CAPITAL INVESTMENT AND PAYBACK PERIOD
Even the most modest of home studios requires significant capital investment. Thousands of dollars Will be invested in hardware, software and acoustics by the time you have even the minimum requirements to qualify as a competitive independent home studio in a market infamous for having clients with very little spending money. Until the studio's net revenues exceed the costs in capital investment, one cannot even begin to think about making money.

Therefore, many people look at a capital investment in terms of payback period. It's easy to calculate: capital investment divided by net profits equals payback period. Let's say you can spend $10K in gear and treatment, and bill 1,000 hours a year (in your spare time) at $25 an hour. That's $25k a year in gross revenue, or just a bit over $2000 per month in gross revenue. That's a payback period of 5 months. Hooray! It's all free money after that, man!

Or is it?

I mean, if it's that good, why does anybody ever open a Mickey D's?

Payback period is a somewhat useful concept, but it's actually excessively optimistic and pessimistic at the same time. You'd think those extremes would cancel out and yield a useful figure. Sometimes they do. But knowing when they do often requires more experience than the average startup business owner has to muster. The actual numbers get much more complicated than that.

What if you hired an engineer to run your sessions and you just pocketed the profits?  Now what do you get net, maybe $5-10 per hour? That's a one to two year payback period instead of five months.

But we're not done yet.

RESIDUAL VALUE
Where payback period calculations fall on the pessimistic side is that they ignore residual value. Let's say you operate for two years, and hire an engineer at $20 per hour. That's the break even point; that makes your net profits zero, right? Wrong. You still have $10K of gear. It might not be worth $10K anymore, let's say depreciation has brought the value down to $6K. So you sell that off and your net profit is $6K.

So while you have only broken even on paper, the assets you purchased still have residual value. So, now your $6k ahead of the game because that is the value of the assets in which you originally invested your capital.

Almost.

TIME IS MONEY
Where simple payback period can be a bit too much on the optimistic side, the giant misleading concept of payback period, is the lack of this fundamental principle of finance: money has time value. $6K in two years isn't worth as much as $6K today. You'll probably think of inflation as the culprit here, and that's a big part of it, but inflation is only part of the scene.

Every investment has an opportunity cost, which is your cost of capital, or your marginal interest rate for borrowing (or investing). Marginal means the rate you'd pay off first, or the rate you'd get if you borrowed more money. The more time it takes to pay that cost of capital, the higher that cost rises. So even if you have $10K in cash laying around, there's still a capital cost associated with spending it on gear rather than paying off the balance of your loan or mortgage.

That incredible vintage hardware you found on eBay for only $1000 would add another two weeks to the original 5 month payback period.. That new microphone? Another week. The hundreds or thousands of blank CD-Rs, DAT tapes, etc. Add a week for every $500 spent. And that's just for the principal capital cost. The extra costs in finance charges, depreciation, etc. that are incurred because of the extra time required for the payback extends the payback period just that much further.

But that's still not right.

I AM SOMEBODY
If you are evaluating your business plan (you have one of those, right?), you need to consider both residual value of assets and time value of money to get it right.

You need to also value your own labor. Here's why: One thing you are trying to do in a financial model is evaluate the profitability of a capital investment. The rate at which you can get away with billing your clients is largely determined by two factors: your level of engineering skills, and your facility/gear. (OK, really it's who you know, but this is a finance lesson, not marketing!). You don't improve your engineering skills by buying gear, we all know that. So if you want to know if buying a particular piece of gear is worthwhile, you must consider how it will affect your hours booked and hourly rate, which drop to the bottom line. But in terms of return on capital, you need to remove the value of your labor to see whether or not it's worth charging it on your Musician's Friend credit card at 21% interest.

I didn't include interest expense in my spreadsheet model (see below), but feel free to change the marginal interest rate to 21% to give you a pretty good idea of what such expenses would be like. If the present value of net cash flow drops below zero, that basically means you have lost money on your capital investment, even if you've made some scratch from your salary.

CRUNCHING THE NUMBERS
I have with this article included for free download a simple Excel spreadsheet (click the image to download.) that makes some of these basic calculations. Just click on the spreadsheet image to download.

I've added a few more assumptions in there; hours booked and rate grows as you reputation spreads. By Year 5, you're ready to go full time. Depreciation is 10% per year straight line, which is certainly not a tax measure, that's supposed to be actual reduction in residual value. So if you cash out after Year 5, you'd have the residual value too. But I have stubbornly stuck to including your salary as an expense.

Feel free to play with the numbers and see how they affect the actual financial calculations, and the importance of each of the variables in the overall scheme of running a studio for profit.

IT'S NOT ALWAYS THE MONEY
One final point: if your operations never improve beyond Year 1, you are better off sticking with your day job and picking up overtime. I know, I hated working a day job too. There are non-financial considerations to this business that make it worthwhile anyway. But don't lie to yourself about the finances because of it . . .