Your financial report says that you’ve achieved a 35% gross margin on your latest project/job. Should you be happy? Maybe. Gross margin doesn’t tell the whole story.
First, the definition of gross margin:
Gross Margin = Gross Profit / Sales.
Gross Profit = Sales – Direct Expenses.
Direct expenses are those expenses that you have because you sold something. These can be labor, materials, freight, commissions, or other project related expenses.
Gross profit is always expressed in dollars. Gross margin is always expressed in a percentage.
I’ve known companies to achieve a 35% gross margin on a project and have the project earn a profit. I’ve known companies to achieve a 35% gross margin on a project and lose money on that project. I’ve known companies who achieve a 35% gross margin for the month and still lose money for the month. Unfortunately, this is happens frequently. Here’s why:
Unless your sales are exactly the same each month, you will have months that have higher revenues and months that have lower revenues—i.e., busy months and slower months. There is a simple explanation for a gross margin that doesn’t cover total expenses in slower times of the year. Even if you achieve a decent gross margin, your total sales are not high enough to cover your company’s monthly overhead. Let’s assume that your company’s monthly overhead is $100,000. During June you generate $250,000 in revenues at a 35% gross margin. This means that your gross profit is $250,000 X 35%, or $87,500. Since the company overhead is $100,000, the company lost $12,500.
Does this mean that you should increase your project prices in slower times of the year so you achieve a higher gross margin? Probably not. Many owners actually decrease their prices in slower times of the year. They want to at least break even so they price their projects lower to ensure they get enough volume to cover the slower months. How much do they lower prices? To a maximum of the break-even point of the company. And they look at break-even in terms of overhead cost per hour and gross profit per hour.
Understanding your overhead cost per hour and gross profit per hour are critical. Not understanding this is how you can achieve a gross margin of even 50% and still lose money on a job. Here’s how:
Assume that your company does a project for Mrs. Jones. You charge her $300 for 3 hours of work. Your gross margin is 50%. Your overhead cost per hour is $60. The gross profit of the job is $300 X 50% or $150. Your gross profit per hour is $150 divided by 3 hours. This means your gross profit per hour is $50. Your overhead cost per hour is $60, so you actually lost $10 per hour or $30 on that project.
Before you say, “That can’t happen in our company!” take a good look and a pencil to your financial statement. Determine your overhead cost per hour. Divide your total overhead last year by the total number of productive hours (i.e., revenue generating hours). Use only the hours that your employees actually worked producing your products and services. Cleaning the office, answering the telephone, training hours, meeting hours, vacations, holidays, and sick days don’t count in this equation.
The thought, “I can’t do anything in slower times of the year,” is untrue. One of my former clients almost never lost money in the traditional slower months. I asked him how he achieved this profit, since most companies didn’t. His answer was that he had no choice. He didn’t have the cash saved in the beginning to lose money in any month. Then, as the business grew, it just became a habit. He was extremely proactive in slower months, knocking on doors, calling customers and offering specials. Since he knew what his overhead cost per hour was and what revenues he needed to generate each month, he knew what lower price he could offer a customer for purchasing “now” rather than when the company got busy.
Relying only on gross margins to determine whether a project went well or not is dangerous. You have to know and understand what your gross profit per hour and overhead cost per hour are. The only thing that really counts is the net profit per hour that you are generating. That’s what you can convert to cash and take to the bank.