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Advanced KPIs: Software-as-a-Service – Magic Number

This is part 2 of a 5 part series on Advanced KPIs.

As we discussed previously, Sales Efficiency can help you make decisions about your sales & marketing spend by measuring how much revenue you generate from every $1 you spend. (Hint: If you generate more than $1 you should spend more.)

However, it can be hard to calculate Sales Efficiency if your company is a Software-as-a-Service (subscription). For subscription businesses it is hard because you will not know how much revenue you generated from January sales until 12 months later! This is why SaaS businesses use a metric called the Magic Number.

You calculate your Magic Number by taking the amount of incremental revenue you generate in a given quarter, multiply it by 4 and divide it by the sales and marketing spend for the previous quarter. For example, if you spent $10k on sales and marketing in Q1 and generated $5k of incremental revenue in Q2, then you would calculate your Magic Number as:

magic_numberWhy do you multiply the incremental revenue by 4? You are estimating how much that new business will be worth over 12 months (4 quarters) instead of waiting 12 months to find out. This shortcut allows you to calculate your Magic Number every quarter and make changes immediately instead of waiting a year! (More explanation here)

That sounds like hocus pocus.

Ha, that’s a pretty good pun. Seriously, though, you are right that it seems dangerous to extrapolate revenue by simply multiplying by 4. Let us break down the strengths and weaknesses of the Magic Number.

The Good

  • You can calculate the Magic Number and make decisions quickly, before you know the Lifetime Value of your customers (LTV). This makes it useful in the early stages of a product or service which might not have years of data.
  • Subscription businesses are typically very stable, so simple multiplication can be a fairly accurate projection of future value. In many SaaS businesses, the Quick Ratio projection can be over 90% accurate.

The Bad

  • If your customer churn is very high, you may not actually have customers pay for 12 months so you would vastly overestimate incremental revenue. In that case, you would use a more appropriate (lower) multiplier than 4.
  • If your sales and marketing strategy is shifting, you may not be able to attribute all the incremental revenue in a given quarter to the spend from the previous quarter. You should fall back to simpler measures of Sales Efficiency in this case.
  • If you don’t have a very clear definition of incremental revenue, you can misattribute revenue you would have earned anyway to your sales and marketing, which will overestimate their effectiveness.

Even with these dangers lurking, the Magic Number is a useful compass when making decisions about increasing your sales and marketing spend at subscription businesses. It is also a useful yardstick to use to compare how well your sales and marketing is performing compared to other companies in your industry.

Read more about Magic Numbers across different companies.

Quote of the Day: “Any sufficiently advanced technology is indistinguishable from magic.” – Arthur C. Clarke

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The Advanced KPIs series