Get to know gross margin

There are lots of areas of your financials that deserve attention: revenue, equipment, salaries, tools, rent. But few are more important than gross margin – a key metric that determines your company’s financial success. It’s just as important as revenue, cash flow and accounts receivable.

Remember that without the right amount of gross margin, you won’t be able to pay your overhead costs and have enough left over to make a net profit.

The gross margin of your company pays for all of the overhead, which includes indirect costs like gas, equipment, vehicles, supervisors and mechanics, as well as SGA costs (sales, general and administration) like salespeople, office staff, administration staff, yard rent and your salary.

Whatever is left over after paying for the overhead costs is net profit. Without achieving the right amount of gross margin, we just become very hardworking folks making a living and not a profit.

The Goal for Gross Margin (Gross Profit) – 45% Minimum and 50% + Desired.

Generally, the combined gross margin of a company needs to be a minimum of 45% and preferably 50% to make a fair and reasonable net profit. Gross margin is the financial furnace that keeps the company warm. First, let’s discuss how to calculate this important metric.

Overall Company Revenue (self-performed work) minus Overall Direct Costs (Labor + Payroll Taxes + Workers’ Compensation Insurance + Materials) equals Overall Company Gross Margin or Gross Profit. This should be a minimum of 45% and ideally 50% or higher.

Now calculate your gross margins for each revenue stream (i.e., maintenance, extras, install, snow, irrigation, etc.). Note: gross margins per revenue stream will vary from a low of 40% to a high of 65% or more for snow.

The 5 Drivers of Gross Margin.

When looking at reasons for achieving low or high gross margins, they can be traced back to five areas. We usually find it’s a combination of all five of these that eat up gross margin.

1. HAW: Hourly Average Wage. Know what your labor cost is on average per revenue stream. This is the average per hour of crew leaders and workers combined, plus payroll taxes and WC insurance. These vary by revenue stream, and generally range from $18 to $22 per hour.

2. Estimating. This is where it begins with an accurate assessment of what it takes to do the job with the needed labor and materials. Calculate HAWs and how much material will it take.

3. Pricing. After you have accurately estimated the total direct costs to perform the work, you need a method to arrive at a price that will achieve the right gross margin. You also need to be competitive within your marketplace. Divide overall direct costs by the reciprocal of desired gross margin to arrive at the price needed to get your targeted gross margin. Example: If your costs = $1,000 and the desired GM is 45%, take the $1,000 cost and divide by .55 = sales price of $1,818.

4. Efficiency and Execution. After the first three parts are completed, you need to execute the work on budget, make the customer happy and collect the money. This area always needs keen scrutiny. It deals with how well your budgeted time to complete work compares to the actual time it takes to finish the job. Obviously, the more you beat the budget, the better. Keep in mind that if you always easily beat the hours budget, you may be over-estimating the hours needed to complete the job, or you may be sacrificing delivering on quality. Always look for areas to improve your completion time.

Even the best-laid plans and estimates will have hiccups or unexpected costs; others will have some victories. Always be on alert as the job unfolds for things that will whittle away your gross margin. Focus on your budgeted hours and materials, and keep track of how you are spending your time on the job.

5. Renewals. For maintenance folks, here is the final way to increase your gross margin. Focus on the right renewals with appropriate increases to cover your added costs particularly with the cost of your workforce in mind. Look for the best and most efficient means to accomplish the work on budget and with the expected level of quality delivered for your customers.

Now you have the tools to figure out and monitor one of the most important financial metrics in your company. Remember, that if you don’t plan on the correct amount of gross margin for each revenue stream, you won’t have enough at the end of the day to make any money as in NET Profit.

Contact Bill Arman at harvest@giemedia.com.