Quantifying Your Value Proposition

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.