Latest / Budget Your Business / Is Your Gross Margin a Business Superpower or Kryptonite?
Transcript
- 0:00Scott Geller: gross margin.
- 0:02Scott Geller: Please calculate it correctly, use it for planning, use it to make financially informed decisions.
- 0:08Scott Geller: It is absolutely, in my opinion, one of the most important metrics, or in numbers, to know in your business.
- 0:16Scott Geller: Hello and welcome.
- 0:20Scott Geller: To Budget your Business, the podcast for small business owners who want to learn how to financially plan for every aspect of their business.
- 0:29Scott Geller: I'm your host, scott Geller, and today we're going to do things a little differently.
- 0:33Scott Geller: While I prefer having a guest on here, so I'm not rambling the entire time I decided, after about a year of podcasts, I would record one myself.
- 0:42Scott Geller: And since it's my own podcast and it's me talking, I decided to pick what I believe and I consider one of the most important numbers, or metrics or rates, if you want to say, that every business owner should be aware of, and that is the gross margin.
- 0:59Scott Geller: You could call it the gross margin rate, the gross margin percentage, the margin.
- 1:04Scott Geller: At the end of the day, it's the gross margin and one of the most important pieces in my opinion.
- 1:10Scott Geller: So let's start with the basics.
- 1:11Scott Geller: What is the gross margin?
- 1:14Scott Geller: Well, it's the percent you make on every $1 earned in sales before your operating expenses.
- 1:24Scott Geller: So let me say that one more time the gross margin is the percentage you make on every dollar of sales you generate, before your operating expenses.
- 1:34Scott Geller: All right, that's fine.
- 1:36Scott Geller: What does that really mean, though, and how do I calculate the gross margin?
- 1:40Scott Geller: Well, the gross margin is calculated by taking your revenue and subtracting your cost of goods sold to reach your gross profit.
- 1:49Scott Geller: You then take your gross profit and you divide it by the revenue.
- 1:54Scott Geller: That's a gross margin.
- 1:55Scott Geller: A few key just notes to be aware of is you want to do it for a specified period of time and you want to make sure that time's the same.
- 2:04Scott Geller: So if you're looking at revenue, you want to look at revenue over the same period of time that you're looking at the cost of goods sold.
- 2:10Scott Geller: You want to look at it for maybe a specific product or a service or maybe different companies that you have you can also look at.
- 2:19Scott Geller: You can also calculate it per client, even you could calculate it on several different customer areas as well, but it's always calculated the same.
- 2:29Scott Geller: It's always calculated as the revenue minus the cost of goods sold, which equals a gross profit.
- 2:36Scott Geller: You take that gross profit and you divide it by the revenue to give you the rate.
- 2:41Scott Geller: So let's talk about an example first, let's say I have revenue of $1,000 and my cost of goods sold are $800.
- 2:50Scott Geller: I try to keep the math simple so that I can make sure I get it right.
- 2:53Scott Geller: So I have revenue of $100,000 and cost of goods sold of $800.
- 2:59Scott Geller: 1,000 minus 800 equals $200.
- 3:01Scott Geller: That's $200 in gross profit.
- 3:04Scott Geller: You take that $200 and you divide it by the revenue or $1,000 to calculate a gross margin of 20%.
- 3:12Scott Geller: Now something to make sure you're aware of is that gross margin is not the same as markup.
- 3:21Scott Geller: Let's talk about that for a minute.
- 3:23Scott Geller: What the difference is.
- 3:25Scott Geller: Let's go back to our same example.
- 3:27Scott Geller: You have $800 in cost of goods sold.
- 3:30Scott Geller: You've decided that you're going to mark up your cost of goods sold by 20%.
- 3:36Scott Geller: Should be a 20% margin, right?
- 3:40Scott Geller: Not so fast.
- 3:41Scott Geller: Let's do a little math.
- 3:43Scott Geller: If you have $800 of cost of goods sold and I'll do the math for you here and you multiply it by 1.20 or increase it by 20%, you're going to charge out $960.
- 3:57Scott Geller: You're going to generate $960 in revenue on that $800 of cost of goods sold.
- 4:03Scott Geller: If you take that $960 and follow our gross margin calculation, you take $960 in revenue, subtract the $800 in cost of goods sold to get $160 in gross profit.
- 4:19Scott Geller: So that's the 960 minus the 800.
- 4:21Scott Geller: You take the 160 and divide it by the revenue, which is $960, and you get a 16.7% gross margin.
- 4:32Scott Geller: So you see the difference there.
- 4:33Scott Geller: You've got $1,000 in revenue with $800 in cost of goods sold, compared to $960 in revenue and $800 in cost of goods sold.
- 4:48Scott Geller: Your margin went from 20% to 16.7%.
- 4:52Scott Geller: So that's a little different between gross margin and the markup.
- 4:55Scott Geller: I think some people I hear people or see people using those interchangeably and there really is a difference.
- 5:02Scott Geller: All right, every business has a gross margin.
- 5:04Scott Geller: All right, Every business has a gross margin.
- 5:05Scott Geller: Yes, every business has a gross margin.
- 5:09Scott Geller: And if you think you don't, you do SaaS companies, tech companies, services companies, manufacturing companies, inventory-based companies, even government organizations in one way or another, I think can find it.
- 5:23Scott Geller: Staffing companies let's see if I can come up with any others HVAC companies, you know, driving companies everybody has a gross margin Now and you must know what it is.
- 5:34Scott Geller: Now I will admit, the gross margin may not be as important in some businesses as others.
- 5:40Scott Geller: I had a client where their gross margin was literally like 96%, 98, 96, 96, 98%.
- 5:50Scott Geller: They were mainly a pass-through organization.
- 5:55Scott Geller: They used somebody else's technology.
- 5:57Scott Geller: They passed it through and so they had a massive operating expenses, but they had a very small and really it at it.
- 6:05Scott Geller: Even though it was very consistent and very small part of their business, it was still there.
- 6:22Scott Geller: We still looked at it.
- 6:23Scott Geller: So I recommend you know what it is.
- 6:25Scott Geller: Why do you need to know what the gross margin is?
- 6:27Scott Geller: Because it's the horsepower of your business's engine.
- 6:32Scott Geller: It is the power that drives your business and you can do more, just like a car.
- 6:38Scott Geller: You can do more with more horsepower.
- 6:40Scott Geller: So let's make it.
- 6:42Scott Geller: Let me use a car example to explain this gross margin.
- 6:45Scott Geller: Let's say you have a baseline Ford Mustang that has 310 miles per hour and that can, that can go from zero to 60 in five to 5.3 seconds.
- 6:57Scott Geller: That's kind of a standard metric for car buffs is how fast can my car get from zero to 60 miles per hour?
- 7:08Scott Geller: And for a baseline Mustang with 310 horsepower, that's about five seconds.
- 7:11Scott Geller: 410 horsepower, that's about five seconds.
- 7:14Scott Geller: If you increase that horsepower to 450, and you can decrease the time from zero to 60 to less than four seconds, everything else is the same, the car is the same, the weight, the tires, the interior, the music you're playing it all stays the same.
- 7:33Scott Geller: And if you're racing and, let's be honest, business is kind of like a race, a lot of times is a race Would you rather have a 310 horsepower Mustang or 450 horsepower Mustang, the 450, right?
- 7:48Scott Geller: Well, your business is the same way.
- 7:51Scott Geller: You want the higher horsepower as you can possibly get in your business.
- 7:57Scott Geller: So let's think about it in your business, if you have a 20% gross margin on a $1 million business, you are making $210,000 in gross profit.
- 8:08Scott Geller: So that's $1 million.
- 8:09Scott Geller: With a 20% gross margin, you get $200,000 in gross profit.
- 8:14Scott Geller: If you have a 22% gross margin on a $1 million business, you're making $220,000 in gross profit.
- 8:24Scott Geller: You just increase your gross profits from $200,000 to $220,000.
- 8:30Scott Geller: And, just like that car, you didn't have to do anything else.
- 8:33Scott Geller: In your business, if you can improve that gross margin, you just raced forward by $20,000.
- 8:39Scott Geller: Your business is better by $20,000 by purely improving that gross margin.
- 8:45Scott Geller: Now, yes, it's way easier.
- 8:47Scott Geller: It's also way easier to make net income with higher gross margins than increasing the top line, mathematically speaking.
- 8:55Scott Geller: Of course, now, maybe it ignores market effects, competition, other pieces of the business and other aspects of the business that, yes, can come into play.
- 9:04Scott Geller: But, just purely speaking, you can race your business forward just like that, mustang to the higher profits with a better gross margin.
- 9:13Scott Geller: You can make more doing the same work.
- 9:16Scott Geller: All right, scott, this is great.
- 9:18Scott Geller: We talked about gross margin, why it's important, but how do I get to my gross margin in my business?
- 9:24Scott Geller: So let's talk about that.
- 9:25Scott Geller: The first so just to recap, it's revenue minus cost of goods sold gets your gross profit and you divide that gross profit by your revenue.
- 9:34Scott Geller: The revenue should be the easy part.
- 9:35Scott Geller: Almost everybody I talk to they know their revenue number.
- 9:38Scott Geller: What they don't always know is their cost of goods sold, and it can be tricky, but it's critical to get that cost of goods sold right in your business.
- 9:50Scott Geller: If you don't include everything, or if you include items that are not cost of goods sold, it will impact what you think your profitability is and it can lead to making wrong decisions about your business.
- 10:03Scott Geller: So what is cost of goods sold?
- 10:05Scott Geller: Well, the cost of goods sold is any expense that is required to get that dollar in sales or revenue.
- 10:13Scott Geller: So let's talk about some examples for that.
- 10:15Scott Geller: It might be inventory, it might be parts that you put together to sell.
- 10:21Scott Geller: Maybe it's a good, it might be people.
- 10:23Scott Geller: A lot of times there's people, they're directly related to that revenue number.
- 10:28Scott Geller: It can be tech spend that's directly related to that revenue number.
- 10:32Scott Geller: It's really anything that's directly related or required to generate that revenue, that dollar in sales.
- 10:40Scott Geller: So let's talk about a couple of examples for cost of goods sold and one is consulting.
- 10:45Scott Geller: So let's talk about a consulting business example for what's in cost of goods sold and that is primarily the people time spent working to provide that service.
- 10:56Scott Geller: It's the time that is spent providing the service to that end client.
- 11:02Scott Geller: So does that include administrative time?
- 11:06Scott Geller: If it's the same person, let's say the same person does client work and they do some administrative work.
- 11:11Scott Geller: Well, guess what that client times, the hours spent on the client, goes to cost of goods sold.
- 11:16Scott Geller: The administrative hours, nope, they're not.
- 11:19Scott Geller: So think about, even if it's invoicing the client, if it's collecting on the receivables for that client, those hours are administrative.
- 11:29Scott Geller: They were not generating that dollar in revenue, that revenue, so no, they should not be in your cost of goods sold.
- 11:37Scott Geller: Time spent on planning for the business, even if you're talking about clients, even if you're planning how many clients you're going to get, who you're going to target, that time did not generate the revenue.
- 11:49Scott Geller: So no, that does not go in your cost of goods sold.
- 11:52Scott Geller: Let's say you're coding a new product feature.
- 11:54Scott Geller: Well, are you selling that product feature to the client or is that feature for the client?
- 12:00Scott Geller: Then, yes, that does go into the cost of good soul.
- 12:04Scott Geller: If you're coding a new product feature for the business, for your business to sell, nope, that does not go under cost of good soul.
- 12:12Scott Geller: That is an investment within the business.
- 12:13Scott Geller: Let's move.
- 12:13Scott Geller: So.
- 12:13Scott Geller: Let's move on to another example.
- 12:14Scott Geller: I work with a lot of goods sold.
- 12:15Scott Geller: That is an investment within the business.
- 12:16Scott Geller: Let's move.
- 12:16Scott Geller: So.
- 12:17Scott Geller: Let's move on to another example.
- 12:18Scott Geller: I work with a lot of staffing companies.
- 12:20Scott Geller: So let's talk about what falls into cost of goods sold for staffing companies.
- 12:25Scott Geller: The biggest piece for a staffing company are the hours you are paying the individual.
- 12:30Scott Geller: So you place an individual for a period of time at a client's location let's call that.
- 12:36Scott Geller: You know you call them a traveler provider placement, whatever that individual.
- 12:40Scott Geller: The hours you pay that individual via payroll or however you pay them, goes into the cost of goods sold.
- 12:47Scott Geller: Reimbursements Maybe you're paying the individual travel expenses or other type of reimbursements, training reimbursements that is cost of goods sold.
- 12:57Scott Geller: Allowances maybe you have some allowances that are part of the pricing deal.
- 13:01Scott Geller: That goes into cost of goods sold.
- 13:04Scott Geller: Payroll taxes boy, people forget about payroll taxes.
- 13:07Scott Geller: Yes, cost of goods sold.
- 13:10Scott Geller: If it's related to in a staffing company, the hour that you're paying, it goes in Workers comp for that individual that you're paying, goes in Workers comp for that individual that you're placing.
- 13:19Scott Geller: Yes, cost of goods sold let's say you provide benefits to your placements.
- 13:25Scott Geller: Cost of goods sold yes, it does.
- 13:27Scott Geller: Two others that people sometimes forget if you're paying VMS fees, yeah, you're passing them through that VMS or that MSP.
- 13:36Scott Geller: That's how you're getting that individual placed.
- 13:39Scott Geller: Cost of goods sold.
- 13:40Scott Geller: Referral fees Maybe you're paying somebody a referral fee.
- 13:43Scott Geller: Well, you're not going to get that revenue if you didn't pay that referral fee.
- 13:47Scott Geller: So, yes, that goes into cost of goods sold.
- 13:50Scott Geller: What you don't include are operating expenses.
- 13:53Scott Geller: So expenses that keep the lights on in the business, if you will.
- 13:56Scott Geller: If you want to hear more about operating expenses, so expenses that keep the lights on in the business, if you will.
- 13:57Scott Geller: If you want to hear more about operating expenses and how that breaks down, check out episode 10.
- 14:02Scott Geller: It's another one where I chatted, I talked about I just did myself and I talked about planning for your operating expenses, so you can check that out.
- 14:10Scott Geller: So how do you?
- 14:11Scott Geller: What do you like?
- 14:11Scott Geller: What do I Scott?
- 14:12Scott Geller: What do I use this gross margin for?
- 14:14Scott Geller: Well, you incorporate it into and you compare it with your pricing.
- 14:19Scott Geller: You feed that back into the pricing machine so you understand what's happening in your business and what's happening with your pricing is one Another is forecasting.
- 14:28Scott Geller: It's critical in forecasting.
- 14:30Scott Geller: So let's talk about that for a little bit.
- 14:32Scott Geller: There's a few ways to forecast your gross margin.
- 14:34Scott Geller: So this whole podcast is around forecasting.
- 14:38Scott Geller: Right, how do I plan for my business?
- 14:39Scott Geller: So how do I plan?
- 14:41Scott Geller: How do I forecast my gross margin?
- 14:43Scott Geller: So let's talk about a couple of different ways.
- 14:45Scott Geller: The first way to forecast your gross margin is using a trending.
- 14:50Scott Geller: Let's take a look over the last three, six, nine, maybe 12 months and let's average out per revenue.
- 14:58Scott Geller: So let's see what the average of my cost of goods, what the average gross margin, has been over the last six let's say three, six or nine months and I would recommend a rolling average there and then use that to project it out.
- 15:13Scott Geller: So if your you know so if your revenue is X, going to be X and the trailing six months of cost of goods sold was 76% of revenue for actuals.
- 15:24Scott Geller: Then use that same 76% as your cost of goods sold and go moving in the future.
- 15:32Scott Geller: Another way is to create targets.
- 15:35Scott Geller: What do you think your gross margin should be?
- 15:38Scott Geller: What are the targets at, maybe different levels?
- 15:41Scott Geller: So maybe you think your gross margin is going to be 20% for the next six months and because you're instituting, you're giving yourself, you think you can price a little bit differently.
- 15:50Scott Geller: Starting month seven through nine, you think you can get it to 21%.
- 15:54Scott Geller: Month 10 through 12, you can get it to 22%.
- 15:59Scott Geller: So you can use it as targets.
- 16:01Scott Geller: What are your target gross margin?
- 16:03Scott Geller: And then you apply that to the total revenue.
- 16:05Scott Geller: You could also apply it per product, say at a client level or even a service or good level, and then roll all that up into the total cost of goods sold.
- 16:16Scott Geller: Think about another way to forecast.
- 16:19Scott Geller: Gross margin is by a category.
- 16:21Scott Geller: So break your gross margin into maybe there's a fixed component, maybe there's a variable component.
- 16:27Scott Geller: So determine using historical information with that fixed component.
- 16:32Scott Geller: Let's say it's a fixed component is 10 grand per month.
- 16:37Scott Geller: So put in 10 grand every month.
- 16:39Scott Geller: Then you have a variable component and let's say, the variable component is 68% of your revenue.
- 16:46Scott Geller: So you have 10 grand as a fixed component and then you have a cost of goods sold number that's 80, 68% of your revenue.
- 16:55Scott Geller: And then you know, flow the math through to find out what your cost of goods sold and then your subsequent gross profit and your gross margin.
- 17:03Scott Geller: In that way, you know, in this method of using it in the categories, you really want to think of what the drivers are for each of those and really dig into whether it is a driver between with fixed because at some point it's probably going to change a little bit and then the variable.
- 17:19Scott Geller: So what do you do with this?
- 17:20Scott Geller: Well, like all the finance folks, you input those into financial model.
- 17:25Scott Geller: Yes, start with projecting the revenue and then you're projecting the cost of goods sold and then you're tracking the gross margin.
- 17:32Scott Geller: What is critical is you stay at it, you keep at it, you keep reviewing it, if not monthly, at least quarterly, and then you compare it to the actuals.
- 17:43Scott Geller: Okay, so what did I say the gross margin was going to be?
- 17:47Scott Geller: And then I need to compare that to what the actuals really were so that I can use that to improve the forecasting and improve your financial education within the business.
- 17:59Scott Geller: Determine.
- 18:00Scott Geller: Then the next step is determining the what, how and the whys.
- 18:04Scott Geller: The actual gross margin differed from the projected gross margin.
- 18:08Scott Geller: Just saying it differed is okay, great.
- 18:10Scott Geller: But unless you take that next step of understanding the how and the why, what good is that going to do you?
- 18:15Scott Geller: It doesn't.
- 18:16Scott Geller: It's not going to help you make better decisions in the business.
- 18:19Scott Geller: And then compare your methodology, change it every now and then see what you can do to, to to improve that and again, feed those learnings really important.
- 18:27Scott Geller: Feed those, those learnings back into your pricing.
- 18:31Scott Geller: So at the end of the day, your pricing is rolling into is going to tell you what your gross margin is.
- 18:38Scott Geller: All right, accounting.
- 18:39Scott Geller: Let's talk a little bit about accounting the impact on gross margin.
- 18:43Scott Geller: The first is let's make sure you have your chart of accounts set up so you have your revenue, you have your cost of goods sold and then you have your operating expenses.
- 18:53Scott Geller: Then you need to understand whether you are a cash or accrual-based business.
- 18:58Scott Geller: If you're calculating your gross margins and your gross margin looks like an EKG reader, you're on cash accounting more than likely.
- 19:06Scott Geller: So think about this If you have a margin that is 60% one month and then negative 10% the next month, 24% the month after that, 60% the month after that.
- 19:16Scott Geller: Is your business really losing money one month and then making a ton of money the next month?
- 19:23Scott Geller: Odds are it probably isn't.
- 19:25Scott Geller: And that's an indication typically of cash accounting, whereas if you go accrual accounting, the idea is you're lining up all the revenue that is for the work performed in that month to generate their revenue, all the cost of goods sold as related to the revenue that was generated in that month, and then you compare that.
- 19:46Scott Geller: So you're comparing apples to apples, whereas in cash which is important to look at cash a lot of times compares apples to oranges.
- 19:53Scott Geller: A quick example would be think about if you're a service business and you pay payroll weekly or bi-weekly.
- 20:02Scott Geller: That's probably captured within the month, right, but you may not bill that client for 30 days after that and then they may not pay you for another 30 or 45 days.
- 20:11Scott Geller: So the revenue is hitting several months down the road, but the cost for that work is falling months before you realize that revenue.
- 20:19Scott Geller: So it's really going to mess up your margins.
- 20:20Scott Geller: So on the accounting side, think about the chart of accounts and think about the cash flow in a first accrual accounting.
- 20:26Scott Geller: All right.
- 20:27Scott Geller: Why is this important, scott?
- 20:29Scott Geller: Well, it's important in understanding your business.
- 20:32Scott Geller: It's a huge lever in your business.
- 20:34Scott Geller: If you can keep your operating expenses flat but you can increase your gross margin, that extra money goes straight to the bottom line.
- 20:43Scott Geller: It goes straight to you.
- 20:44Scott Geller: Think about that $20,000, or example you can just make $20,000 more on just increasing your gross margin.
- 20:54Scott Geller: Then that's $20,000 in your pocket.
- 20:57Scott Geller: It's really important scenario planning and what ifs.
- 21:01Scott Geller: What if we raise prices but we lose clients?
- 21:05Scott Geller: Well, it might be okay, because you can sometimes make more money that way.
- 21:09Scott Geller: Can we afford to invest more in our operating expenses if we can increase our margin?
- 21:14Scott Geller: Well, maybe we can.
- 21:16Scott Geller: So it's really important in that scenario planning.
- 21:19Scott Geller: You know.
- 21:19Scott Geller: What's also really important is if you go to sell your business, because if you go to sell your business, the individuals or the companies or private equity, whoever it is that's interested in your business, they're going to want to know what the gross margin is.
- 21:33Scott Geller: And if you don't know, or you give them financial statements that show that you know, going back to the EKG reader, where they're up and down and all over the place, well, it's not going to look good and you're going to be more valuable, as the value of your business is going to be higher, if you know what the margins are and you tell them, rather than asking an acquirer, an interested acquirer, what they are.
- 21:56Scott Geller: So, gross margin, please calculate it correctly, use it for planning, use it to make financially informed decisions.
- 22:04Scott Geller: It is absolutely, in my opinion, one of the most important metrics, or in numbers, to know in your business.
- 22:11Scott Geller: Well, I feel like I've run on long enough with gross margin and I always like to wrap up shows with one to three media takeaways that our listeners could literally put into action as they turn off the podcast.
- 22:24Scott Geller: And today, since gross margin is the topic at hand, here are three initial steps.
- 22:29Scott Geller: Step number one structure your chart of accounts correctly between the cost of goods sold and the operating expenses.
- 22:37Scott Geller: Step number two check your accounting methodology.
- 22:40Scott Geller: Know if you're accrual or cash so that you know if your gross margin is real or not.
- 22:47Scott Geller: Hint, cash does not give you a good gross margin or an accurate gross margin.
- 22:51Scott Geller: Three calculate and know your gross margin percent every month.
- 22:57Scott Geller: I also like to share a good podcast or book recommendation.
- 23:00Scott Geller: Today, I'm going to share a podcast of two Bobs the number two, and then Bobs, with David C Baker and Blair Innes.
- 23:08Scott Geller: I think it's really targeted toward creative agencies, but I think it's fantastic for general business knowledge pricing, making big decisions in your organization.
- 23:20Scott Geller: It's just a really interesting.
- 23:22Scott Geller: They're usually pretty quick, but I always get something out of it.
- 23:25Scott Geller: All right, folks, that's it for today.
- 23:27Scott Geller: Thank you for indulging my gross margin talk and if you liked the show or found something useful, please text somebody else and tell them hey, I've got this show, budget your Business.
- 23:39Scott Geller: I want you to listen to it and help somebody else learn something about planning for their business.
- 23:46Scott Geller: I'm Scott Geller and I hope you join me next time for Budget your Business.