April 07, 2022

Sometimes It Is Hard To Calculate Margin

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Maybe you work at an Agency. The agency sells a product. It costs $1,000,000 to develop the product. You sell the product for $25,000. When you sell the product, it costs you $5,000 to maintain the product per client. You expect to sell the product to 50 clients in year one, 20 clients in year two, 10 clients in year three, and then just 5 clients in year four.

What is the gross margin of this product?

There are a LOT of experts who will give you different answers. Ultimately, you have to do what is right for your business.

In the example above, you expect to sell the product 50+20+10+5 = 85 times. Each time you sell the product you incur a cost of $5,000 ... 85*5,000 = $425,000. You spent $1,000,000 developing the product. Total cost = $1,425,000.

You'll sell 85 "units" ... so $1,425,000/85 = $16,765. Your cost of goods sold = $16,765.

At $25,000 per "unit", your gross margin is $25,000-$16,765 = $8,235.

Your gross margin percentage is $8,235/$25,000 = 32.9%.

I know, there's a LOT of experts who will tell you that my math is wrong.

But conceptually, you now have an idea how profitable your product is.

You can also play "what if" games. What if you sell the product for $40,000 instead of $25,000? Using the "negative square root rule" you might estimate ($40,000/$25,000)^(-0.5) = 79% of the units sold. Maybe you don't believe that and you believe sales would be cut in half. Ok, fine. Now allocate production costs across 42.5 unit instead of 85 units and then tack on the $5,000 cost per unit to maintain the product and see where that takes you.

Again, there are a LOT of experts who will argue with you about the "right" way to do this stuff.

I'm just asking you to "do something".

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