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What Your Gross Margin Tells You

...even if you own a service business.

I know what you’re thinking...

”I don’t have a gross margin because I don’t make anything. I don’t have manufacturing costs or inventory, so I don’t track Cost of Goods Sold.”

I’m not telling you that you’re in a different type of business, but what I am telling you is that no matter what you do, there are direct costs that go into doing THAT.

Sit back and take this in. Service businesses (or thought-driven companies) don’t produce a widget, but they could have a gross margin.

Take a law firm. What goes into the cost of producing revenue? I can think of the following items:

  • Depositions – outside sources generally are paid to conduct depositions, and sometimes there are transcription expenses as well.
  • Copying/printing – have you seen how much paper these guys go through?
  • Meals and travel for case work out of town – not to be confused with meals with clients in town.
  • Car rentals while out of town on casework – again, not to be confused with a mileage reimbursement for in-town travel to meet with clients.
  • Jury questionnaire expenses – doesn’t apply to every law firm, but for those conducting jury trials, it could be a valid expense.
  • Associate attorney salary expenses – if the associates are never billed out for administrative work, their salaries could be included here.

You follow what I’m doing here? Knowing your gross margin is power.

What goes into the cost of producing revenue?

What is your gross margin?

It’s the portion of your sales revenue that you keep after paying the direct costs associated with the sales revenue. 

So, the higher your gross margin, the better for your business. This means you’re making a profit on the sale before you pay your overhead.

Wait…did you catch that? The gross margin in the profit you make on your work BEFORE you pay your overhead. That’s why I wrote this blog. I want you to be able to separate the costs to provide your service from the other costs you incur to run your business.

For instance, your telephone expense shouldn’t be in the same category as your “production” costs. The cost of your telephone isn’t a part of the cost of building a website for your client or defending the client in a lawsuit. You want to make sure to cover the cost of your telephone by charging your clients a price commensurate with the value you’re providing, but that’s a different discussion. Same goes for your rent, or your liability insurance, or the cost of your office supplies.

It’s amazing how different the landscape looks when you separate those direct costs from the discretionary overhead. It’s like taking all the edge pieces out of the puzzle box first, then immediately seeing the scope of the work ahead of you to fill in the middle of the puzzle.

And notice I said “discretionary” overhead. While you may not be able to easily negotiate your telephone expense with AT&T, or your rent with your landlord, there are overhead costs that will jump out at you as discretionary. Reducing discretionary overhead could lead to more profit!

I’ve taken some clients through this exercise, and it’s meaningful and useful to them. Thinking about the cost of producing a service for a client, then analyzing the use of the funds that are left over is a powerful analysis. You find yourself thinking completely differently about those two cost centers, as well as how you approach the profitability of your company. Good stuff, entrepreneurs….good stuff!

If this sounds interesting to you, let us know and we’ll walk you through it. We believe the more you know and understand about your business, the better off we ALL are!

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