As a kid growing up in the Midwest I remember seeing t-shirts that said “life begins at forty“. Today, with all we know about fitness and foods, the folks who were wearing those t-shirts have likely updated them to now read “life begins at sixty” and probably even look better in them today then they did back then.
In a similar manner, small business success also starts at “forty”, but I’m not referring to either forty days or forty years. The “forty” I’m referring to is a 40% Gross Margin, and that’s the topic of today’s blog, #4 in my list of five topics called “’Bilities” where we will focus on one of the most important topics of all — Profitability.
As part of the Business Plan I hope you did, and should have done, you most certainly have a simple Profit & Loss or “P&L” worksheet to reflect what you believe will be your businesses income and expenses. If you are significantly past start-up mode and in operation, you already know what these are. But below I’ll share with you a few things that you may not have given too much consideration and may want to do so now.
The 4th “Bility” — Profitability — is intrinsically tied to a measure called your Gross Margin, which by definition is a percentage, and is essentially your Revenue less your Costs for delivering a given product or service, whether it’s a burger or underground cable installation (it doesn’t matter), and then that number divided by your Revenue again. This percentage is your “Gross Margin %” — and your small business’ eventual profitability (or lack thereof), starts here. It’s very much like the adage “…starting off on the right foot” with “the foot” being your GM% — if it’s not large enough to begin with, it’s very likely your operation will not attain the profitability levels it needs to be successful and going forward, sustainable.
Coming back to Profitability and it’s link to your GM %, the magic number we like to see, is a Gross Margin of at least 40%. Why 40%? Well, it’s because this is the number which has shown to be, over and over again in small businesses, the minimum number that is necessary to cover your basic business expenses, and leave something at the end – that something being your Net Income, or alternatively, in plain in simple English — profit. Without profit, there is no success, and really no reason to be in business, so today’s discussion is pertinent and weighted.
By having a Gross Margin % of at least 40% you can generally expect to have enough “meat on the bone” to cover the items which gnaw away at your bottom-line Profitability, and here is a short list of some examples to illustrate what I mean:
- Going from Gross Sales to Net Sales – here we’re talking allowances, discounts, rebates, and sales return fees: This will take your Gross to Net Sales down, anywhere from a low of say 2%, to a not uncommon 7 or 8%. Example #1: PayPal. For processing invoices PAYPAL charges their small business clients a fee of roughly 2.75% — so on a $10,000 invoice you get nicked $275.00 bucks – and like football, which is a game of inches, business is a game of percentages – and every ONE percent adds up. Example #2: when providing goods or services to large companies it is routine to get the “2% net 30 days” as your sale terms, meaning they give you a 2% haircut when they pay your invoice “on-time” at 30-days. Like PayPal in the 1st example, you haven’t even left the starting gate and you’re already leaving dough on the sidelines — precious percentage points which will be missed when we get to the bottom-line or net profit.
- Cost of Goods Sold (CGS) – Now you’ve subtracted from your Revenue the cost of providing your product or services to your Customer and you are HOPEFULLY at that magic minimum number of 40% — which may, no longer be 40%, because you’ve been nicked by any number of “Discounts and Allowances” as described in the previous example. So it’s important to keep in mind that your pricing strategy, if and wherever possible, must contemplate leaving your business a baseline CGS which starts at our magical 40% GM.
- Fixed Expenses – here we’re talking all your monthly fixed costs which do not fluctuate with the level of Sales of your company or the level of sales service you provide. This is Office Rent, Warehousing, Lease payments, Equipment, Insurance, Professional service provider retainers (Lawyers, Accountants), Software Licenses, etc. Ideally, these expenses should be the same each month, and as a percentage of sales are predictable, meaning you have a good idea of how much they will impact GM %, and your subsequent small business operation’s profitability.
- Variable Expenses – the next group of expenses on your P&L widdling away at your Gross Margin are Variable, meaning they go up and down according to your monthly sales and operational activities. On your P&L they are frequently put together under the moniker of “Selling, General, & Administrative expenses” or “SG&A” – and these are the myriad of expenses to support your Sales and Marketing teams, Travel, Entertainment, Cell Phones (oh…that’s a big one…and always a surprise. I’m always amazed how much people can talk), Delivery and Transportation, etc. The profile of your variable expenses will vary based on your company and industry, but the point to be made is that these expenses frequently create some unpleasant surprises for you as the small business owner if sufficient controls are not in place to monitor and predict what they will be. Many Small Businesses are typically working so hard at delivering their products and services, that these controls are often absent, much to the dismay of the business owner or finance manager, with the result being very little moola left to report when we get down to the nutty gritty bottom line.
- Lastly, Salaries & Payroll – I put this last because as the owner, and as you ramp up sales of your small business you won’t likely be in the position to be paying large and generous salaries for all your employees (including yourself, probably) but will be paying what the market bears for those and others, and maybe less in some essential positions that may be secured by other forms of incentives which could include ownership, bonuses, special distributions, or stock.
So now, as a result of our summarized list, we have sliced our chunky 40% GM down to something in the very low, single digits, and if we’re lucky, it’s still positive, right?
The key once again, and I can’t stress this enough, is starting out on the right foot — meaning pricing your product /service offering at a sufficiently high level which leaves your Business at least a 40% Gross Margin. By starting from this level, you can typically ensure some money will be left over after paying out the long list of expenses just described and others, thereby creating for your small business a surplus in revenue, bringing us to the 4th of our “Bilities” – the much desired and sought after — Profitability.
To learn more about how business owners can scale and drive more growth, through tools like Factoring and other important considerations, please check out the list of blogs on this website, or you may contact us directly at [email protected]. You can also find me on Twitter and LinkedIn.
Stay tuned for our next blog when we address the final ‘bility’ on our list: Certifiability.
Thank you and best wishes for continued success,
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