Business Health Checkup: Pre-Tax Net Income – Gross Margin

Authors: David Wagstaff and Calvin Longer 

Periodically we will highlight a ratio or benchmark and talk about how you can use these to better understand your business.

The disclaimer: Benchmarks and ratios, blindly applied, can be dangerous. Benchmarks can be useful in understanding areas to investigate, but it’s important to understand what’s being compared and why variances might exist.

The Benchmark: Gross Margin

Last month we discussed Pre-Tax Net Income, which is fundamental to indicating a business’s current health. In unraveling the layers which contribute to Net Income, this month we will look at Gross Margin.

Investopedia defines Gross Margin as “A company’s total sales revenue minus its cost of goods sold” (direct costs attributable to the production of the goods or services sold, including materials and labor), “divided by the total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.”

A review of Gross Margin provides insights into opportunities or issues in product pricing and / or with direct costs. While many businesses report or look at these numbers in the aggregate (the business’s total gross margin), a more useful insight can come from looking at margins for each product and service sold.

For example, in reviewing the business performance of a health club with $300,000 in revenue we noticed the overall gross margin was a healthy 73.4% ($220,200). In general, a 73.4% margin will allow a business to cover its general selling and administrative expenses (Management, Finance, Accounting, Legal, Marketing and HR etc.), so this might not immediately be a cause of concern. However, when drilling a little deeper we found significantly different gross margins by product offered.

• Aerobic classes
  • Priced at $8 per student were typically sold out with an average of 20 students totaling $160 per class / hour.
  • Cost per Instructor = $14 per hour / class
  • Cost for the room was $50 a day. The room was used exclusively for aerobic classes and fitness coaching. Aerobic classes and fitness coaching each used the room 5 times per day (10 total sessions).
  • Gross Margin = $160 – ($14 + $5) = $141 /$160 = 88.125% GM
• Private Fitness Coaching
  • Priced at $28 per coached client. Since these were private sessions only 1 client per coach totals $28 per coaching session / hour.
  • Cost per Instructor = $20 per hour / class
  • Cost for the room was $50 a day. The room was used exclusively for aerobic classes and fitness coaching. Aerobic classes and fitness coaching each used the room 5 times per day (10 total sessions).
  • Coaching also required weight lifting equipment which cost $30 a day (based on cost and expected life of equipment). $30 day / 5 coaching sessions = $6 a session.
  • Gross Margin = $28 – ($20 + $5 + $6) = $-3 /$28 = (10.7%) GM
• Total Gross Margin = (($141 –3) * 5 times a day * 26 days) = $17,940 / (($160 + 28) * 5 times a day *26 days a month ) = $24,440 = 73.4%

In conclusion, when benchmarking Gross Margin against industry averages, consider the margin of the overall company, but also consider the margin of individual products and services. In doing so, business decisions can be focused on the parts of the business which need the most attention.

Benchmarking reports were retrieved from the Bizminer Database. Industries Examined [NAICS]: General Contractors & Builders [236115.02]; Restaurants [7225],; Health Care [62]; Legal Services [5411]; Engineering Services [541330]; Store Retailers [453].

If you are in a different industry or size business and would like additional information on how you compare to your industry, give us a call.