Finance and accounting analysis can offer great insight to help you grow your business. That said, you need two “table stakes” in place before they are actually helpful:
- You need solid data – managing by bad data is like navigating with broken instruments. No matter how good you are, you might still make the wrong decisions
- You need to right metric for the right situation – there are a lot of metric floating around to measure profitability. Some argue over which are most useful. We think they all have their place, but you need to know what their place is!
Here are three metrics we encourage our clients to pay attention to for different reasons: true gross margin, contribution margin, and EBIT margin. We’ll spend this post discussing how we define each of these metrics and some common applications for them.
This is a common metric. The uncommon part of it is finding robust data on what gross margin truly should be. Often we find gross margin to be over stated when we start working with clients. They often don’t include the full costs of delivering a product or service. For instance, it’s common for IT Services companies to calculate gross margin based only on products they sell, but not to include the technical support labor, which they include below the line. Another common example is companies in custom manufacturing or engineered products that don’t include project management costs in the cost of goods sold.
Gross margin is the first indicator of how profitable you are currently and how you can scale your business. If you don’t include the full cost of delivering your products, you won’t achieve the expected levels of profitability as you scale your business.
This is less common than gross margin, but very valuable in certain situations. That said, it can get you into trouble if you don’t also pay attention to total gross margin. Contribution margin is Revenue less Direct Costs (often only variable costs) that you’ll incur for an incremental sale. In other words, its generally higher than gross margin because it may not include fixed costs like depreciation or fixed facilities costs.
You can’t use this to establish pricing alone, but it is useful if you are chasing a one-off project that has strategic value. You know where your floor should be. It’s also valuable when looking at a second product line that may sell for a different price point.
One key point: this metric must be looked at on a product-by-product basis. Contribution margin summarized across a couple of products wouldn’t lead to a good place. This analysis may need to be done outside of your financial system, but it can be updated on a quarterly basis rather than a live metric.
Just don’t get too cozy with this metric. If you base pricing on contribution margin only, eventually those fixed costs will catch up to you and your total profitability will be lower than you expected.
We think this is a great metric to measure the total health of your business. Properly defined its Earnings Before Interest and Taxes. It’s gross margin less operating expenses. One key to make your financial statements useful at an EBIT level is proper categorization of operating expenses. A long list generated directly from Quickbooks won’t help you manage much. It’s just not intuitive.
We recommend categorizing OpEx between understandable categories like Selling Expense, Marketing Expense and General/Admin Expense. Sometimes you’ll need to allocate expenses into multiple categories to make your reports accurate (for instance, payroll).
There you have it – some insight into three basic metrics. Metrics that are really helpful when accurate and used for the right purpose, but damaging when incomplete or used for the wrong decisions.