Much is made of financial metrics. This is good but often the simplest metrics are the best. Here I discuss one of the most important: Gross Margin.
Like many financial measures, the calculation of Gross Margin isn’t that straightforward. Even looking at the financial statements of publicly traded companies won’t clarify the matter as practices vary widely.
What to do? First, make sure that whatever you do, it is done consistently to ensure comparability between periods. Second, it is important that the financial statements, and in particular the Income Statement, are set up is such a manner to provide the most helpful information to management. This is why accounting is as much art as science.
For most businesses the Income Statement is the primary statement for judging performance. And within the Income Statement there are two important metrics: Gross Margin and Net Margin. Net Margin or Net Income is “the bottom line.” It is the income or loss after everything. That’s important, of course, but today’s topic is a subtotal in the Income Statement called Gross Margin.
Gross Margin is the difference between the business’s revenue and cost of sales. Cost of Sales is the cost of providing goods or services to your customers but not including any costs of overhead. For example, if you’re a shoe store, Cost of Sales is the cost of the shoes purchased including freight-in. Payroll and the costs of the store are parts of overhead. Overhead costs are incurred even if your Revenues are zero. The business pays rent, utilities and staffs the store (payroll) even if you don’t sell any shoes. And while the shoe store purchases shoes for inventory, there is no “cost of sales” until a pair of shoes is sold.
Scaling up, the rules change a bit. If you have a chain of shoe stores with a home office, typically a “four-wall contribution” is calculated and the cost of the stores (facility costs) and in-store payroll is part of Cost of Sales. In this case, most of the overhead is at the corporate level.
For service businesses calculating Gross Margin is less straightforward but it is even more important. In a service business, especially professional services, you are selling people. The right way to calculate Gross Margin is to include the cost of labor of all people who provide direct client/customer service within Cost of Sales. That is, if a person has direct customer contact in the provision of your service, the cost of that person is part of Cost of Sales. And that labor cost needs to be fully burdened including taxes and benefits. To use the manufacturing term, that’s called Direct Labor.
Indirect Labor goes in Overhead. Indirect Labor includes managers, supervision and support staff. Often, some people do some work that is directly billable to clients and some work that is supervision or management. In this case, the labor costs need to be allocated between Cost of Sales and Overhead.
For most professional service companies, Direct Labor (unburdened) needs to be charged to clients at 2.5X to 3.0X. For example, if a staff person is paid $50 per hour, they would typically be charged to the client at $125 to $150 per hour. Looked at another way, Gross Margin in a professional service business should be about 50%. That’s Revenue less Direct Labor including burden.
Gross Margin of 50% sounds great but remember overhead and profit need to come out of that 50% margin, leaving (hopefully) some Net Margin.
There are a number of things that are significant about making an accurate Gross Margin calculation. First and foremost, this is the purest measure of the value proposition of a business. It measures what customers will pay for the business’s goods or services against what it costs for the business to provide those goods or services.
The second important thing that calculating Gross Margin does, is set things up for an easy breakeven point analysis. Everything above the Gross Margin line, if set up correctly, should vary directly with sales volume. Thus, if Sales double then Gross Margin should double. On the other hand, Overhead costs should remain stable for a period of time, regardless of Sales volume. There are a few exceptions, such as Sales Commissions. These are usually part of Overhead but vary with Sales volume.
Why is all of this important? It helps with understanding the cost behaviors of the business. This allows one to calculate breakeven, figure out how to be more profitable and whether the business has a viable model.
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