	18.43%	12.29%
2%	37.24%	24.83%
3%	56.44%	37.63%
4%	76.04%	50.69%
5%	96.05%	64.04%

Is it just me, or do those numbers blow you away? The 2 percent for 20 days early-payment discount that you often see works out (if you do the math precisely) to more than 37 percent annual interest. Man, that hurts. And if you don’t take a 5-percent-for-20-days early-payment discount when it’s offered, you’re effectively borrowing money at an annual rate of 96 percent. You didn’t read that last number wrong. Yes, a 5-percent-for-20-days early-payment discount works out to an annual interest rate of almost 100 percent.

I want to make a couple of additional observations. Turning down a 1 percent discount for paying 30 days early isn’t actually a bad deal in many cases. Refer to Table 20-1, which shows that the 1 percent discount for paying 30 days early results in 12.29 percent. Sure, that rate is pretty high, but that interest rate is less than the interest on many credit cards and some small-business credit lines. If you have to borrow money some other way to pay 30 days early, making an early payment may not be cost-effective.

The bottom line on all this ranting is that early-payment discounts, if not taken, represent one of the truly expensive ways to borrow money. I’m not saying that you won’t need to borrow money this way at times. I can guess that your cash flow gets pretty tight sometimes (a circumstance that is true in most businesses, as you probably know). I am saying, however, that you should never skip taking an early-payment discount unless borrowing money at outrageous interest rates makes sense.

Oh, yes — the secret formula. To figure out the effective annual interest rate that you pay by not taking an early-payment discount, use this formula:

To calculate the effective annual interest rate that you pay by not taking a 2 percent discount for paying 20 days early, calculate this formula:

Work out the math, and you get 0.3724, which is the same thing as a 37.24 percent interest rate. (Note that the discount percents are entered as their equivalent decimal values.)

The Scientific view of the Windows Calculator includes parenthesis keys that you can use to calculate this formula and the others I give in the chapter. Choose View ⇒ Scientific to switch to the Scientific view of the calculator.

The “How Do I Break Even?” Formula

I know that you’re not interested in just breaking even. I know that you want to make money in your business. But knowing what quantities you need to sell just to cover your expenses is often super-helpful. If you own a one-person accounting firm (or some other service business), for example, how many hours do you need to work to pay your expenses and perhaps pay yourself a small salary? Or if you’re a retailer of, say, toys, how many toys do you need to sell to pay your overhead, rent, and sales clerks?

You see my point, right? Knowing how much revenue you need to generate just to stay in the game is essential. Knowing your break-even point enables you to establish a benchmark for your performance. (Any time you don’t break even, you have a serious problem that you need to resolve quickly to stay in business.) And considering break-even points is invaluable when you think about launching new businesses or new ventures.

As you ponder any new opportunity and its potential income and expenses, you need to know how much income you need to generate just to pay those expenses.

To calculate a break-even point, you need to know three pieces of information: your fixed costs (the expenses you have to pay regardless of the business’s revenue or income), the revenue that you generate for each sale, and the variable costs that you incur in each sale. (These variable costs, which also are called direct expenses, aren’t the same thing as the fixed costs.)

Whatever you sell — be it thingamajigs, corporate jets, or hours of consulting services — has a price. That price is your revenue per item input.
Most of the time, what you sell has a cost too. If you buy and resell thingamajigs, those thingamajigs cost you some amount of money. The total of your thingamajigs’ costs varies depending on how many thingamajigs you buy and sell, which is why these costs are referred to as variable costs. A couple of examples of variable costs include hourly (or contract) labor and shipping. Sometimes, however, the variable cost per item is zero. (If you’re a consultant, for example, you sell hours of your time, but you may not pay an hourly cost just because you consult for an hour.)
Your fixed costs are all those costs that you pay regardless of whether you sell your product or service. If you have to pay an employee a salary regardless of whether you sell anything, that salary is a fixed cost. Your rent is probably a fixed cost. Things like insurance and legal and accounting expenses are probably fixed costs too because they don’t vary with fluctuations in your revenue.

Fixed costs may change a bit from year to year or bounce around a bit during a year, so maybe fixed isn’t a very good adjective. People use the term fixed costs, however, to differentiate these costs from variable costs, which are those costs that do vary with the number of goods you sell.

Take the book-writing business as an example. Suppose that as you read this book, you think, “Man, that guy is having too much fun. Writing about accounting programs, working day in and day out with buggy beta software — yeah, that would be the life.” So you start writing books.

Further, suppose that for every book you write, you think that you can make $5,000, but you’ll probably end up paying about $1,000 per book for such things as long-distance telephone charges, overnight-courier charges, and extra hardware and software. Also suppose that you need to pay yourself a salary of $20,000 per year. (In this scenario, your salary is your only fixed cost because you plan to write at home at a small desk in your bedroom.) Table 20-2 shows how the situation breaks down.

TABLE 20-2 Costs and Revenue

Description	Amount	Explanation
Revenue	$5,000	What you can squeeze out of the publisher
Variable costs	$1,000	All the little things that add up
Fixed costs	$20,000	Someplace to live and food to eat

With these three bits of data, you can easily calculate how many books you need to write to break even. Here’s the formula:

If you plug in the writing-business example data, the formula looks like this:

Work through the math, and you get 5. So you need to write (and get paid for) five books per year to pay the $1,000-per-book variable costs and your $20,000 salary. Just to prove that I didn’t make up this formula and that it really works, Table 20-3 shows how things look if you write five books.

TABLE 20-3 The Break-Even Point

Description	Amount	Explanation
Revenue	$25,000	Five books at $5,000 each
Variable costs	($5,000)	Five books at $1,000 each
Fixed costs	($20,000)	A little food money, a little rent money, a little beer money
Profits	$0	The costs subtracted from the revenue (nothing left)

Accountants use parentheses to show negative numbers. That’s why the $5,000 and the $20,000 in Table 20-3 are in parentheses.

But back to the game. To break even in a book-writing business like the one that I describe here, you need to write and sell five books per year. If you don’t think that you can write and sell five books in a year, getting into the book-writing business makes no sense.

Your business is probably more complicated than book writing, but the same formula and logic for calculating your break-even point apply. You need just three pieces of information: the revenue that you receive from the sale of a single item, the variable costs of selling (and possibly making) the item, and the fixed costs that you pay just to be in business.

QuickBooks doesn’t collect or present information in a way that enables you to easily pull the revenue per item and variable costs per item off some report. Neither does it provide a fixed-costs total on some report. If you understand the logic of the preceding discussion, however, you can easily massage the QuickBooks data to get the information you need.

The “You Can Grow Too Fast” Formula

Here’s a weird little paradox: One of the easiest ways for a small business to fail is by being too successful. I know it sounds crazy, but it’s true. In fact, I’ll even go out on a limb and say that small-business success is by far the most common reason that I see for small-business failure.

“Oh, geez,” you say. “This nut is talking in circles.”

Let me explain. You need a certain amount of financial horsepower, or net worth, to do business. (Your net worth is the difference between your assets and your liabilities.) You need to have some cash in the bank to tide you over the rough times that everybody has at least occasionally. You probably need to have some office furniture and computers so that you can take care of the business end of the business. And if you make anything at all, you need to have adequate tools and machinery. This part makes sense, right?

How net worth relates to growth

Okay, now on to the next reality: If your business grows and continues to grow, you need to increase your financial horsepower, or net worth. A bigger business, for example, needs more cash to make it through the tough times than a smaller business does — along with more office furniture and computers, and more tools and machinery. Oh, sure, you might be able to have one growth spurt because you started with more financial horsepower (more net worth) than you needed. But — and this is the key part — you can’t sustain business growth without increasing your net worth. Now, you may be saying things like “No way, man. That doesn’t apply to me.” I assure you, my new friend, that it does.

As long as your creditors will extend you additional credit as you grow your business — and they should, as long as the business is profitable and you don’t have cash-flow problems — you can grow your business as fast as you can grow your net worth. If you can grow your net worth by 5 percent yearly, your business can grow at an easily sustained rate of only 5 percent per year. If you can grow your net worth by 50 percent yearly, your business can grow at an easily sustained rate of only (only?) 50 percent per year.

You grow your business’s net worth in only two ways:

Reinvest profits in the business. Note that any profits that you leave in the business instead of drawing them out — such as through dividends or draws — are reinvested.
Get people to invest money in the business. If you’re not in a position to continually raise money from new investors — and most small businesses aren’t — the only practical way to grow is by reinvesting profits in the business.

How to calculate sustainable growth

You can calculate the growth rate that your business can sustain by using this formula:

I should say, just for the record, that this formula is a very simple sustainable-growth formula. Even so, it offers some amazingly interesting insights. Perhaps you’re a commercial printer doing $500,000 in revenue yearly with a business net worth of $100,000; your business earns $50,000 per year, but you leave only $10,000 per year in the business. In other words, your reinvested profits are $10,000. In this case, your sustainable growth is calculated as follows:

Work out the numbers, and you get 0.1, or 10 percent. In other words, you can grow your business by 10 percent yearly (as long as you grow the net worth by 10 percent per year by reinvesting profits). You can easily go from $500,000 to $550,000 to $605,000 and continue growing annually at this 10 percent rate, but your business can’t grow any faster than 10 percent per year. That is, you’ll get into serious trouble if you try to go from $500,000 to $600,000 to $720,000 and continue growing at 20 percent per year.

You can convert a decimal value to a percentage by multiplying the value by 100. For example, equals 10, so 0.1 equals 10 percent. You can convert a percentage to a decimal value by dividing the value by 100. For example, 25 (as in 25 percent) divided by 100 equals 0.25.

The sustainable-growth formula inputs are pretty easy to get after you have QuickBooks up and running. You can get the net-worth figure off the balance sheet. You can calculate the reinvested profits by looking at the net income and deducting any amounts that you pulled out of the business.

I’m not going to go through the mathematical proof of why this sustainable-growth formula is true. My experience is that the formula makes intuitive sense to people who think about it for a few minutes. If you aren’t into the intuition thing or if you don’t believe me, get a college finance textbook and look up its discussion of the sustainable-growth formula. Or do what all the kids today are doing: Search online for sustainable-growth formula.

The First “What Happens If …?” Formula

One curiosity about small businesses is that small changes in revenue or income can have huge effects on profits. A retailer who cruises along at $200,000 in revenue and struggles to live on $30,000 per year never realizes that boosting the sales volume by 20 percent to $250,000 might increase profits by 200 percent, to $60,000.

If you take only one point away from this discussion, it should be this curious little truth: If fixed costs don’t change, small changes in revenue can produce big changes in profits.

The following example shows how this point works and provides a secret formula. For starters, say that you currently generate $100,000 yearly in revenue and make $20,000 per year in profits. The revenue per item sold is $100, and the variable cost per item sold is $35. (In this case, the fixed costs happen to be $45,000 per year, but that figure isn’t all that important to the analysis.)

Accountants like to whip up little tables that describe these sorts of things, so Table 20-4 gives the current story on your imaginary business.

TABLE 20-4 Your Business Profits

Description	Amount	Explanation
Revenue	$100,000	Sale of 1,000 doohickeys at $100 a pop
Variable costs	($35,000)	Purchase of 1,000 doohickeys at $35 a pop
Fixed costs	($45,000)	All the little things: rent, your salary, and so on
Profits	$20,000	What’s left over

Table 20-4 shows the current situation. Suppose that you want to know what will happen to your profits if revenue increases by 20 percent but your fixed costs don’t change. Mere mortals, not knowing what you and I know, might assume that a 20 percent increase in revenue would produce an approximate 20 percent increase in profits. But you know that small changes in revenue can produce big changes in profits, right?

To estimate exactly how a change in revenue affects profits, use the following secret formula:

From the sample data provided in Table 20-4 (I’m sorry that this example is starting to resemble those story problems from eighth-grade math), you make the following calculation:

Work out the numbers, and you get $13,000. What does this figure mean? It means that a 20 percent increase in revenue produces a $13,000 increase in profits. As a percentage of profits, this $13,000 increase is 65 percent:

Let me stop here to make a quick observation. In my experience, entrepreneurs always seem to think that they need to grow big to make big money. They concentrate on doing things that will double or triple or quadruple their sales. Their logic isn’t always correct, though. If you can grow your business without having to increase your fixed costs, small changes in revenue can produce big changes in profits.

Before I stop talking about this first “What happens if …?” formula, I want to quickly describe where you get the inputs you need for the formula:

The percentage-change input is just a number that you pick. If you want to see what happens to your profits with a 25 percent increase in sales, for example, use 0.25.
The revenue input is your total revenue. You can get it from your profit and loss statement. (In Chapter 15, I describe how you can create a profit and loss statement in QuickBooks.)
The figures for revenue per item sold and variable costs per item sold work the same way as I describe for the break-even formula earlier in this chapter.

The Second “What Happens If …?” Formula

Maybe I shouldn’t tell you this, but people in finance (like me) usually have a prejudice against people in sales. That’s not just because people who are good at sales usually make more money than people who are good at finance. It’s really not. Honest to goodness.

Here’s the prejudice: People in finance think that people in sales always want to reduce prices.

People in sales see things a bit differently. They say, in effect, “Hey, you worry too much. We’ll make up the difference in additional sales volume.” The argument is appealing: You just undercut your competitor’s prices by a healthy chunk and make less on each sale. But because you sell your stuff so cheaply, your customers will beat a path to your door.

Just for the record, I love people who are good at sales. I think that someone who is good at sales is more important than someone who is good at finance.

But that painful admission aside, I have to tell you that I see a problem with the “Cut the prices; we’ll make it up with volume” strategy. If you cut prices by a given percentage — perhaps by 10 percent — you usually need a much bigger percentage gain in revenue to break even.

The following example shows what I mean and how this strategy works. Suppose that you have a business that sells some doohickey or thingamajig. You generate $100,000 yearly in revenue and make $20,000 per year in profits. Your revenue per item (or doohickey) sold is $100, and your variable cost per item (or doohickey) sold is $35. Your fixed costs happen to be $45,000 yearly, but again, the fixed costs aren’t all that important to the analysis. Table 20-5 summarizes the current situation.

TABLE 20-5 Your Current Situation

Description	Amount	Explanation
Revenue	$100,000	Sale of 1,000 doohickeys at $100 a pop
Variable costs	($35,000)	Purchase of 1,000 doohickeys at $35 a pop
Fixed costs	($45,000)	All the little things: rent, your salary, and so on
Profits	$20,000	What’s left over

Then business is particularly bad for one month. Joe-Bob, your sales guy, comes to you and says, “Boss, I have an idea. I think that we can cut prices by 15 percent to $85 per doohickey and get a truly massive boost in sales.”

You’re a good boss. You’re a polite boss. Also, you’re intrigued. So you think a bit. The idea has a certain appeal. You start wondering how much of an increase in sales you need to break even on the price reduction.

You’re probably not surprised to read this, but I have another secret formula that can help. You can use the following formula to calculate how many items (doohickeys, in the example) you need to sell just to break even on the new, discounted price. Here’s the formula:

From the example data provided earlier, you make the following calculation:

Work out the numbers, and you get 1,300. What does this figure mean? It means that just to break even on the $85 doohickey price, Joe-Bob needs to sell 1,300 doohickeys. Currently, per Table 20-5, Joe-Bob sells 1,000 doohickeys yearly. As a percentage, then, this jump from 1,000 doohickeys to 1,300 doohickeys is exactly a 30 percent increase. (Remember that Joe-Bob proposes a 15 percent price cut.)

Okay, I don’t know Joe-Bob. He may be a great guy. He may be a wonderful salesperson. But here’s my guess: Joe-Bob isn’t thinking about a 30 percent increase in sales volume. (Remember, with a 15 percent price reduction, you need a 30 percent increase just to break even!) And Joe-Bob almost certainly isn’t thinking about a 50 percent or 75 percent increase in sales volume — which is what you need to make money on the whole deal, as shown in Table 20-6.

TABLE 20-6 How Profits Look at Various Sales Levels

Description	1,300 Units Sold	1,500 Units Sold	1,750 Units Sold
Revenue	$110,500	$127,500	$148,750
Variable costs	($45,500)	($52,500)	($61,250)
Fixed costs	($45,000)	($45,000)	($45,000)
Profits	$20,000	$30,000	$42,500

In summary, you can’t reduce prices by, say, 15 percent and then go for some penny-ante increase. You need huge increases in the sales volume to get big increases in profits. If you look at Table 20-6, you see that if you can increase the sales from 1,300 doohickeys to 1,750 doohickeys — a nearly 35 percent increase — you can more than double the profits. This increase assumes that the fixed costs stay level, as the table shows.

I want to describe quickly where you get the inputs that you need for the formula:

The profit figure can come right off the QuickBooks profit and loss statement.
The fixed costs figure just tallies all your fixed costs. (I talk about fixed costs earlier in this chapter, in “The ‘How Do I Break Even?’ Formula” section.)
Revenue per item is just the new price that you’re considering.
Finally, variable cost per item is the cost of the thing you sell. (I discuss this cost earlier in the chapter, too.)

Please don’t construe the preceding discussion as proof that you should never listen to the Joe-Bobs of the world. The “cut prices to increase volume” strategy can work wonderfully well. The trick, however, is to increase the sales volume massively. Sam Walton, the late founder of Walmart, used the strategy and became at one point the richest man in the world.

The Economic Order Quantity (Isaac Newton) Formula

Isaac Newton invented differential calculus, a fact that’s truly amazing to me. I can’t imagine how someone could just figure out calculus. I could never, in a hundred years, figure it out. But I’m getting off track.

The neat thing about calculus — besides the fact that I’m not going to do any for you here — is that it enables you to create optimal values equations. One of the coolest such equations is the economic order quantity, or EOQ, model. I know that this stuff all sounds terribly confusing and totally boring, but stay with me for just another paragraph. (If you’re not satisfied in another paragraph or so, skip ahead to the next secret formula.)

Perhaps you buy and then resell — oh, I don’t know — 2,000 cases of vintage French wine every year. The EOQ model enables you to decide whether you should order all 2,000 cases at one time, order 1 case at a time, or order some number of cases between 1 case and 2,000 cases.

Another way to say the same thing is that the EOQ model enables you to choose the best, or optimal, reorder quantity for items that you buy and then resell.

If you’re still with me at this point, I figure that you want to know how this formula works. You need to know just three pieces of data to calculate the optimal order quantity: the annual sales volume, the cost of placing an order, and the annual cost of holding one unit in inventory. You plug this information into the following formula:

You buy and resell 2,000 cases per year, so that amount is the sales volume. Every time you place an order for the wine, you need to buy an $800 round-trip ticket to Paris (just to sample the inventory) and pay $200 for a couple of nights at a hotel. So your cost per order is $1,000. Finally, with insurance, interest on a bank loan, and the cost of maintaining your hermetically sealed, temperature-controlled wine cellar, the cost of storing a case of wine is about $100 yearly. In this example, you can calculate the optimal order quantity as follows:

Work through the numbers, and you get 200. Therefore, the order quantity that minimizes the total cost of your trips to Paris and of holding your expensive wine inventory is 200 cases. You could, of course, make only one trip to Paris per year and buy 2,000 cases of wine at once, thereby saving travel money, but you’d spend more money on holding your expensive wine inventory than you’d save on travel costs. And although you could reduce your wine-inventory carrying costs by going to Paris every week and picking up a few cases, your travel costs would go way, way up. (You’d also get about a billion frequent-flyer miles yearly, of course.)

You can use the Standard view of the Windows Calculator to compute economic order quantities. The trick is to click the √ (square root) key last. To calculate the EOQ in the preceding example, you enter the following numbers and operators:

The Rule of 72

The Rule of 72 isn’t exactly a secret formula. It’s more like a general rule. Usually, people use this rule to figure out how long it will take for some investment or savings account to double in value. The Rule of 72 is a cool little trick, however, and it has several useful applications for businesspeople.

What the rule says is that if you divide the value 72 by an interest rate percentage, your result is approximately the number of years it will take to double your money. If you can stick money into some investment that pays 12 percent interest, for example, it will take roughly six years to double your money because images .

The Rule of 72 isn’t exact, but it’s usually close enough for government work. If you invest $1,000 for six years at 12 percent interest, what you really get after six years isn’t $2,000, but $1,973.92.

If you’re in business, you can use the Rule of 72 for a couple of other forecasts, too:

To forecast how long it will take inflation to double the price of an item, divide 72 by the inflation rate. If you own a building with a value that you figure will at least keep up with inflation, and you wonder how long the building will take to double in value if inflation runs at 4 percent, you just divide 72 by 4. The result is 18, meaning that it will take roughly 18 years for the building to double in value. Again, the Rule of 72 isn’t exactly on the money, but it’s dang close. A $100,000 building increases in value to $202,581.65 over 18 years if the annual inflation rate is 4 percent.
To forecast how long it will take to double sales volume, divide 72 by the given annual growth rate. If you can grow your business by, say, 9 percent per year, you’ll roughly double the size of the business in eight years because . (I’m becoming kind of compulsive about this point, I know, but let me say again that the rule isn’t exact, but it’s very close. If a $1,000,000-per-year business grows 9 percent annually, its sales equal $1,992,562.64 after eight years of 9 percent growth. This figure really means that the business will generate roughly $2,000,000 of sales in the ninth year.)