As we discussed yesterday, 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 probably spend more.)
However, it can be hard to calculate Sales Efficiency. For subscription businesses it is especially hard because you will not know how much revenue you generated from January sales until many months later! Have no fear, this is why subscription businesses use a metric called the Magic Number – a metric that allows you to compare the incremental revenue you made in the last quarter against the sales and marketing expenditures, but extrapolated over a whole year.
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:
Why 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. There are some hidden traps here:
- 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 the simpler measure 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.
Tomorrow we’ll talk about another way to think about efficiency: the length of your sales cycles.
Quote of the Day: “Any sufficiently advanced technology is indistinguishable from magic.” – Arthur C. Clarke