Profitability Metrics: Beyond 'Are We Making Money?'

The WeWork Paradox: $47B Valuation with Negative Unit Economics

In 2019, WeWork was valued at $47 billion. They had beautiful offices in major cities worldwide. Revenue was growing at triple-digit rates. They were “revolutionizing” real estate.

Then the S-1 filing revealed the truth:

• Revenue: $1.8B
• Net Loss: $1.9B
• Unit Economics: Negative in every major market
• Core Business: Losing money on every lease

For every dollar of revenue, they spent more than a dollar. The faster they grew, the more money they lost. Growth was making them broker.

The IPO was pulled. Valuation crashed to $8B. The CEO was ousted.

The WeWork debacle teaches us a critical lesson: Revenue is vanity. Profit is sanity. Cash is reality.

But “profit” is too simple. There are many types of profit, and understanding the hierarchy of profitability metrics is essential to running (or evaluating) a business.

Let’s dive into the profitability metrics that actually matter.

The Margin Hierarchy: Understanding Different Types of Profit

Most people think of profit as a single number. But there are four critical margin levels, each telling you something different about your business.

1. Gross Margin: The Fundamental Economics

Gross Margin measures profitability after direct costs of delivering your product or service.

$$ \text{Gross Margin %} = \frac{\text{Revenue} - \text{COGS}}{\text{Revenue}} \times 100% $$

COGS (Cost of Goods Sold) includes:

• Direct materials
• Direct labor for production/delivery
• Hosting/infrastructure costs (for software)
• Payment processing fees
• Shipping costs (for physical goods)

Example (SaaS company):

• Revenue: $1,000,000
• COGS: $150,000 (hosting, support staff, payment processing)
• Gross Profit: $850,000
• Gross Margin: 85%

What it tells you: Whether your core product/service is fundamentally profitable. If gross margin is low, you have a COGS problem.

Red Flag: Gross margin < 50% for software companies. It should be 70-90%.

2. Contribution Margin: Unit Economics at Scale

Contribution Margin subtracts variable costs (costs that scale with revenue) from revenue.

$$ \text{Contribution Margin %} = \frac{\text{Revenue} - \text{Variable Costs}}{\text{Revenue}} \times 100% $$

Variable Costs include:

• COGS (from above)
• Sales commissions
• Payment processing fees
• Customer support costs
• Variable marketing costs (pay-per-click ads, affiliate fees)

Example (E-commerce company):

• Revenue: $1,000,000
• COGS: $400,000
• Sales commissions: $100,000 (10% of revenue)
• Customer support: $50,000
• Marketing: $150,000
• Variable Costs Total: $700,000
• Contribution Margin: 30%

What it tells you: How much each additional dollar of revenue contributes to covering fixed costs and profit. This is critical for understanding scalability.

Key Insight: If contribution margin is positive, scaling increases profit. If negative, scaling increases losses (the WeWork problem).

3. Operating Margin: The Reality Check

Operating Margin (also called EBIT margin) includes all operating expenses.

$$ \text{Operating Margin %} = \frac{\text{Operating Income (EBIT)}}{\text{Revenue}} \times 100% $$

$$ \text{Operating Income} = \text{Revenue} - \text{COGS} - \text{Operating Expenses} $$

Operating Expenses include:

• Sales & Marketing (all, not just variable)
• General & Administrative (G&A)
• Research & Development (R&D)
• Rent, utilities, insurance
• Salaries for all functions

Example (Tech company):

• Revenue: $10,000,000
• Gross Profit: $8,500,000 (85% margin)
• S&M: $4,000,000
• R&D: $2,500,000
• G&A: $1,000,000
• Operating Income: $1,000,000
• Operating Margin: 10%

What it tells you: Whether the business is profitable from core operations, before financing costs and taxes.

Benchmark: Healthy mature companies have 15-25% operating margins. High-growth companies often have negative operating margins.

4. Net Margin: The Bottom Line

Net Margin is what’s left after everything — including interest, taxes, and non-operating items.

$$ \text{Net Margin %} = \frac{\text{Net Income}}{\text{Revenue}} \times 100% $$

$$ \text{Net Income} = \text{Operating Income} - \text{Interest} - \text{Taxes} - \text{Other} $$

Example:

• Operating Income: $1,000,000
• Interest Expense: $100,000
• Taxes (25%): $225,000
• Net Income: $675,000
• Net Margin: 6.75%

What it tells you: The actual profitability returned to shareholders.

Reality Check: Many highly successful companies have low net margins:

• Amazon: ~3-6%
• Walmart: ~2-3%
• Costco: ~2.5%

But they make up for it with volume and capital efficiency (more on this below).

EBITDA and Why Everyone Talks About It

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

$$ \text{EBITDA} = \text{Revenue} - \text{COGS} - \text{Operating Expenses (ex. D&A)} $$

Or more simply:

$$ \text{EBITDA} = \text{Operating Income} + \text{Depreciation} + \text{Amortization} $$

Why EBITDA Matters

EBITDA measures cash-generating ability from operations, removing:

• Depreciation & Amortization: Non-cash accounting expenses
• Interest: Financing decisions (not operational performance)
• Taxes: Vary by jurisdiction

Use Case: Comparing companies with different capital structures or in different tax environments.

Example:

• Operating Income: $1,000,000
• Depreciation: $300,000
• Amortization: $100,000
• EBITDA: $1,400,000

When EBITDA is Misleading

EBITDA can hide problems:

1. Ignores Capital Expenditure needs: A company can have positive EBITDA but burn cash if CapEx is high
2. Ignores working capital: Doesn’t account for inventory or receivables growth
3. Can be manipulated: Companies add back “one-time” expenses repeatedly

Red Flag: “Adjusted EBITDA” with excessive add-backs. WeWork famously created “Community Adjusted EBITDA” which excluded most costs.

Better Metric: Free Cash Flow (Operating Cash Flow - CapEx)

Unit Economics at Scale: The Make-or-Break Question

Unit Economics answers: “Do we make money on each transaction/customer?”

The Unit Economics Formula

$$ \text{Unit Economics} = \text{Revenue per Unit} - \text{Variable Cost per Unit} $$

If the result is positive, scaling is good. If the result is negative, scaling is suicidal.

Real Example: Uber (Early Days)

Per Ride Economics (2015):

• Gross fare: $20
• Uber’s cut (25%): $5
• Driver incentive: $2
• Insurance & fees: $0.50
• Net to Uber: $2.50 ✅

Why Uber lost money overall: Fixed costs (R&D, S&M, G&A) overwhelmed positive unit economics.

Strategy: Achieve scale → positive unit economics cover fixed costs → profitability.

The Contribution Margin Test

$$ \text{Contribution Margin per Unit} = \text{Price} - \text{Variable Cost} $$

Example (Subscription Box):

• Price: $40/month
• Product cost: $15
• Shipping: $5
• Payment processing: $1.50
• Contribution Margin: $18.50 ✅

Covers: Fixed costs of $500,000/month needs 27,027 subscribers to break even.

The Rule of 40: Growth vs. Profitability Balance

The Rule of 40 is a guideline for SaaS and subscription businesses:

$$ \text{Rule of 40} = \text{Revenue Growth Rate (%)} + \text{Profit Margin (%)} $$

Target: ≥ 40%

Why It Works

It acknowledges the tradeoff between growth and profitability:

• High-growth companies can afford to be less profitable (investing in growth)
• Slower-growth companies should be more profitable

Example 1: Shopify (Growth Mode)

• Revenue Growth: 30%
• Operating Margin: 15%
• Rule of 40: 45% ✅

Example 2: Salesforce (Mature)

• Revenue Growth: 20%
• Operating Margin: 25%
• Rule of 40: 45% ✅

Example 3: Struggling SaaS

• Revenue Growth: 15%
• Operating Margin: -10%
• Rule of 40: 5% ❌

The Rule of 40 Quadrants

Strategic Insight: You can dial up growth (by spending more on S&M) or dial up profit (by cutting costs). The Rule of 40 measures the balance.

Revenue Per Employee (RPE): Efficiency Matters

Revenue Per Employee measures how efficiently you turn labor into revenue.

$$ \text{RPE} = \frac{\text{Annual Revenue}}{\text{Number of Employees}} $$

Industry Benchmarks (2024):

Top Performers:

• Meta: ~$1.9M RPE (advertising platform, massive leverage)
• Alphabet (Google): ~$1.6M RPE
• Apple: ~$2.3M RPE (combination of software & hardware)
• Netflix: ~$3.5M RPE (content platform, extreme leverage)

Why RPE Matters

High RPE indicates:

• Leverage: Technology/systems that multiply individual output
• Pricing power: High-value products/services
• Efficiency: Lean operations

Low RPE indicates:

• Labor intensity: Services businesses, low automation
• Inefficiency: Bloated headcount
• Low pricing: Commodity products

Strategy: As companies mature, they should increase RPE through automation, better processes, and higher-value offerings.

Warning: Don’t chase RPE at the expense of growth. A 10-person startup with $5M revenue ($500k RPE) is better than a 3-person lifestyle business with $900k revenue ($300k RPE) if the startup is growing.

When Margins Lie: The Amazon Paradox

Amazon’s net margin is ~3-6%. By conventional analysis, it’s barely profitable. Yet it’s one of the most valuable companies in the world.

Why?

Return on Invested Capital (ROIC)

Margins don’t tell the whole story. Capital efficiency matters.

$$ \text{ROIC} = \frac{\text{Net Operating Profit After Tax (NOPAT)}}{\text{Invested Capital}} $$

Amazon’s Secret:

• Low margins (3-6%)
• But very high inventory turnover (8-10x per year)
• Negative cash conversion cycle (gets paid before paying suppliers)
• High ROIC (~26%)

Translation: Amazon makes money so efficiently that low margins don’t matter. They turn inventory into cash faster than they have to pay for it.

The Grocery Store Model

Grocery stores have 1-3% net margins, but they’re great businesses because:

• Inventory turns every 5-7 days
• Customers pay immediately (cash)
• Suppliers are paid in 30-90 days
• Free float to reinvest

$$ \text{Annual Returns} = \text{Margin %} \times \text{Inventory Turns} $$

Example:

• Margin: 2%
• Inventory Turns: 20x/year
• Annual Return on Inventory: 40%

When Low Margins are Bad

Low margins are a problem when:

• Capital intensive: Need heavy investment to grow
• Slow turnover: Inventory or receivables sit for months
• Negative working capital: You pay before you get paid
• Competition: No moat, margins will be competed away

Red Flag Example: WeWork had negative margins and high capital intensity (lease deposits, build-outs). The worst of both worlds.

Industry Benchmarks: Know Your Numbers

Understanding industry benchmarks helps you know if your margins are healthy.

Software (SaaS)

Why high margins? Low COGS (hosting is cheap), high leverage (software scales).

E-commerce / Retail

Why lower margins? Physical goods, shipping costs, returns.

Professional Services (Consulting, Legal, etc.)

Why lower RPE? Labor-intensive, limited leverage.

Marketplace / Platform

Why high margins? Platform leverage, minimal COGS (facilitating transactions, not owning inventory).

Decision Framework: When to Optimize for Growth vs. Profit

The eternal question: Should we grow faster or become profitable?

The Growth vs. Profit Decision Tree

When to Prioritize Growth

Grow aggressively when:

1. ✅ Unit economics are positive (contribution margin > 0)
2. ✅ Large, growing market (TAM > $1B)
3. ✅ Winner-take-most dynamics (network effects, switching costs)
4. ✅ Competitive threat (need to capture market before competitors)
5. ✅ Access to capital (can raise money to fund growth)

Examples:

• Uber: Raced to dominate ride-sharing before competitors
• Amazon AWS: Captured cloud market early, sacrificed profit for share
• Netflix: Invested heavily in content to build moat

Metric to Watch: Rule of 40. As long as Growth% + Profit% ≥ 40%, you’re in a healthy zone.

When to Prioritize Profitability

Optimize for profit when:

1. ❌ Unit economics are negative or marginal (contribution margin ≤ 10%)
2. ❌ Market is mature or small (limited growth potential)
3. ❌ No competitive moat (commodity business, easy to replicate)
4. ❌ Capital is expensive or scarce (can’t raise money easily)
5. ✅ Already dominant (won the market, now optimize)

Examples:

• Apple (Post-iPhone dominance): Optimized for margin, not market share
• Microsoft (Mature Windows era): Focused on profit, not growth
• Costco: Low growth, high profit, strong cash generation

Metric to Watch: Operating Margin and Free Cash Flow. Healthy businesses should generate 15-25% operating margins.

The Danger Zone: Neither Growth nor Profit

Red flags:

• Revenue growth < 15%
• Operating margin < 0%
• Rule of 40 < 30%
• Burning cash with no path to profitability

What to do:

1. Fix unit economics — Can you raise prices? Lower CAC? Reduce churn?
2. Cut unprofitable segments — Focus on what works
3. Reduce burn rate — Extend runway
4. Pivot or sell — If fundamentals are broken, fix or exit

Example: WeWork tried to grow out of bad unit economics. It didn’t work. Should have fixed the model first.

Bringing It All Together: A Profitability Dashboard

Track these metrics monthly:

Color Code:

• 🟢 Green: Meeting or exceeding benchmarks
• 🟡 Yellow: Below benchmark but improving
• 🔴 Red: Below benchmark and declining

Key Takeaways

1. Gross Margin reveals fundamental economics — If it’s low, you have a COGS problem

2. Contribution Margin determines scalability — Positive means growth is good; negative means growth kills you

3. Operating Margin measures overall efficiency — Mature businesses should have 15-25%

4. Net Margin is the bottom line — But low net margin isn’t always bad (see Amazon)

5. EBITDA measures cash generation — Useful for comparison, but watch out for “adjusted” EBITDA games

6. Rule of 40 balances growth and profit — Target Growth% + Profit% ≥ 40%

7. Revenue Per Employee indicates leverage — Higher means more efficient operations

8. Margins can lie — Capital efficiency (ROIC, turnover) matters as much as margins

9. Industry matters — Know your benchmarks; software should have 70-90% gross margins, retail 30-50%

10. Fix unit economics before scaling — Never grow a business that loses money on every unit

Next in Series: Stay tuned for more Business Math deep dives on pricing strategy, financial modeling, and cash flow management.