My name is Jody. I’m an accountant, a Virtual CFO by trade, with over 15 years of experience helping service-based businesses maximize profits and minimize taxes.
I’m about to get real for the next few minutes, so listen up.
By the end of this article, you’ll know how to turn $10 into $300,000. I’ll walk through all the steps, and hopefully you’ll walk away with a stronger understanding of how to tackle the unit economics of your service-based business.
Here we go.
There’s a strong chance your company isn’t financially healthy.
You weren’t expecting that, were you!
When I think about the unit economics of a service-based business, one of the first key performance indicators (KPIs) I look at is a company’s cash reserve.
Here’s the thing. A cash reserve is the lifeblood of any service-based business, but most companies I speak with don’t know what a cash reserve is, don’t have one or don’t have one that’s large enough.
What’s a cash reserve?
A cash reserve is nothing more than a chunk of money you have available in the bank. Without a cash reserve, the smallest financial hiccup in your business becomes a huge deal.
You know, things like:
- When a client abruptly terminates the deal or goes out of business and can’t pay you.
- When your sales pipeline dries up.
- When an opportunity arises (to hire an A+ performer, to acquire another company, etc.) but you don’t have enough cash to take advantage of it.
If you haven’t been there yet, and you’re serious about scaling your service-based business, trust me…you’ll get there soon enough.
It’s hard to weather the storm without a cash reserve.
As a best practice, you should have at least 10% annualized revenue in your cash reserve at all times.
Really, you should shoot for 30%.
As an example, if you brought in $600,000 in revenue last year, your cash reserve should be between $60,000 (10%) and $180,000 (30%).
Another way to frame this — you should stow away a chunk of cash that’s worth somewhere between two and six months of your company’s operating expenses.
While you can pad your cash reserve with a line of credit, you ultimately want to have a cash reserve that’s 100% cash.
Very few service-based businesses like web design, development, or consulting shops have this kind of cash lying around. Only the service-based businesses that are really crushing it strive to build and to maintain those numbers on a regular basis.
How do I build a cash reserve?
Here’s where it may be helpful to get out your calculator and a pad of paper. Even a bean counter like me can’t do this kind of math in my head.
First, let’s start with some assumptions. Your average producer:
- Works 2080 hours/year.
- Works at 80% efficiency — 80% of those hours represent direct client work, and the other 20% of those hours are spent on things like non-client projects, vacation or sick leave.
- Bills $140/hour — Even if you’re not strictly billing hourly, in a service-based business it’s critical that you know this number. Strong service-based businesses track their producers’ time not to whip them into shape, but to forecast their company’s financial health.
- Works at 90% realization — For every hour spent on a client, your producer only realizes 90% of that in revenue back to the company. This is pretty standard in service-based business. Think discounts, write-offs, poor time-keeping habits, etc.
2080 x 80% x $140 x 90% = $209,664/year
So, we’re assuming that each full-time producer on your team bills a little over $200,000 in revenue each year. Not too bad!
Now, let’s make some assumptions about your expenses:
- 120% = payroll, payroll taxes, and benefits you’d pay on a full-time employee
- 30%, 10%, and 4% = your administrative, production, and facility expenses as a percentage of sales.
Now, let’s subtract your expenses from your revenue:
$209,664 — $182,252 = $27,412
And there’s your company’s annual profit per producer.
If you’ve got 20 producers on your payroll, that’s $548,237 in profit each year.
What happens when I raise my effective hourly rate by $10?
$10 is a seemingly small amount, but when you plug it into all the math we just did, see how it snowballs into some pretty significant gains?
OK, you got us.
It’s not quite $300,000 — but if you’ve got 20 producers working for you, and you raise your rates by just $10/hour, you’re looking at an additional $299,520 ($847,757–$548,237) each year in profit. And you can guess, this additional profit translates directly into CASH.
That’s a huge increase, and certainly one way to beef up your company’s cash reserve. Get ‘er done, folks!
Get your custom, financial scorecard
Still reading? Cool!
If you run a service-based business and want to learn more about how you can improve its financial health, here’s a link to a no-obligation offer my team is running to help showcase what we do. You’ll get a free, custom financial scorecard for your business and a follow-up from one of our Virtual CFOs.
Questions? Feedback? Visit our website at www.summitcpa.net/virtual-cfo-services or Email me at firstname.lastname@example.org.
Jody Grunden is a nice guy who likes hockey, golf, and his family. He also meets with businesses on a weekly basis as a Founder and Managing Partner over at Summit CPA Group, a Virtual CFO firm that helps growing companies manage (and improve) their finances.