You are in business to make money! So am I, actually, so we have something in common. But what does it mean to “make money”?
The amount of cash you bring in is your revenue, but that is not the money you make as it costs money to generate revenue. When we talk about making money, we are usually talking about profits.
The most important metrics to track about your business are your margins. Your margins measure your profitability and are calculated by comparing your profits to your revenue. Typically, margins are measured as a percent of revenue so that you have an easy way to judge the profitability of your business.
Why are Margins so Important?
Tracking your profitability over time is essential to understanding the viability, growth and future prospects of your business. Tracking the amount of your profits (or losses) alone is not enough. Your profit might be $10,000 one year and $100,000 the next, which sounds like you are growing well! However, if your revenue was $20,000 the first year and $500,000 the next, then you made less profit from more revenue!
Margins can be complex to calculate and understand as they come in many flavors. We’ll cover the most common ones and their applications this week.
Tomorrow we’ll get started by talking about the difference between Gross and Net Margins, two metrics you never want to confuse!
Margin Metrics: Gross v Net Margins
This is part 2 of a 5 part series on Margin Metrics.
What’s your margin?
In business, you often hear about companies being measured by their “margins”. But what do we mean by “margins” and how can you use them to make decisions?
Your margin refers to the difference between your revenue and costs, specifically what percentage of your total revenue is left after removing costs.
That is, of course, extremely vague which is why margins come in three different flavors: Gross margins, Net margins and Contribution margins. We’ll cover the first two today and leave Contribution margins for tomorrow.
Your Gross Margin is calculated by subtracting your total cost of goods sold (COGS) from your total revenue and then dividing by total revenue. The cost of goods sold only includes the cost of providing or manufacturing the product or service and does not include all of your personnel (salaries), marketing costs, etc. For example, if you make basketballs and sold $10,000 worth of balls while you spent $5,000 making those balls then your Gross margin would be 50%.
Your Net Margin is calculated similarly to Gross Margin but instead of subtracting just COGS, you subtract all variable costs which include your COGS, marketing, sales, etc. Going back to our basketball example, if you sold $10,000 worth of balls, spent $5,000 making those balls and another $2,500 on salaries, office space and advertising (for a total of $7,500 in costs) then your Net margin is 25%.
Many people consider Net Margin the most accurate measurement of margin and hence the best measure of profitability. However, it can be hard to measure so in the early days many companies will start with Gross Margin and move to Net Margin as they grow.
Great, so what?
Now that you have your gross and net margins in hand, there are a lot of valuable strategic questions you can answer:
- Is my business getting more or less efficient as we grow? By tracking your net margins over time, you can tell if your business is gaining or losing profitability as you grow. If your net margins were 40% when you had $100k in revenue but are 20% when you have $500k in revenue then you are becoming less profitable as your revenue grows.
- How do I compare to the competition? Margins give you a way to compare two businesses that have wildly different amounts of revenue and products. If your business generates $500k in revenue but has 30% margins and your competition has $2M in revenue with 20% margins then you know that your business is more efficient even though their business is larger.
Tomorrow we’ll jump into another form of margins, Contribution Margins, which can answer even more strategic questions.
Margin Metrics: Contribution Margins
This is part 3 of a 5 part series on Margin Metrics.
First, a quick review: Your margin is the difference between your revenue and costs. There are many ways to measure margin, including Gross, Net and Contribution. Today we cover Contribution Margins, which is perhaps the most important.
Contribution margins are measures of per unit profit, by subtracting the variable cost per unit from the sale price of the product or service. It is very similar to the Net Margin, but is calculated at the individual sale level which makes it more difficult to determine. For example, if you sell basketballs for $25 each and it costs you $10 to make each ball, your contribution margin per basketball is $15 or 60%.
The benefit of tracking your Contribution Margin is that you can easily do a break-even analysis which shows how many units you need to sell to break even on your costs. For example, if your annual fixed costs (office space, administration, etc.) are $100k and the contribution margin for each item you sell is $5, you break even when you sell 20,000 units a year.
Contribution margin is most often used for businesses that sell physical goods, since it can help take into account returns and defects which other metrics may exclude. It can be hard to determine the contribution margin for subscription businesses since the sale is not a single transaction, but you can estimate it if you know how long customers maintain their subscriptions on average.
Of course, very few businesses have a single product with a single price and a fixed costs. Most businesses have many products or services each with their own margins. Tomorrow we’ll talk about how to roll all of those up into a single metric for your business.
Margin Metrics: Blended Margins
This is part 4 of a 5 part series on Margin Metrics.
Very few businesses have a single product with a single price and a fixed costs. Most businesses have many products or services each with their own margins. So how do you come up with a single measure of the profitability of your business?
The easiest way to blend margins together is a simple weighted averaged, calculated by weighting the margins by the amount of revenue for each product or service. Let’s say we sell $10,000 of basketballs with a 20% net margin and $15,000 of footballs with a 25% net margin, we can calculate our overall margin as a weighted average:
The advantage of using a weighted average is that you can easily combine the margins of any group of products or services. For example, if you sell three different products which each come with their own support service subscriptions, you can easily:
- Group all products together to measure your overall product margins.
- Group all services together to measure your overall service margins.
- Group each product with its services to measure product delivery margins.
It is important to be careful when you blend margins, since any product or service that generates the vast majority of your revenue will dominate the blended margin. If product A generates 90% of your revenue and product B generates only 10%, you may not notice changes in the margins of product B since it is such a small part of the overall.
Tomorrow we’ll get even more advanced by talking about how you can use margin calculations to understand the efficiency of individual functions of your business.
Margin Metrics: Sales Efficiency
This is part 5 of a 5 part series on Margin Metrics.
This week we’ve covered many flavors of margins and how to calculate them. But the margins we’ve discussed so far are based on products and services. What if you want to understand how efficient individual functions or departments are in your business? Let’s look at an example.
As with any business, I’m sure your company spends a lot of money on marketing and sales. How do you know if you are getting a return on that investment? Sales Efficiency (also known as Sales & Marketing Efficiency) is a measure of how much revenue you generate for every $1 you spend on sales and marketing.
To calculate your sales efficiency, you divide the amount of new business you generated in a set time period (e.g. January) by the total sales and marketing cost for the same time period. For example, if you spent $10k on sales and marketing in January which generated $15k in new customer revenue then your Sales Efficiency would be 1.5.
If your Sales Efficiency is above 1 it means your sales and marketing are generating more cash than they consume and you should spend more! If the value is lower than 1 it means that you are burning capital and you need to watch your bank account.
Just like margins, Sales Efficiency is a great metric to track over time to understand if your sales team is becoming more or less profitable as your business grows. It also allows you to compare yourself to other businesses regardless of differences in revenue and product pricing.
Okay, that sounds too easy. What is the catch?
You are right, that does sound too easy! As with any advanced metric, Sales Efficiency can be difficult to calculate for a number of reasons:
- It can be hard to determine how much of your revenue is due to sales and marketing spend. If a customer returns to your site and spends more money, is that because they had a great experience previously or because you spent money to reach them again? What about subscription businesses where you might not know how much revenue you generated in January until September?
- It can be hard to classify expenses as sales and marketing! Advertising is easy to classify as marketing, but what about promotional discounts? What about channel partnerships where you provide wholesale pricing?
- If your business experiences seasonal swings, it can be hard to have a consistent measure of efficiency. E-commerce businesses boom around the holidays which can influence the Sales Efficiency calculation.
Even with these complications, Sales Efficiency is a great example of how you can extend the idea of margins to various parts of your business. Understanding the relationship between revenue and profit will make sure you always know the fundamentals of how your business operates.
Recommended Reading: “A Diamond in the Rough – Warren Buffett Talks Jewelery” This article analyzes Warren Buffett’s winning strategy in the jewelry business, which is based entirely on margins.