In the “Seven Simple Numbers for Business Success” series we’re talking about each of the Seven Key Numbers that really matter to sustainable, profitable businesses. Based on the principles in Simple Numbers, Straight Talk, Big Profits!, these insights will show you how to use the Simple Numbers Profit Tool to run a profitable, sustainable business.
Revenue gets too much credit and Gross Margin is misunderstood and measured incorrectly.
A company that focuses on revenue without profit is like the First National Change Bank skit on Saturday Night Live. “Four quarters for a dollar, how do we make profit? Volume!”
A company that focuses on the Gross Margin percentage instead of Gross Margin dollars will quickly find there are not enough foolish customers in the world that overpay for things to support their uncompetitive business.
This blog is about how to get the two brothers to play nicely – and about why Gross Margin dollars is a higher quality number than Revenue.
Revenue is certainly the starting point of every P&L statement, but I contend that many businesses over-emphasize revenue. Each revenue dollar is not equal when it comes to the Gross Margin you get after your direct costs.
Definition of Gross Margin
I have a slightly different definition of Gross Margin than most accountants. Gross Margin is Revenue minus all direct costs that do not include labor. A direct cost (commonly referred to as cost of goods sold or cost of sales) is any cost that is directly associated with the production of revenue. Easy examples are:
- merchandise cost that a retailer sells
- materials for a construction contractor
- a subcontractor for a government contract
Other business models might not be as easy. For example, an IT services business might include subscriptions to software tools that they resell to their customers as part of their monthly service fee. The key to what you include is to be consistent in putting the cost in the same place. Many times, we model out for a client the presentation of the data as a direct cost and then show them the same data within Operating Expenses to see which one resonates best. With our bucketing approach to our Simple Numbers Tool, it makes it easy to change which bucket you put it in before you have to commit. At the end of the day, it is more about where it makes sense for you than the accountant!
Why Not Include Direct Labor?
I have long contended that since labor is the key driver of profitability in your business, you never want to mix labor with anything that is not labor. This required us to create a new subtotal after Gross Margin and before you get to Operating Expenses. Gross Margin minus Direct Labor is what we call Contribution Margin. Contribution Margin is the true “output of the business engine.” By keeping Direct Labor on a separate line, it allows me to quickly hold Direct Labor accountable to Gross Margin.
Gross Margin Dollars Holds Direct Labor Accountable
Every type of labor has a number that it is held accountable to. Our measurement of “Direct Labor Efficiency Ratio” or “Direct LER” is Gross Margin divided by Direct Labor. This ratio gives me the multiplier effect of my Direct Labor instead of the common calculation of looking at labor as a percentage of something. My experience says people would prefer to be considered a multiplier instead of a fraction.
If you measured your Direct Labor against Revenue instead of Gross Margin, you would get significant distortion if you sold goods or services at different margin percentages. This is why I never recommend the “Revenue per FTE” metric. (FTE = Full Time Employees) Revenue dollars are not equal if they come at different margins, and certainly no two employees are equal. A Gross Margin Dollar is the highest quality number for true income and a Dollar of Labor is the highest quality cost metric to measure it against.
Gross Margin Strategy
By focusing on Gross Margin Dollars, you open up your mind to different business models. We had a client who sold a high cost item on the Internet at cost just to get profit from high margin accessories and make a profit on shipping. His goal was to make $800 of Gross Margin per customer interaction, not maintain a GM%.
Once your Gross Margin as a percentage of Revenue drops below 40%, you may want to consider basing all of your profit metrics off of Gross Margin instead of Revenue. We typically push up the target percentage if we use Gross Margin, and it is not unusual for those businesses to make 20%+ net Profit as a percentage of Gross Margin. The key challenge with a high volume, low GM% business model is making cash flows work out. If you can fund your cost of goods with either vendor money or your own money, these can be very lucrative business models.
As a service business, I currently do not have any cost of goods sold in my model, but I leave the line there because I could choose someday to resell other people’s services, subcontract out some work or sell product. It may or may not fit your values or focus, but it is good to leave open the possibility should the right situation come along.
Measure Revenue as a starting point, but make Gross Margin the true top line of your business for internal discussions.