The Rule of 78’s
In the course of my work, I often need to estimate the expected revenue or gross margin to be generated by a sales rep from new customer acquisition. This usually happens along these lines:
Beth: How many new customers a year do you expect the rep to land?
Client: Twelve.
Beth: Ok, so roughly one per month?
Client: Yes, that’s reasonable.
Beth: What size client is this? How many loads per day or revenue or gross margin in a month?
Client: Probably about ten loads per month.
Beth: Ok, so a reasonable expectation then would be that, at the end of the year, this sales rep has landed twelve clients that are each generating ten loads per month. Or a run-rate of 120 loads per month
Client: Yes, that’s right.
Beth: Ok – then if we are going to set an expectation for the first year, for how many loads the rep will bring in from new client activity, 778 would be a good number to start with.
Client: …
Beth: Are you there?
Client: Yes, but why isn’t the goal 1,440 loads (10 loads per month times 12 months times 12 clients)?
Beth: Because the rep didn’t land all twelve clients in January, but rather they were collected over the course of the year.
My mathematical trick here is something that is derived from “The Rule of 78’s” which is typically used in other applications (such as mortgage interest payments), but it works just fine here as well. You can Google “The Rule of 78’s” or “Sum of the Digits Method” to get a deeper understanding. You might ask “how do we get the number 78”? 78 is the sum of one, two, three, four, …, ten, eleven, twelve. Essentially the second month adds to the first month and the third month adds to the first two, until you have added all twelve months of the year.
Here I will give you a little primer so you can use it in your own business and amaze your friends at parties:
If the rep landed one client in January, a second in February, a third in March, etc. and none of them were lost, then you would have a Waterfall type chart.
The total number of months that you would have had new clients (and loads from new clients) is calculated using the Sum of the Digits or the Rule of 78’s. 1 client in Jan, plus 2 clients in Feb plus 3 clients in March, etc. means you had 78 months of client activity. If you received 10 loads from each client, in each active month, then you received 780 loads. 780 divided by 10 gives 78 – hence why this is called the rule of 78’s.
Note that 78 divided by 144 (which is 12 times 12) is about 54%. Multiplying either by 78 or by 54% can be just the shorthand you need to make the right estimation, depending on what value you are starting with. If you know the one-month expectation for a rep, then you can simply multiply that by 78.
For example: Joe is expected to sell $2,000 each month in new customer revenue, while not losing the business that was sold in preceding months. Joe’s annual first goal should therefore be $156,000 ($2,000 times 78). His second-year goal (with no attrition) would be $444,444 ($2,000 x 144 from all the customers he added the first year + $2,000 x 78 from new customers added in year 2).
However, if you know that at the end of the year, your total monthly run rate from new business acquired over the course of the year needs to be $350,000 per month, then it’s reasonable to estimate your first year actual to be around $2,268,000 ($350,000 times 12 equals $4.2M full annual Revenue after the first year, times 54% equals $2.268M in the first year). OR…$350,000 divided by 12 equals approximately $29,167 added each month of the year and $29,167 multiplied by 78 equals about $2.275M. The difference between the two numbers is only a rounding error.
If you only know the “fully baked” number (e.g. a seasoned rep operating at full capacity should be doing $2M a year), then you can estimate the first year “ramp up” to be 54% of that number, or $1,080,000. By the way, this requires the rep to add about $13.9k in new business each month. More precisely, $13,888 multiplied by 78 equals approximately $1.08M and $13,888 multiplied by 144 (what second year revenue from all of these accounts will look like, with 12 accounts providing $13,888 a month over 12 months) equals $2M (within rounding error).
So, if you are starting with one month of data, multiply by 78 for the first-year Waterfall ramp up goal. If you are starting with a fully seasoned run rate for an entire year, multiply by 54% to return to the first-year goal.
Example 1: You know the end of year Monthly Production Expectation
For all my freight brokers out there, let’s do a real test. Many brokers consider $15k a month in gross margin a “reasonable” entry level rate that a rep should be able to reach within a year. At $15k a month the rep is generating $180k in Gross Margin and covering their costs about threefold (using $60k total comp estimate). It’s not great, but it works (if paid as straight commission this would be 33.33%, by the way – not that I’m recommending that).
So, what amount of new business each month needs to be added to get to $15k a month by the end of month 12 and how much gross margin will be generated in the first year? The first part of the question is easy: $15,000 divided by 12 equals $1,250. The second part is where we need the Rule of 78’s
Example 2: You know the total GM$ generated by a new customer in first 12 months
Here is a second example. You know that you typically get $4,800 from a small new customer in the first 12 months after their first shipment. You expect a rep to get four of these small new customers per month, which is 48 in a year. What is the expectation in gross margin from this rep in their first year?
Keep in mind, the difference between the two examples. The first one used one month of production as the starting point (so we divided by 12 months in method A). The second one used an annual production number as the starting point so we have to divide by 12 months and then divide by 12 again (you could speed this up and divide by 144 if you like).
Personally, I think Method B is faster for most cases that I’ve run into. But, if you are in the world of software sales and dealing with Monthly Recurring Revenue (MRR), then Method A is your golden rule.
One final example for the software sales folks out there. If your rep needs to reach a $1M quota for the year, and the rep gets 12 months of MRR credit toward quota from new customers, and your MRR from a software license is $1,000. How many new customers need to be added each month?
Just reverse the equation:
So the rep needs to add slightly less than 13 new accounts each month to generate $1M in total MRR by the end of the year. Approximately 154 total new accounts will have been added over the course of the year.
In the second year, all of these accounts (assuming they continue their business) will generate $1,848,000 in MRR. Unsurprisingly, the first year’s MRR of $1M is (drum roll please) 54% of the fully on-boarded second-year number.