Today we have a guest blog from David Lightfoot:
Much is made
of financial metrics. This is good but often the simplest metrics are the best.
Gross Margin is one of the best. 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.
The right
way to calculate Gross Margin in a service business is to include the cost of
labor of all people who provide direct client/customer service within Cost of
Sales. And that labor cost needs
to be fully burdened including taxes, benefits and paid time off (PTO). 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.
Businesses
selling goods rather than services will have significantly different gross
margins. I’ve seen 30% typically for contracting and 90% or more for software.
Whatever the business, gross margin, properly calculated, is usually one of the
Key Performance Indicators (KPIs).
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. It is the quantification of your value proposition.
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.
Do you know
what your gross margin is?
David Lightfoot
David Lightfoot has over 35 years of accounting, finance and operational experience as Controller, Chief Financial Officer or Vice President of Finance for small and medium-sized businesses. He also has operations experience and has worked as a CEO, giving him a broad business perspective.
Mr. Lightfoot is currently a Partner with B2B CFO, the world’s largest provider of CFO services. David’s clients range from start-ups to $50M in annual revenue. He specializes in professional services, real estate/construction, software and healthcare.