When you examine your P&L statement or your budgets/forecasts which represent P&L data, a great place to start is to examine two percentages that tell a great deal about your financial story. These two percentages are the Gross Profit Margin % and the Indirect Expense %. Consider this basic formula:
EBITDA % = Gross Profit Margin % – Indirect Expense %
(EBIDTA = Earnings before Interest, Taxes, Depreciation, and Amortization and some call this “operating income”)
Sure, you can say that “EBITDA = Revenue – Expenses.” However, that is looking at the raw numbers and you lose the parts of the story, the context that percentages can resent, of how specific areas of your business are performing. You also lose the perspective on the impact of certain decisions and specific areas you can manage to increase your EBIDTA.
So, let’s examine why I believe you should pay attention to these important percentages.
Gross Profit Margin and Gross Profit Margin %
Gross Margin is a number that represents the total revenue you receive for your products and/or services minus the total cost that are directly related to the production and delivery of those products. The Gross Margin % is the percentage that is a result of dividing those total direct costs by the total revenue.
For example, if in one month, you sell $100,000 of products and/or services, and it cost you $25,000 to create/product those products and deliver those products, your Gross Margin is $75,000 and your Gross Margin % is 75% (as shows in Figure 1.
Figure 1 – Gross Margin Example
| Revenue | $100,000 |
| Direct Costs | $25,000 |
| Gross Margin | $75,000 |
| Gross Margin % | 75.0% |
Why track Gross Margin %?
Why is tracking the Gross Margin % important? There are two primary reasons to track this.
The first reason is because not all sales are the same and some sales may not even be healthy for your overall company financials. You must track the relationship of all sales or categories of sales to the actual costs for producing and delivering those products to make sure you are maintaining and growing your margins on those products. The following are common reporting situations I discover with entrepreneur/business owners I work with:
- P&L reports have NO direct costs and gross margin tracking at all (all expenses are just reported in the Indirect (G&A) Costs. The owner has no idea how much products and/or services cost to produce and deliver. This is especially true for those that deliver project based work like consulting, programming, web development, creative, design, etc.
- Owners are working hard to sell MORE of low-margin products that are “losing” money overall (lowering your Operating Income). However, those owners are not closely tracking their Gross Margin and Gross Margin % on products/services, and don’t realize they are negatively impacting business by chasing “bad” revenue.
- Owners are not truly examining their pricing in the context of the actual costs to produce and deliver their products and their margin gets worse as costs rise. Owners resort to how they “feel” about pricing instead of doing the math to product pricing models to test.
The second reason to track Gross Margin % is that Gross Margin %, not total Revenue is the actual predictor of your ultimate EBIDTA Margin %. Given that your Indirect Expenses (we will discuss below) are primarily fixed, the better your Gross Margin (actual) and Gross Margin Percentage, the more money you will have available for the bottom line. You have control to drive up Gross Margin % to create more room for profit.
Indirect Expenses and Indirect Expenses % (G&A)
Indirect expenses are called other names by some. This category is often called “G&A Expense” (General & Administrative Expenses) and sometimes even referred to as “Fixed” expenses.
This category of expenses are all expenses OTHER than those that are directly related the production and delivery of your product or services. So, these expenses include overhead salaries, benefits, rent, utilities, marketing, travel (not related to a specific project delivery expense), accounting, general technology, phone, etc. These are referred to as ‘fixed” because it is likely that there are many expenses in this category that indeed are relatively fixed for a time – rent, utilities, etc. – to keep the doors open. There are also expenses in this category that you have committed to spending where you may be slow to change (support salaries, benefits, IT, accounting).
Why track G&A Expense %?
The primary reason you track G&A Expense % is that you need to fully understand the minimal G&A expenses that you MUST maintain to keep your doors open. You need to understand what % that is of your current revenues and how that relates to your current Gross Margin %. What revenue and Gross Margin % is your break-even point? For example, if you are currently running G&A expenses at a rate of 60% of your average revenues, and your Gross Margin is also averaging 60%, you are making 0% EBITDA. You may be up and down in months and you need to focus on what changes you can make that will produce consistent results that move that EBITDA and EBITDA % to a healthy place for your business. Your choices then get clear – improve Gross Margin (raise price, increase efficiency, etc.), sell more at current margins (because more revenue will reduce the fixed cost expense %, or reduce your G&A expenses to a level that you can support at current revenue levels.
The second reason you track this is to create a planned growth path over time. As you plan for and see future revenue growth, it is better to track any new G&A expenses by committing to maintain a target % instead of just adding without a plan. When do you hire more people? How do you anticipate a rise in fixed costs like rent, mortgage, utilities, insurance? What are you going to have to make happen to keep growing your profits?
For example, if you know that you want a 20% EBITDA Margin, and you know that your current Gross Margin % is 60%, then as your revenue increase, you MUST keep your G&A Expenses at a 40% or better (lower) to maintain that 20% or better margin (Gross Margin % – G&A Expense % = EBITDA %).
Start Using these Percentages as Tools
Here are some key takeaways that I suggest you consider moving forward as it relates to this discussion on key percentages to monitor and use in managing your business:
- If you currently only organize your budget and P&L into two big buckets – Revenue and Expenses (not separating Direct Expenses – called COGS – Cost of Goods Sold, and COS – Cost of Services), work with your accounting firm/person to identify and report those expenses separately from your G&A Expenses.
- If you currently do not track Gross Margin and Gross Margin %, begin tracking those on all P&L reports (must complete #1 above to do this).
- Learn how to track Gross Margin for each specific product or product category and even by project so that you can truly examine pricing, types of product, types of sales, types of projects that are “healthy” for your business (good margin) and which are not healthy (margin lowers your overall EBITDA %.
- As you build your budget or as you refine your forecasts, start paying attention to what these key percentages (Gross Margin %, G&A Expense %, EBIDTA %) are and how changes you make will directly impact changes in those percentages. Be aware of the relationship of these percentages and trends and how you can manage to optimize those.
- Start with your goal – your desired EBITDA % – and then work backwards to make decisions that line up Gross Margin % and G&A Expense % to achieve that goal consistently.
Revenue is most definitely the cure for all ills in many businesses. It’s true that enough revenue can frequently deliver positive results. However, to be an effective leader, it is not enough to just allow enough revenue to cause you to lose sight of effective P&L management. Gross Margin % is where the story of success lies.
