Real Revenue Growth
We work with many business owners who are concerned with changes in their company’s nominal revenue, referred to generally as “growth.” On an annual basis, revenues increase, decrease, or stay the same but this nominal revenue growth does not account for changes in the pricing of services or products sold.
Nominal revenue growth includes changes due to new business, as well as increases or decreases in pricing or changes in costs of goods sold (COGS). To understand what is actually happening, we need a real revenue growth analysis.
If your COGS stay the same and the company increases the price of services or products, this causes a percentage change in revenues that would show up as a nominal revenue increase. Likewise, if we decreased the pricing, the nominal revenue would decrease in turn. What you really need to be concerned with is how much of the change – plus or minus – in revenues is due to real growth in additional units of products or services. This is what we call real revenue growth.
You can think of the difference between nominal and real revenue changes by thinking about a thermometer on a cold, windy day. You may see a temperature of 20 degrees, but after factoring in wind chill, the temperature feels like 10 degrees. You would be more concerned with the perceived 10-degree temperature if you were going to be out in the weather.
The nominal change in revenues only provides partial information as the effect of pricing is not factored into the equation; there is no quick way to know what the real change in services or products provided by the company is.
If your revenues for the year are up 15% but you increased the overall pricing by 5%, the nominal increase is 15%. The real revenue increase, however, is the 15% nominal change minus the 5% price increase, or 10%. The real revenue increase of 10% is the actual “temperature” or growth with which we are concerned. This example assumes that the COGS percentage to revenues did not change.
Let’s look at it another way. If your nominal revenue growth is up 10% and the overall price increase is 15%, the nominal revenue growth would be 10%. The real revenue growth analysis, however, would show a decline of 5%.
Now, let’s say that the nominal revenue growth comes in for the year at -10% and the prices were increased by 5%. The real revenue growth would be a -10% minus the +5% price increases resulting in a real decrease of 15%!
Real revenue change impacts your business’s over-all operations. Increasing revenues at an annual real rate of 10% may require you to buy and hold more inventory and maintain higher accounts receivable balances. You may also have to consider more plant and equipment investments as well as more employees.
In the above examples, we assume that the COGS are not changing (more precisely, the percentage of COGS to revenues did not change). In our real revenue growth analysis we don’t ignore these changes in COGS in relation to pricing policy.
So, let’s see how changes in the COGS affect real pricing changes. If prices stayed the same during the year but the COGS used for those sales decreased by 5%, this would have the same effect as a price increase, but only by the amount that COGS are a percent of revenues. If COGS are 50% of revenues then the -5% decline in COGS would be equivalent of 50% of -5%, or a positive 2.5% effective price increase to the revenues. This would be true in the opposite as well with a 5% increase in COGS resulting in an effective decline of revenue pricing of a minus 2.5%.
At first, this is might seem very counter-intuitive but doing the calculations will reveal the same results. It becomes more complicated when both revenue and COGS are moving up and down together or separately on a continuous basis.
Don’t make financial decisions with only part of the revenue picture. Let the Business Ferret help your company find your Real Revenue growth and determine how it affects your business’s entire operation.