PROFIT MARGINS

PROFIT MARGINS

Five years ago, when I should have known better, I was asked by an owner of a construction business what type of clients we worked with.  It was a casual conversation, hanging over a fence at an equestrian event.  I was in boots and jeans enjoying the sun on my back and the smell of creosote, timber and spring grass in the air.

Without thinking too much I started into my tried and tested pitch of sectors and business types we focused on.  Construction is not one of them, we work better with growth businesses in technology, services and manufacturing.

I mentioned turnover levels of €10m plus.  This was a fatal mistake.  We work in many profitable sectors where our clients make net profits of €1m plus and we are ideally suited to advise at this level.  In the construction sector you need to have annual revenues of €50m to €100m to make the same net margins as other sectors make on €10m to €20m of annual revenues.  Opportunity lost. I could tell he thought we were too small for him, even though we were probably ideal.  I had made the classic mistake of ignoring margins as I generalised on sectors.

Do you know your profit margin percentages and how they compare in your industry and to other sectors?  More importantly do they make sense to you?  To Know Your Business, you need to Know Your Numbers.  An essential component of your numbers are your margins.

There are three elements to your margins worth knowing: Your gross margin, your net margin and your operating margin.

Gross margin

Your gross profit is the figure you get when you take your costs of goods sold, cost of sales or cost of service delivery from your sales.  These costs are often described as your above-the-line costs.

These costs are variable in nature and should have a relationship to sales.  It is fairly straight forward to work this out in a retail or a distribution business as you will include product costs, transport and some wages.  In manufacturing considerable effort will go into tracing the manufacturing costs which will go above the line and in a service business you need to consider direct salaries versus support salaries etc.

When you express your gross profit as a percentage of sales it becomes your gross margin.  It is essential to calculate your gross margin and understand it.

You should watch your gross margin in real time if possible but at least monthly and understand why it moves.  In a stable business your gross margin should be consistent and similar divisions or subsidiaries will have similar gross margins.

Gross margins will vary when the mix of different margin business changes (sales mix) but it is unusual to see dramatic changes.  That said, I recently looked at a healthcare business with vastly different gross margins across all divisions and month on month the margins varied considerably.  Either their sales mix was changing continuously, or their financial information is poor.  In my experience poor financial information is the most likely driver of dramatic variations in gross margin.

Gross margin information on your industry should be readily available and by analysing it you will have a sense of whether you are above or below the average. If you are beating the industry, understand why and leverage it.

Be careful when looking at gross margins, a high gross margin is desirable but if it is due to high prices you need to be sure your sales are not been adversely affected by pushing for higher prices.

I have reviewed some US data which shows sectors vary considerably with Pharmaceuticals and Finance industries generating gross margins in excess of 70%, Retail is typically 20% to 30% with some exceptions like Pharmacy that can achieve greater than 40% gross margins, on-line retail gross margins are 45% which is telling, Farming and construction average at 12% gross margin.

In your business, your front-end technology (CRM, POS, ERP) should generate real time gross margin data which integrates with or reconciles to your accounts system.  In the growth businesses we get introduced to, we rarely see this working effectively even though the technology capability is there.  It is something we focus on and so should you.

Net Margin

Turnover for vanity, profit for sanity and in this case, we mean Net Profit.  The bottom line is what sustains the business, not to be confused with the line referred to earlier as above-the-line.  If it has occurred to you that financial terminology is designed to confuse; then you’d be right.

Net profit is calculated by taking all other costs off the gross profit, including interest and tax.  If we don’t take off interest and tax, then we have Operating Profit: or put another way, profit before interest and tax.  Interest and tax are often left out as they don’t relate to the running of the business and will change depending on methods of finance and tax circumstances which can mislead.

When we express net profit as a percentage of total sales it is called the net margin.  Generally, when we speak of margins, we are referring to net margins. As in, ‘it is a tight margin business’ but if someone says they need to increase their margins then most likely they are referring to gross margin as they will then look at increasing the price or reducing direct costs.  Confused yet?  On the other hand, if you are struggling in a tight margin business then your only option is to address fixed overhead and in this case you’d look at administration cost, rent other business supports which impact your net profit only.

Again, using US data, which was the easiest to access, we can see that net margins range from 30% for certain finance related sectors down to 2% to 4% for transport, telco’s, grocery, mining.  Most low net margin businesses require significant capital investment and trade with very high levels of turnover (sales).  The average for the entire market is about 7%.

Be careful of these figures, if you are in Software Systems and Applications and you have a GP% of 55% and NP% of 10% then you might be inclined to think you’re doing great when in fact the sector achieves 72% and 19.5% respectively.

In truth, net margin is interesting to look at globally, nationally, or by sector but in your business, it is unlikely that you spend time focused on it, except maybe as a benchmarking exercise.  When you are running your business, you should look at your gross margin in real time (or the drivers for it) and Operating Profit on a monthly basis.

Operating margin

As mentioned, operating profit is profit before taking off interest and tax.  This figure is a closer figure to what the business is generating from how it runs.  Between Gross profit and operating profit, we will often summarise costs into administration, establishment (property), marketing, finance, and others.  There are no rules here, it is a matter of personal preference and sense.

When I assess businesses, I am always interested in the operating profit and particularly the cash the business generates.  EBITDA is an over-used profit classification.  It means Earnings (profit) Before Interest Tax Depreciation and Amortisation and what it is trying to get at is the cash that a business can generate.  I prefer to use Maintainable Earnings but more on that in a later blog.  Regardless, a quick way to get to this cash figure, EBITDA if you like, is to add Depreciation back to the Operating profit figure.  We can usually ignore amortisation as it mostly relates to grants and is rarely material.

Now we have the Operating Profit which expressed as a percentage relative to sales is the Operating Margin.  By adding back Depreciation we will get a figure that compares favourably to the cash a business generates and this can be expressed as a percentage if this is useful for you.

Again, we need to be careful with these numbers.  I dealt with somebody recently who has a fascination with EBITDA and the need to express it as a percentage in the monthly accounts even though I was sure that the base numbers were wrong.  Debtors wasn’t reconciling and we weren’t convinced that we were capturing all the costs, our focus needed to be on getting the information right not on a single figure summarised into a percentage.  Be happy that the base data is reasonable and then monitor the trends.

Reporting tools are so powerful now that when you have good data there is no limit to how it is presented.

Know Your Numbers

If you do not do it already, calculate your gross margin, your net margin and your operating margin.  Compare them to last month and to previous years.  Understand the movements and make sure your team understands the movements.  Think about what worked to improve margins in the past and leverage this information and what worked against them and see if you can defend against that in the future.  Now your numbers are working for you.  If your business systems do not give you that data reliably then fix it.

Relevant, accurate and timely information is a must for your business.

Hanging on a fence one spring evening, I wasn’t focused on margins and I lost a potential piece of business: it was in the construction sector, not our focus so I wasn’t too disappointed, but a nice little lesson for me and hopefully for you too.

(Benjamin Atchley Photo)