Lesson 1 of 7
How a business makes money
Reduce a business to one unit, its price, its variable cost and what is left over, and read that bridge straight out of the 10-K.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Every business sells some unit: a subscriber, a store, a tonne, a contract.
- Price minus variable cost is the contribution each unit makes before fixed costs are paid.
- Fixed costs are spread over however many units sell, so volume changes the profit per unit.
A business model is a claim about one unit sold. Find the unit, its price, and what it costs to make one more of it. Add what is left to cover the costs that do not move with volume, and you have read the model without a single ratio.
One unit's bridge from price to profit
- Price per unit$100
- Variable cost−$60
- Contribution= $40
- Fixed cost per unit, at today's volume−$25
- Operating profit per unit= $15
Find the unit first
A retailer's unit is a store or a transaction. A software company's is a subscriber. A miner's is a tonne. A contractor's is a signed contract. The unit is rarely a line on the income statement. Item 1 says what the company sells and Item 2 often counts stores or plants. Many companies also report key metrics such as subscribers or revenue per unit in Item 7, MD&A. The segment note under ASC 280 splits revenue and profit by business line, which shows which units matter most. Start there, not with the total revenue line.
Do it on a real 10-K
- Find the unit named in Item 1 or counted in Item 2.
- Find the unit count and revenue per unit in Item 7, MD&A.
- Find cost of sales and operating expenses in Item 8, the financial statements.
- Divide each cost line by the unit count to build the bridge above.
Price minus variable cost is contribution
Contribution is what one more unit adds before any fixed cost is paid. It is not gross margin. Cost of sales includes fixed factory costs such as plant depreciation, and some variable costs, such as freight or sales commissions, sit lower down in operating expenses. Gross margin is the nearest filed line, not the same figure. A contribution near zero leaves nothing to spread over fixed costs, however many units sell.
Fixed costs do not care how many units you sell
Rent, salaried staff, and the plant itself cost the same whether the company sells one unit or one million. Divide the fixed cost by the units sold and you get a fixed cost per unit that falls as volume rises. That is the whole mechanism the next lesson calls operating leverage. At the volume behind the figure above, fixed cost per unit is $25, so profit per unit is $15.
The same bridge tells you what changed
A margin that fell can fail at any one of three points: price was cut, the variable cost rose, or fixed costs grew faster than volume. Reading the bridge in order, rather than jumping straight to operating margin, is what tells you which one it was. The three failures need different fixes and mean different things about the business.
Check yourself
A unit sells for $50 and costs $30 to make. What is the contribution per unit?
- $50
- $20
- $30
Show the answer
Answer: B.
Contribution is price minus variable cost: $50 minus $30 is $20. Fixed costs have not been subtracted yet.Volume rises but price and variable cost per unit do not change. What happens to fixed cost per unit?
- It rises
- It stays the same
- It falls
Show the answer
Answer: C.
The same total fixed cost is now divided by more units, so the fixed cost carried by each one falls.Where does a company usually name its own unit of business, such as a subscriber or a store?
- The auditor's opinion
- Item 1 and the key metrics in MD&A
- The cover page of the 10-K
Show the answer
Answer: B.
Item 1 describes what the company sells, and the key metrics in Item 7, MD&A, count the units, such as subscribers or stores.Sources
- SEC interpretive release on key performance indicators in MD&A, Release 33-10751, 2020.
- ASC 280, Segment Reporting.
What this leaves out
- The bridge and the volume example use round invented numbers for one illustrative unit; no filing reports a company this way directly.
- Real cost structures mix fixed and variable costs inside a single line item, so a 10-K rarely splits them as cleanly as this figure does.
- Nothing here says what any company's true unit economics are, or what any business is worth. Nothing here is advice about any security.