It’s a good time to be an MSP (Managed Service Provider / IT Service Provider). Our IT Services clients are doing well, top line and bottom line. Small companies have embraced outsourcing IT and are moving towards MSP. Technology has also enabled MSPs to provide great services for less (more remote features, more robust equipment, cloud-delivered technologies). But a key question our clients and other MSP’s we’ve run into ask is, “are we as profitable as we could be?” And the logical corollary, “what changes could we make to improve our profitability?”
In this post we’ll address MSP profitability, but more importantly, we’ll take a look at how financial statements should be set up to help you know what levers you can pull to make a difference. We’ll discuss proper use of Gross Margin, Contribution Margin and EBIT Margin. For a quick refresher on these three metrics, see this post.
For MSPs, proper definition of gross margin is critical. The cost of goods sold need to include much more than just procurement items, software licenses and re-sold services. This is a common problem we see with new clients.
To develop a robust view of gross margin, make sure to include technical payroll, travel and expenses (cars, mileage, etc), data center expenses, and equipment depreciation. Gross margin should be understood for each service line to understand true profitability by product/service. Without a service-level gross margin, you won’t have very actionable data.
This is an important metric for MSPs and IT Service providers to keep an eye on. Especially since your firm is selling long-term recurring revenue contracts, you need to understand the impact on your for each service. Since contribution margin doesn’t include fixed costs, it gives you insight into a few key areas: What customer acquisition cost or selling expense can you afford for new clients? How aggressively can you price a strategic piece of business? Where should you spend your marketing and selling efforts?
One example we’ve worked on with a client is the difference between gross margin and contribution margin for cloud services vs. recurring support contracts. At their current revenue levels, their gross margin is higher for recurring support contracts, but through further analysis, we found that their contribution margin for cloud services was over 75%, while their contribution margin for support contracts is similar to their gross margin (~45%). So if they would act only based on gross margin, they might emphasis support contracts in their selling efforts, but this would be the wrong strategic decision.
Even more than gross margin, contribution margin only makes sense when analyzed on a product-by-product basis.
EBIT Margin or Operating Profit
EBIT Margin is a great management tool for MSPs because is strips away the noise of interest and taxes to give you pure operations view into your profitability.
While this metric is pretty well understood, most firms we interact with don’t have their financials set up to report operating expenses in a simplified and actionable manner. Grouping operating expenses by major category of selling expense, marketing expense and general & administrative expense will help you see trends much quicker.
For MSPs a great target is to have enough contribution margin from recurring revenue sources to cover your operating expenses. Once you cross this threshold, you have a very stable business with some built in downside protection. So as you plan your sales and marketing efforts or as you add additional operating expenses, keep that ration in mind.
We’ve worked with our benchmarking team to pull a sample together of MSPs around the country. Here’s Gross Margin and EBIT for selected MSPs. We think a reasonable range to target EBIT margin is about 16 – 21%. Much higher than that isn’t always a good sign – you may be under investing in the future.
One key to this discussion is having financials that make sense. QuickBooks won’t do this by itself. It’s a wonderful program, but it tends to spit out too much data in a format that we don’t intuitively understand. Just as a comparison, here is the format for the managerial P&L for one of our clients (sanitized, of course). We think this is much more actionable.
At CoEfficient, we love data. We also understand that data, without context and proper analysis, doesn’t really help. If you need help with your financials, feel free to reach out for a discussion.