Gross profit and gross margin are two key numbers in every business. They are also…
The Importance of Gross Profit and Gross Margin in Service-based Businesses
Gross profit and gross margin are often neglected numbers in service-based businesses.
These numbers are better understood for product based businesses but are equally important for those selling services. Yet the management information to be gleaned from both these numbers will have a significant impact on your profit and cash flow.
More often than not businesses that sell services don’t have their accounting system set up correctly to provide gross profit and gross margin figures. But if you think about it logically, service-based businesses sell time, and there is a cost for that time in wages and/or contractor costs. Legal and accounting firms have kept track of the productivity of their staff but often outside their accounting system. Other service-based businesses may not even have this.
Gross profit for a service based business should look like this:
Sales revenue $100 000
- Contractor costs $10 000
- Salaries & Wages $21 000
- Superannuation $ 2 000
Total costs $ 33 000
Gross Profit $ 67 000
Gross margin is a percentage calculated by taking the gross profit and dividing by the revenue. Thus, in the example above:
Gross margin = gross profit/sales revenue expressed as a percentage.
. = $67 000/ $100 000 x 100 = 67%
The key to working in a serviced based business is to identify the costs associated with delivering the service. The salaries and wages and contractor costs to be included in the cost of sales are those relating to the service delivery and not those of an administration (admin) or sales and marketing nature.
Take John who runs a software installation business. John has employees and contractors who work on the installation; he has a project manager and a bookkeeper. John’s time is split between service delivery and sales and admin. In order to better understand what his people were doing, he implemented a time tracking system and identified that his implementation team were spending more hours on the implementations than he had anticipated and included in his proposals. Not only that, but they were also doing more admin than he had realised which explained in part why the timeline of the projects was longer than he had anticipated.
Armed with this information, John was able to re-arrange workloads to remove elements of admin from the implementation team, and he spent time training the team to be more efficient with the implementations. By spending the time with the team, he was able to identify bottlenecks and issues that arose and help them to resolve them quickly and efficiently. Not only that, but he had them create documentation on the matters which will provide the framework for dealing with the issues in future implementations.
The bookkeeper changed the way the contractor costs and wages were allocated in the accounting system so that John can see his costs of delivery as a cost against the revenue and the admin costs are shown separately in the overhead expenses. The result meant that he had a realistic gross profit figure in his accounting system.
With the clarity of the figures, John has increased his gross margin and has also reduced his admin costs too. Without the detail, John had no information upon which to make decisions and didn’t know how he could move forward to take on more projects. Not only that but he has the information to improve his calculations of the costs of implementation when next he does his proposals, and he has the details to enunciate the issues and challenges that arise and how his team will overcome and solve them.
In addition, John has set targets of the number of hours each team member should be spending on the different areas of their job descriptions and how many hours each needs to be doing on projects and how much on each project. With a weekly team meeting and reporting on progress, John now has the framework from which to expand his business and take on more contracts
The five steps to setting up your system to provide you with gross profit and gross margin information:
- Identify the components of cost of delivery of your services.
- Implement a time tracking system to identify how much time is spent in the different components of the business.
- Change your accounting system to report those costs as cost of sales which in turn will provide the gross profit figure in your reports.
- Calculate your gross margin from the gross profit figures.
- Focus on reducing the costs of sales in the first instance. Then when you’ve improved that as much as you can, then focus on increasing the income.
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