Penny Pendragon the Paramount can do more than pull a rabbit out of a hat. She’s a local magician dominating the birthday party market in the tri-state area. Her fellow magicians are both jealous and intrigued by her success, peppering her with questions each week at the weekly Mad Hatter dinner party:
How do you come up with such clever new tricks?
How are your clients finding you?
How do you make kids laugh and not cry when you make their stuffed dog disappear?
What’s your gross margin?
Uhh…that last question leaves Penny Pendragon speechless. Her eyes grow wide and she suddenly looks like she has stage fright. Her mind spins: What is gross margin? Do I have a gross margin? What does it look like? Could it help my business grow?
She’s heard Magic Marvin, the magic store owner, talk about gross margin and how he had to increase prices to boost his gross margin. But Penny doesn’t sell products, she sells the service of magic! Does she really need to know her gross margin? For the first time in her life, Penny Pendragon doesn’t know the behind-the-scenes truth of a mystery.
If you aren’t sure what gross margin is — or don’t know if it is relevant to your business — I would love to serve as your financial magician. As a Fractional CFO, I am a money magician who reveals all the secrets so that you can have confidence in your business’ financial health. I can help you understand, calculate, track, and adjust your gross margin to meet your exact financial goals. Schedule a call with me today to learn more about a partnership with me.
Is gross margin relevant to service businesses?
Yes, gross margin is relevant no matter what type of business you own. It allows you to evaluate how efficiently your company produces its goods or delivers its services. But if you’re like Penny Pendragon, the term “gross margin” might give you financial stage fright. Rest assured, once you understand the magic behind it, it’s a lot less like voodoo and a lot more like wise financial knowledge.
For businesses who manufacture products, the math is fairly straightforward: you take your Revenue and subtract your Cost of Goods Sold (COGS) — the cost of the materials and labor it takes to build your product — to find your Gross Profit ($).
But when your “product” is a service — like Penny’s sleight of hand skills and birthday party entertainment — your COGS is technically your Cost of Sales (COS). COS are the costs required to deliver the services sold and recognized in your revenue. The biggest piece of this puzzle is usually labor and labor burden — which includes not just the hourly wage you pay your people, but also the burden of Social Security taxes, Medicare, disability, health insurance, and retirement benefits. You may also need to factor in other costs required to pull off the job.
How do I calculate my service business’ gross margin?
Here are the basic service-based formulas that all work together to provide the magic numbers of your financial health:
- Your gross profit is measured in dollars and is your cost of goods sold subtracted from your revenue. Revenue – COGS = Gross Profit ($)
- Your gross margin is measured as a percentage and equals the gross profit (calculated above) divided by your total revenue. Gross Profit / Total Revenue = Gross Margin (%)
- Net profit is what’s left of gross profit after all expenses (salaries, rent, general and administrative costs) are deducted. It’s your “bottom line.” Gross Profit – Expenses = Net Profit ($)
These formulas can get a little complicated when revenue and expenses are spread out over several months. Accrual basis accounting provides the most accurate picture of your business position, as well as your profitability. With accrual basis, your financial activities are recorded when products or services are received (expenses) and delivered (revenue).
In manufacturing, you might buy raw materials today but not sell the finished widget those materials were used to create for six months. To keep the books from looking like a chaotic card trick, you must ensure that only the materials used to create the items actually sold that month are included in your COGS.
In a service business, the goal is the same: you want to line up your costs with the revenue recognized in that same month (AKA the matching principle). When done correctly, your gross margin should stay relatively steady, ideally with only a small variability of 3-5%. If your gross margin is jumping around like a jittery rabbit just pulled out of a hat, it’s a sign you likely aren’t following accrual basis accounting.
A Work in Progress (WIP) schedule can help tame the financial chaos (see note about GAAP below). For example, Penny Pendragon received a 50% deposit in April for a grand finale show that doesn’t happen until September. How is she supposed to track the revenue and expenses when they don’t align month-to-month? A good Fractional CFO like me (armed with a trusty spreadsheet) uses a WIP schedule to track these types of projects. This process can be complicated and depends heavily on how your accounts are set up, but it is the key to maintaining a clear picture of your monthly performance. If you need help setting up accrual basis accounting or a WIP schedule, book a call with me today.
Pro-Tip: While the methods I recommend might “flex” some GAAP (Generally Accepted Accounting Principles) rules, I find that this approach makes much more sense for small business owners who need to track what they are actually making month-to-month. It’s okay to adapt the rules to fit your business’s needs — if you ever face an audit, we can simply adjust to standard GAAP.
Calculating gross margin for individual service offerings
You can calculate gross margin for your business as a whole, but should also calculate gross margin for each of your service offerings so that you know which service is most profitable. Penny offers three types of party services: a simple magic show, a magic show with a tutorial aspect to teach people how to do the tricks, and a magic show + Jolly Juggles the Clown. Thanks to her fabulous and talented Fractional CFO, Penny learned that the simple magic show has the lowest gross margin, while the magic show where she partners with Jolly Juggles has the largest gross margin. Penny would never know that without tracking her gross margins separately. Now she can focus on selling more of her highest margin service, bolstering her bottom line. She can also consider how to raise her prices without losing customers for the other two service offerings, to increase their gross margin.
Pro tip: Monitor margin trends to prevent profit erosion over time. When your COS goes up, you need to raise prices to protect those margins. If there is a margin where one month is way off, there may be a mistake. If you aren’t monitoring these trends, you don’t know there is a potential problem until it’s too late.
Hire a Fractional CFO Magician
Keeping track of your business’ financial health requires more than waving a magic wand. I’d love to put my expertise and years of experience to work helping your business lock in strong gross margins. If you’d like to chat about strategies to make this happen, give me a call!
