When reviewing a business plan investors will be looking to see whether the financial projections show their potential investment has a scalable business model. A scalable business model is one in which revenue is increasing but expenses are controlled and remain stable or increase at a much slower rate than revenue.
Operating expenses in the formula refers to research and development, sales and marketing, and general and administrative expenses.
It follows then that a more useful definition of a scalable business model is one in which as revenue increases the break even point remains stable or increases at a much slower rate than revenue.
Break Even Revenue and the Scalable Business Model
The diagram below shows the revenue and break even revenue of a typical growing and scalable business model plotted against time
The gap between revenue and break even revenue determines the amount of profit the business earns. As the revenue increases the operating expenses, gross margin percentage and therefore the break even revenue are held relatively constant.
As with any startup the business goes through a stage where revenue is below break even and the business makes a loss. After the break even point the revenue rapidly increases beyond break even and the business makes a larger and larger profit as the revenue increases. This type of graph is typical of a scalable business model.
Economies of Scale
It should be noted that in a scalable business model economies of scale will also reduce the variable unit costs of the product and improve the gross margin percentage. Using the break even formula above the effect of improving the gross margin percentage is to reduce the breakeven even further as the business grows.
Is a Growing Business Always Scalable
A business can be regarded as growing if its revenue increases over time; however, a growing business is not necessarily scalable.
If operating expenses increase each time revenue increases then the break even point of the business will not remain stable and will also increase over time.
For example, if the operating expenses of a business are 54,000 and the gross margin percentage is 60% then the break even revenue is calculated as follows.
Break even revenue = Operating expenses/Gross margin % Break even revenue = 54,000/60% = 90,000
If the operating expenses of the business increase to 72,000 as the revenue increases then the break even revenue increases calculated as follows.
Break even revenue = Operating expenses/Gross margin % Break even revenue = 72,000/60% = 120,000
Each time revenue increases the operating expenses and the break even point also increase.
The diagram below shows the revenue and break even revenue of a growing but non-scalable business.
This time as the revenue increases the operating expenses and therefore the break even point increase proportionally. This might be the situation for example with a professional services firm which needs to add additional employees each time the business expands.
As before initially the revenue is less than break even and the business makes a loss. As the revenue increases the operating expenses increase and the break even point moves higher. The higher break even point reduces the profitability of the business as it expands. This type of graph is typical of a non-scalable business model.
How to Build a Scalable Business
All startup scalable business ideas are different but there are a number of common features which make it more likely that the business will be seen as scalable from an investors point of view.
- A large and unique total addressable market (TAM).
- Low and stable operating expenses in particular sales and marketing expenses and general and administrative expenses.
- Research and development expenses might initially be high but should eventually reduce to a more sustainable and stable level.
- Low headcount facilitated by the use of outsourcing and automated systems.
- High gross margin percentage to reduce the break even point. This can be achieved using economies of scale to keep unit cost of sales to a minimum and by maintaining high customer prices.
- The working capital requirements of the business should be as low as possible. A low working capital requirement reduces the need for funding as the business grows.
Scalable Business Model and the Financial Projections Template
Both revenue and break even revenue are shown in the financial projections template. Revenue is found at line 3 and break even revenue at line 73 of the template.
By plotting these two sets of data against time a graph similar to those shown above can be created. The graph should then be used to give an indication as to whether or not the business has a scalable business model.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.