True story ahead. Years ago I was at a client’s office closing up the books for the month. I’ll call this client Fred to save him some embarrassment. Fred ran a successful business, with consistent positive cash flow. He had recently implemented some pricing changes that our firm had helped him figure out. The results were starting to show up in his numbers. So I printed the financial statements and dropped them on his desk. I gave him big thumbs up sign and said “Congratulations, your margins are kicking ass.”
Fred told me to close the door, ordered me to sit down. “Walter you’re the third person in two weeks who’s used that word ‘margin.’ And you’re the only one I know well enough to admit that I don’t know what you’re talking about. I figure it’s good news because you started with congratulations. You’re smiling, giving me the thumbs up. But I’m embarrassed to say that I don’t know why. What does margin mean?”
When I tell this story to people I get two responses. Bankers, accountants, and other financially savvy advisors will say, “Are you kidding me? Didn’t know what margin is? How’d he stay in business?” But when I talk to small business owners, more than a few will say, “Been there, done that.” Turns out, I know a lot of guys (and gals) like Fred. Smart successful business owners, many with positive cash flow, who are financially illiterate. Raise your hand if you took an accounting class, and it was one you slept through, flunked, or dropped.
Why are the bankers and business advisors so surprised that a business owner could survive without knowing their margin? Because it’s that important a number! It can have a profound impact on cash flow, and it often goes unexamined. Too many small business owners obsess about their top line (aka gross revenue) and focus on their bottom line (aka net income) while ignoring their gross profit – which I’m going to call their middle line.
Everyone knows about top line revenue. That’s our total sales, total billings, total receipts. It’s all the money we make selling our products or delivering our services before any expenses are taken out. Likewise, most folks understand the bottom line. That’s what’s left of our sales after all the bills have been paid. It’s the amount we get to keep and for many small business owners that amount is woefully small. And that amount is likely to remain small unless we understand the middle line – gross profit and its related number, margin.
Here’s what happened back in Fred’s office on that fateful day. We sat down and looked at his income statement. “Fred, I know you’re smart enough to realize the basic equation is sales minus expenses equals your profit. The part you’re missing is that while all expenses are important, some are more important than others.” I explained that Fred had two types of expenses – direct and indirect.
Direct expenses were those bills Fred paid that were directly connected to how Fred made money. (Accountants will often refer to direct expenses as Cost of Goods Sold which gets abbreviated as COGS.) In a restaurant, the list of direct expenses would include food, liquor, and kitchen labor. In a service business, the list of direct expenses is typically dominated by the labor costs to deliver the services. For a web developer, it would be wages for coders and programmers. For a law firm, it’s wages for attorneys and paralegals. When we subtract direct expenses (COGS) from gross revenue, we get a number called gross profit. The gross profit margin shows up as a percentage. It is the ratio of gross profit divided into gross revenue.
The second category of Fred’s expenses – indirect – included all those bills that kept the lights running but were not directly connected to how Fred made money. Indirect expenses for Fred included rent, insurance, advertising, telephones, and so on. I knew we were making progress, when Fred asked “Indirect expenses is another phrase for my overhead, right?” Affirmative. And when we subtract the indirect expenses from the gross profit, we’re left with net income or net profit. (Accountants will often call this number operating income.) The proverbial bottom line. Fred indicated his quick grasp of the distinction between direct and indirect expenses when he said with excitement, “So if I increase my margin, I have more cash to pay my overhead. And since my overhead is pretty fixed and stable, more cash drops to my bottom line!” Bingo.
If I buy pencils for 50 cents and sell for a dollar, I have a gross profit of 50 cents. And my margin is 50%. I’ll have 50 cents left over from every sale to cover my indirect expenses. For most businesses, the indirect costs tend be fixed and flat over time. So if I can find a way to buy pencils for 45 cents while maintaining my dollar sales price, I’ve increased margin to 55% and get to keep the extra nickel. It gets even better if I can lower my direct pencil expense (50 cents to 45 cents) and simultaneously raise my sales price to $1.10. Now my margin has increased to 60%, and I get to pocket the extra 15 cents to help pay for indirect expenses.
I reminded Fred that when we helped him figure out some recent price changes, we had done two things. We told Fred to find lower cost solutions for his direct expenses. He had done that. We also told him to raise prices. He had done that. The combination of higher gross revenue (from higher prices) and lower direct expenses (from new and cheaper suppliers) had increased Fred’s gross profit margin. Fred’s indirect expenses aka overhead had remained stable, so the positive changes in margin flowed right through to positive changes in net profit.
And here’s where I really got Fred’s attention. “Guess who’s part of overhead, Fred? You, that’s who. You are an indirect expense.” I pointed out that by increasing his margin, Fred had increased cash flow. By increasing cash flow, Fred had more money to pay himself. That’s when Fred said, “Now I understand the congratulations and the thumbs up!”
Our firm works to help clients improve cash flow and owner’s compensation. And that work often begins by identifying and understanding gross profit margin. When the client improves their middle line, all sorts of positive changes start to appear. I love helping people put more cash in their pockets. Please reach out to me if that’s a desire of yours or someone you care about.
Wishing you lots of positive cash flow.