Margins - the difference between a migraine and a margarita

I have two businesses, both up for the taking. Which do you want?

Business A: 400 clients each paying an average of $200/mo

Business B: 200 clients each paying an average of $150/mo

Trick question? You bet.

This revenue picture makes you lean toward Business A. Of course you want the business that’s bringing in the most money.

Or do you have enough information? At a minimum, to make a good decision you’d want to compare net profit margins for each of the above.

As a personal services business owner, you might have an intimate understanding of your business’s margins, or you might not. You might know exactly how many clients you have, and you might know your monthly gross revenue and the balance in your business checking account, too. But what about your margins? You’ve heard talk of margins, but what exactly are they? And more importantly, what do they signify for your business?

Even if you are a new business owner or are running a “small” business, it’s important to have a thorough understanding of your business’s finances. In fact, knowledge of a few basic principles may determine the degree of success you enjoy as a business owner. As the saying goes, knowledge is power. The more information you have at your fingertips, the better position you’re in to make decisions.

So what are margins, you ask?

Put simply, margins are the fraction of every dollar that comes through your door that you get to keep. There are gross profit margins (that portion of the dollar you keep before your operating expenses and overhead are taken into account) and net profit margins (the bottom line, so to speak). Depending on how you pay your staff, you might also have different margins for each of the services you provide.

If it costs you 70 cents of every dollar to service your clients, your gross margin is the remaining 30 cents, or 30%. If it costs another 25 cents of every dollar to cover your operating expenses, then your net margins are 5%. Put another way, five cents of every dollar coming through your doors is the profit your business makes.

Okay, that makes sense, but why should I care?

Three reasons, primarily:

1. First, tracking your margins each month provides more accurate visibility into how your business is performing. You might grow your client base, offer more services, and even bring in more revenue, but if your costs to deliver on all of the above also increase, your net margins might actually decrease (remember revenue isn’t the whole story).

2. Second, margins give you an idea of how much wiggle room you have when contemplating how you price your services, compensate your employees, and so on. If you know that your margins are skinny, you can look for ways to improve them or, at a minimum, fiercely protect them from being eaten by other expenses.

3. Finally, if you have any thoughts of ever selling your business, you’ll want to be keeping a keen eye on your margins. A prospective buyer will want to know all sorts of things about your business, net profit margin being one of the more important.

Let’s get down to business

To calculate your margins, here are quick definitions and some data you’ll need to gather:

• Recognized revenue Revenue that has been serviced and therefore “earned” in a given time period.

• Realized revenue Gross sales in a given time period. In many cases, realized revenue is a liability until the services are actually provided. I’ll give you an example of a 20-session package of Private Lessons shortly.

• Cost of goods sold In a service business this is the cost of labor you pay to provide your services.

An example

Let’s say you own a personal services business like a dance studio that offers a mix of classes and private appointments.

First, you’ll want to calculate your class margins and your appointment margins separately. Next, you’ll want to compute your overall gross profit margin and the net profit margin for your business.

Appointment margins

A client comes in today and purchases 20 private lessons for $1,500. You “realize” the full value today when you record the $1,500 sale. But you haven’t actually earned that $1,500. In fact, you now “owe” your client 20 private lessons. You will recognize it $75 at a time, when the client comes in for each of his 20 lessons.

Now let’s imagine that your instructor, “Bob,” is the one servicing this client. You pay Bob 65% of each appointment, or $48.75 per lesson. This leaves you with a per-lesson gross margin of $26.25, or 35%.

If you have multiple instructors and they’re each paid differently, you’ll want to calculate your margins for private lessons across your entire staff.

If you’re using Pike13, you’ll run your Recognized Revenue report to get the dollar amount of appointments that have been earned in a given time period. (Let’s say it’s $8,750 for the month of September). You’ll then run your Staff Pay report to find out your total labor costs for appointments for that same time period. (Let’s say this number is $4,465). Then you pump those numbers through this little formula to find your gross profit margin for appointments:

(Recognized revenue for appts – cost of labor for appts)/Recognized revenue for appts

Using numbers from my example above:

($8,750 – 4,465)/$8,750 = 49%

In other words, you’re paying out 51 cents of every appointment dollar in labor, and you get to keep 49 cents (remember, this is a gross margin) before we take into account your operating expenses.

Class margins

The formula is the same. To calculate your class margins, you’ll take the total amount of recognized revenue in a given time period, subtract the labor you paid out to service those classes in that time period, and then divide by the total amount of recognized revenue.

For example, I sell monthly memberships for group classes for $100 per month. For the month of September I sold 60 memberships, resulting in $6,000 of recognized revenue. I typically offer 20 classes per week, and during the month of September we ran a total of 82 classes. I run my Staff Pay report and see that I paid out $1,800 in class labor.

I calculate my gross margin for classes like this: ($6,000 – 1,800)/$6,000 = 70%

Calculating margins for each type of service you offer can help you understand your labor costs and see which of your services are more profitable. In the example above, classes result in greater net revenue for the business.

Business Gross Profit Margin

To find this, we use the same formula and just sum across the different services we offer. In this example, our Recognized Revenue for both appointments and classes is $14,750, and our total labor costs are $6,265, with resulting Gross Profit margin of $8,485 or 57% for this business.

Essentially, after paying the labor to provide the services my business offers, I am left with $8,485 or 57 cents of each dollar to use toward operating expenses and hoping to have some remaining for net profit.

Business Net Profit Margin

To find your net profit margin, you subtract your total expenses from your your Gross Profit to find Net Profit and then divide that result by Gross Profit. You’ll need to grab your expense data from Quickbooks or whatever bookkeeping system you use. In my sample business there were $7,550 in operating expenses. I can calculate my business’s net profit like this: Gross Profit – total expenses = Net Profit.

$8,485 – $7,550 = $935

Because we are using recognized revenue (earned revenue) in our calculations I can say that this business actually EARNED $935 this month.

I am now able to calculate my Net Profit Margin as follows:

Net Profit/Gross Profit or $935/$8,485 = 11%

Back to our example

Business A is located in a major metropolitan area with expensive rents and labor costs significantly greater than the industry standard. The business is barely profitable with a net profit margin of 1% (one penny of every dollar) with profit before tax of $800/month.

Business B is located in a more rural community, has negotiated a killer deal on the lease, and labor costs are average for the industry. This business has a net profit margin of 12% (12 cents of every dollar) with profit before tax of $3,600/month.

So tell me, which one do you want now?

The owner of Business A just might end up with a migraine. On the other hand, the owners of Business B might find themselves sipping margaritas.

photo credit: leyink via photopin cc