Founders who have a few startups under their belt are successful because they understand one simple accounting term:
Avoiding unnecessary costs and choosing an accounting method that attributes these costs in the best way for your business is just as important as choosing the right industry for your startup. When all things are equal, successful founders know that what you do with sunk costs can make a big difference.
Learn about the different costs your business will deal with, how to create a startup that can actually earn a profit, and learn NineTwoThree’s secrets for maximizing utilization rates (which is the path to profitability for any company).
Sunk Cost Product Building
A seasoned entrepreneur will naturally build up businesses that avoid sunk costs. Yet most new entrepreneurs will create ONLY sunk costs for years.
The typical process a startup navigates through is the following:
- Think of an idea
- Build the idea for months
- Ensure design is perfect (even pay for it)
- Launch a website and announce the “release”
- Start selling and marketing
Steps one through three are sunk costs. Why?
When your product launches, the investment of time and money prior to launch is not the same costs as the costs required for the growth of the company. All engineering hours, glorious ideas implemented, and perfectly designed screens will be categorized as sunk.
Another way to look at it is to imagine that on the day of launch, you just purchased the product you are launching. How much does that product cost you?
The next decision on launch day is dependent on the current state of the product. What costs will be associated with those decisions? The answer is that relevant costs, which include the future costs that still need to be incurred to create the features the first 100 customers will inevitably request for. Your current product can be called a rough draft and in need of a full replacement.
Relevant Costs for Startups
Relevant costs are the only costs that will be affected by the decisions founders make after the product launches. These costs include marketing, sales, engineering, and the founder’s own salary.
Most importantly, it does not include the debt already incurred. The math to determine profitability is based on post-launch costs:
Monthly Expected Revenue - This Month’s Relevant Operating Costs = Monthly Profit.
Knowing your sunk costs means you will have a future point in which your profit will cover the investment. The return on Investment (ROI) will be when your cumulative monthly revenue pays back your sunk cost. For first time founders it could be years.
Another negative scenario that often plays out is that the relevant costs outpace the revenue resulting in negative profit (and adding to your sunk costs.)
When growing a business, making a decision on how much sunk cost you wish to incur is a valuable exercise to go through as a founder. It is crucial to think of what costs will be associated with your build and how long you will have to pay those costs.
Calculating Operating Costs
In the above equation we can replace “this month's relevant operating costs” with COGS (cost of goods sold and SG&A. Both will be explained below.
Cost of Goods Sold
For software, without a lot of professional services, the COGS relates to the cost of hosting, servicing, or duplicating the software for each future customer. Many SaaS products have the unbelievable metric of acquiring a new customer for close to $0 cost.
Simply put, COGS is any cost that is associated with the performance and completion of a project. Engineers, project managers, quality assurance and even account managers that end up producing value for the end product should be classified before gross profit.
In a software agency, COGS can be tied directly to a project. For example, if your Agency had one project and everyone on the team was working on that one project, then your entire team should be considered a cost of the one good sold. . A startup is no different.
Most early stage startups focus on producing the product on a light speed release schedule while all hands on deck push feature after feature - hence classifying the entire team as a COG.
But what if you hire a marketer, or social media manager, or a sales girl to get a second project? Well...
Selling, General and Administrative Expenses (Operating Expenses)
Often called operating expenses, all business expenses that do not directly contribute to the production of the product will be categorized on your P&L as SG&A. This includes servers, third party software, legal fees, marketing budgets, advertisement dollars and, of course, sales.
In our fail fast example above, steps one through three will generally not have much SG&A because the startup is only focused on the product. On launch day, however, marketing, sales, lawyers and server costs become operating expenses that must be adhered to and budgeted for.
Experienced Business Owners Focus on Operating Expenses
Most first time business owners are all about the COGS baby. By your tenth business, you’re all about the SGs and As. The more marketing, sales, and customer service a startup can apply early on, the bigger the chances that they will have superior results than a startup that focuses on product first.
As we talked about in our Learn, Measure, Build Framework guide, understanding the market first and how the product will fit when it is built provides less risk to both your personal level of effort and your aforementioned sunk costs.
Therein lies the conundrum. Without a product one cannot achieve sales (unless you're famous and you can do a pre-sell). But without unlimited funding how can you survive on just marketing and sales?
The reason why third, fourth, and fifth time founders avoid sunk costs is because they have the personal capital to invest in marketing FIRST. This truth provides crooked advice as the successful entrepreneurs shout how easy it is to discover product market fit through a series of Facebook ads, social media marketing, and Reddit forums. While the costs of acquiring those insights might range into 5 figures - the beauty is that the product will only be built once the market begins to seek such a product.
But a first time founder does not have the capital to spare so they build the product to gain attraction through features. The only “cost” here is time - which we learn will eventually turn into sunk cost. This is an uneven playing field being dictated by capital. What is the answer?
The Digital Agency Saves The Day
What if I told you that there is a startup that operates ONLY on relevant costs, has never seen sunk costs, and allocates 100% of its resources towards COGS? A motivational speaker is actually a good answer, but not the one we are looking for…
If a principal has a conundrum it is trying to solve and cannot use internal resources it will think of experts that could assist in the near term project to solve the problem for short money. Hence, the agency model is born.
A team of experts sells their services to achieve a very distinct and measured goal. “Build an app to deliver food” or “allow me to chat with my friends in China” are enterprise problems with agency solutions.
Building a digital agency changes the focus from the product to the people and procedures. It also changes the focus from sunk costs to relevant costs - more importantly how to create top-line profit without overhead. All of the resources from the agency are “pre-sold” to the customer for both cost and time.
An agency allows founders to acquire the talent for a period of time because the project has a defined end date - and the profit is easy to calculate. Just don’t pay the team more than the customer is paying you and you should be on your way to some profit.
Once the commitment is made to build a sustainable agency the first thing you should do is start tracking your costs.
Tracking Cost of Goods Sold for Digital Agencies
When I worked on nuclear submarines, all employees worked on a time clock. Each time I opened a document, that document had to be recorded as time spent on that specific job. There was a 10-digit number I had to scan just to read the document. When I completed the document, I scanned that my effort for that job was over.
Management would aggregate all the hours spent on a specific project and bill the government accordingly. More importantly, every hour spent was accounted as a direct cost to the job and it was stupid simple to calculate job profitability. This cost method is very advantageous for the business owner, especially when the managers are mandated to ensure their employees' timesheets are maximized daily.
Implementing this process across any software organization has its obvious benefits. By splitting the company into small departments and tracking their costs - managers have the ability to understand overages and creep. Then, when the product ships - instant profit calculations can be computed.
Pesky Overhead Costs
But what project code does an accountant use to calculate costs for all the projects at one time? What work order does she apply her time to? This is where overhead comes in. Any part of the business that does not translate directly into production and revenue is considered overhead.
Many agencies will fall into the status of acquiring top talent without realizing that the clients they are trying to serve are interested in the builders - the doers. Management becomes the distraction between the work that needs to be done and the client waiting for answers.
From a cost perspective it is impossible to run a successful agency if you're gaining 50% gross profit and then spending 40% of that profit on overhead. What was the point of pricing the project for 50% margins to begin with? The client surely doesn’t want to pay for your SVP of Gossip. The client just wants to pay for the work - so focus on limiting overhead to 5%.
Product Managers, CTO, CMO, and any other C level exec (or the three founders in a startup with a C-level tag) are probably overhead. Sure, a C-level exec might jump into some code and help out - but are you tracking how much time that person puts in compared to the revenue that month? Are you tracking their work to the minute like you are with regular employees?
Types of Companies To Track Costs
Tracking costs for a startup is very difficult. It is safe to assume that all costs are sunk costs on product launch days and sure, startups have a very high failure rate. Tracking a small business is not as difficult.
A typical software agency will align a team around a specific project. On January 1st Team A will begin to work. By February 1st a second project begins and Team B is assigned to the later project because Team A is still working on the original project. The profit from the first customer is simply the projected revenue minus Team A Costs. Team A is 100% COGS, making you a gross profit of X. Team B is also simply calculated as the second customer's revenue minus Team B costs.
But what happens when the first customer no longer needs the services and ends the contract? More importantly, you don’t have another customer to place your valuable people assets into!
Uh, oh - you just learned about sunk costs again :(
One of the biggest challenges of running an agency is what to do with the COGS when there are no longer projects. Engineers become invaluable resources (no different than inventory) sitting on the shelf of a warehouse waiting to be sold.
Agencies were supposed to be an easy way to start a company. What happened, where are all the customers, and why can’t they call us when we need them!?
The Digital Venture Studio Saves the Day (For Real This Time)
As we navigate the avoidance of “sunk costs” there is a way to apply the resources in between projects to opportunity costs.
In other words, instead of wasting the resource due to lack of client work - apply that resource to something that will create value in the future. For example, a baker will start preparing bagels for the next day when there are no afternoon customers.
Agencies end up with the industry term “a bench”, meaning that there are idle engineers waiting to be placed into the next project. Oftentimes agencies will utilize these assets for sales or marketing tasks with no real measure on ROI. Basically, they put them to work for work's sake.
A Digital Venture Studio such as NineTwoThree is a digital agency that also devotes resources to internally funded ventures. All resources in between projects are applied to the startups the studio always has available. Every year, 3-4 startup ideas are available for work and any engineer or project manager in between projects has the opportunity to build for the future of the company.
If the project succeeds then the cost accounting was properly named “opportunity costs” and your agency is thriving at 100% efficiency. However, you must expect that many of these ventures will fail - leading towards sunk costs - but only after tax season in which you classified it as an opportunity. (See what I did there :)
At first, the ventures are basic and meek. But just like learning a sport, building products is an art. The more the team practices together builds together, and communicates - the products will get better and better. The key ingredient, again, is how you track the resources...
Tracking Time at a Digital Venture Studio
At NineTwoThree we track time for every project we work on - just like a Nuclear Submarine Facility. Every minute you work on a project your time is tracked to that specific project. If the engineer is asked to support a Maintenance and Support task mid-day for another client, that engineer will clock out of their current job and clock into the M&S job.
Every hour placed into a NineTwoThree Venture is tracked in its own timesheet - from the CEO to a contractor that worked one day on a landing page. Each day, managers can understand what the cost of any project has on the business.
Startup costs are no different - it is just another project. An engineer can work 4 hours on a startup and 4 hours on an agency project and track accordingly.
The P&L still classifies the engineer as a COGS but two HUGE savings come into play.
- All of the startup work by any individual in the agency gets a 20% tax credit. This means that your opportunity costs are now 20% less than what would have been your sunk cost.
- Your team is still classified above the gross profit line. The startups are contributing to the cost of goods sold as the product being built will be sold in the future. This leads to high-efficiency ratios of work output.
Finally, we come to the KPI that determines an agency’s success. If I were to coach other agencies, I would ask them to provide me with their utilization rate. I have a strong assumption that any company, anywhere in the world, selling any product that does not obtain at least a 50% utilization rate will ultimately fail.
Calculating Utilization Rates
Derived from manufacturing, capacity utilization is defining how productive the team is without mistakes or lost time. On the surface, it is seemingly impossible to measure a software startup or digital agency’s utilization rate due to the idea that both teams are constantly producing products that need to be redone, reworked, or deleted. However, getting an actual measure of utilization rates could reveal a surprising amount of lost time and profitability.
For example, let's say for 1 month a team of 5 people produced 800 hours of work for a client project worth $40,000. The hourly rate of the project is $40,000 / 800 = $50. If the project was quoted for 800 hours then the utilization rate would be 100%. Every available hour was utilized towards the cost of the project - without a mistake.
However, in month 3, some of the features got scrapped and the team ended up waiting for the client to provide input before proceeding. Due to delays, they only produced 640 hours of work despite having time available for 800 hours of work.
The profit of the project immediately decreases because the costs are still valid. Your team still used 800 hours and only got paid for 640. The new hourly rate is $37.5 but more importantly your utilization score dropped dramatically from 100% to 640/800 = 80%.
If your agency has other client work to do you could reassign those 160 hours to another project to avoid the opportunity costs, but there isn’t usually client work sitting on a shelf unassigned. Instead, these hours can be spent working on one of your startups as part of your digital venture studio.
Combining Accounting and Digital Venture Studios for Startup Success
Simply keeping costs low isn’t enough to ensure your startup’s success. Understanding accounting principles like sunk costs, opportunity costs, and utilization rate will help you understand exactly what your startup will need to succeed.
Since minimizing sunk costs is so vital, a digital venture studio is a fantastic strategy for developing your startup while contributing to the cost of goods sold by the agency (instead of the sunk costs of your startup). On the flip side, having internally funded ventures for your agency teams to work on helps keep your utilization rates high and avoid opportunity costs.
As you calculate all the costs for your startup or digital agency, consider the benefits of pivoting to a digital venture studio to see more success with each.