The profit equation in the transaction-driven, traditional on premise business is well known.
Revenue less cost of goods sold equals gross profit. Subtract selling, general and administrative expenses and you get net income before interest and taxes. In order to increase profit you increase revenue, and/or reduce cost of goods sold and/or take costs out of selling, general and administrative expenses and/or do any or all of the above. Not easy but known and reasonably predictable by most managers and owners. No real problem matching sales and marketing expenses with the revenues that they generate, and no worries about the net present value of annuity revenue generated impacting business valuation algorithms. Generally the difference between what you receive as revenue, and what you spend to get it is what you have as profit.
As you have seen from the discussions in previous installments the revenue and expense drivers in the cloud and other recurring revenue driven businesses are a little bit different then the drivers in your traditional on premise business. For some business people it requires a different take on profit management, different financial models and different business plan.
So what does it take to make a profit in the cloud or SaaS business and in a startup situation, how long might it take to happen?
Accounts in the cloud and SaaS business become profitable when the cumulative revenue generated by the account exceeds the cumulative cost of account acquisition and ongoing account retention. Accounts are not profitable on signing because the initial expenses lead the initial revenue and it takes a period of time for the total revenue generated to catch up with, and overtake, the pool of total expenses. In fact, this dynamic leads to a requirement for a “cash plug” until the revenue contribution overtakes the expense load. At the most basic level, account revenue in a period must at least exceed account retention costs of the period or there will never be a positive contribution made to cover the costs of customer acquisition and fixed overheads. But your financial modeling will show you this.
Profit happens in the cloud or SaaS business when the total revenue generated from the portfolio of all accounts is in excess of total costs of all functions in your cloud or SaaS business. The revenue in the business varies as a function of the number of accounts, and the average account size. The expense function has a fixed component and a variable component. The fixed expenses are related to labor/salary costs and allocated facility costs. The variable expenses are related to revenue driven sale compensation, and program driven marketing costs.
The way the dynamics of revenues and expenses work in the cloud and SaaS business work, it is possible to have profitable accounts in an unprofitable business. It is also possible to have an unprofitable business that contains profitable accounts. However it is not possible to have a profitable business if the majority of the business written in accounts is not in fact profitable. This state of the world takes time to develop, once again as your financial modeling will tell you.
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About Channelcorp
Margaret and Bruce Stuart founded Channelcorp in 1989. The firm is a global leader in the assistance of reseller, distributor and vendor clients. Channelcorp specializes in the business model transformation that is required in the face of the structural changes to recurring revenue driven business models in the worldwide IT business (www.channelcorp.com/services.php). Channelcorp publishes and sells four industry- leading books and 12 white papers (www.channelcorp.com/publications.php).
