Budget Your Business
Budget Your Business - budgeting for every aspect of your small business - is a show for small business owners with less than $50M in revenue. If you are looking for actionable advice, practical tips, and techniques to budget every aspect of your business, this is the podcast dedicated to you. We host finance experts, subject matter experts, and small business owners to share their perspectives on planning for your business. Think of a deep dive for every part of your business and how to plan for it. Budget Your Business is hosted by Scott Geller who will share his experience working with corporations and small businesses, and guide you down the path of planning the financial future for your small business.
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Budget Your Business
Is Your Gross Margin a Business Superpower or Kryptonite?
In this solo episode (yep, just me, no guest to rescue you), I dive into what I believe is one of the most important numbers in your business: Gross Margin. Every business has a gross margin—even if you swear yours doesn’t. In this episode, I break down what it is, where to draw the line on costs, and how to use it to price smarter, forecast faster, and stop flying blind. I even break out a Mustang analogy (because, why not?) to explain how boosting your gross margin is like supercharging your business horsepower. Gross margin isn’t just an accounting term—it’s your business’s money-making engine. Let’s make sure it’s running smooth.
Podcast Recommendation: 2Bobs with Davd C Baker and Blair Enns
Find out more about Scott: https://www.linkedin.com/in/scott-geller-cfo/
gross margin.
Scott Geller:Please calculate it correctly, use it for planning, use it to make financially informed decisions. It is absolutely, in my opinion, one of the most important metrics, or in numbers, to know in your business. Hello and welcome. To Budget your Business, the podcast for small business owners who want to learn how to financially plan for every aspect of their business. I'm your host, scott Geller, and today we're going to do things a little differently. While I prefer having a guest on here, so I'm not rambling the entire time I decided, after about a year of podcasts, I would record one myself. And since it's my own podcast and it's me talking, I decided to pick what I believe and I consider one of the most important numbers, or metrics or rates, if you want to say, that every business owner should be aware of, and that is the gross margin. You could call it the gross margin rate, the gross margin percentage, the margin. At the end of the day, it's the gross margin and one of the most important pieces in my opinion. So let's start with the basics. What is the gross margin? Well, it's the percent you make on every $1 earned in sales before your operating expenses. So let me say that one more time the gross margin is the percentage you make on every dollar of sales you generate, before your operating expenses. All right, that's fine. What does that really mean, though, and how do I calculate the gross margin? Well, the gross margin is calculated by taking your revenue and subtracting your cost of goods sold to reach your gross profit. You then take your gross profit and you divide it by the revenue. That's a gross margin. A few key just notes to be aware of is you want to do it for a specified period of time and you want to make sure that time's the same. So if you're looking at revenue, you want to look at revenue over the same period of time that you're looking at the cost of goods sold. You want to look at it for maybe a specific product or a service or maybe different companies that you have you can also look at. You can also calculate it per client, even you could calculate it on several different customer areas as well, but it's always calculated the same. It's always calculated as the revenue minus the cost of goods sold, which equals a gross profit. You take that gross profit and you divide it by the revenue to give you the rate.
Scott Geller:So let's talk about an example first, let's say I have revenue of $1,000 and my cost of goods sold are $800. I try to keep the math simple so that I can make sure I get it right. So I have revenue of $100,000 and cost of goods sold of $800. 1,000 minus 800 equals $200. That's $200 in gross profit. You take that $200 and you divide it by the revenue or $1,000 to calculate a gross margin of 20%. Now something to make sure you're aware of is that gross margin is not the same as markup. Let's talk about that for a minute. What the difference is.
Scott Geller:Let's go back to our same example. You have $800 in cost of goods sold. You've decided that you're going to mark up your cost of goods sold by 20%. Should be a 20% margin, right? Not so fast. Let's do a little math. If you have $800 of cost of goods sold and I'll do the math for you here and you multiply it by 1.20 or increase it by 20%, you're going to charge out $960. You're going to generate $960 in revenue on that $800 of cost of goods sold. If you take that $960 and follow our gross margin calculation, you take $960 in revenue, subtract the $800 in cost of goods sold to get $160 in gross profit. So that's the 960 minus the 800. You take the 160 and divide it by the revenue, which is $960, and you get a 16.7% gross margin. So you see the difference there. You've got $1,000 in revenue with $800 in cost of goods sold, compared to $960 in revenue and $800 in cost of goods sold. Your margin went from 20% to 16.7%. So that's a little different between gross margin and the markup.
Scott Geller:I think some people I hear people or see people using those interchangeably and there really is a difference. All right, every business has a gross margin. All right, Every business has a gross margin. Yes, every business has a gross margin. And if you think you don't, you do SaaS companies, tech companies, services companies, manufacturing companies, inventory-based companies, even government organizations in one way or another, I think can find it. Staffing companies let's see if I can come up with any others HVAC companies, you know, driving companies everybody has a gross margin Now and you must know what it is.
Scott Geller:Now I will admit, the gross margin may not be as important in some businesses as others. I had a client where their gross margin was literally like 96%, 98, 96, 96, 98%. They were mainly a pass-through organization. They used somebody else's technology. They passed it through and so they had a massive operating expenses, but they had a very small and really it at it. Even though it was very consistent and very small part of their business, it was still there. We still looked at it. So I recommend you know what it is. Why do you need to know what the gross margin is? Because it's the horsepower of your business's engine. It is the power that drives your business and you can do more, just like a car. You can do more with more horsepower. So let's make it.
Scott Geller:Let me use a car example to explain this gross margin. Let's say you have a baseline Ford Mustang that has 310 miles per hour and that can, that can go from zero to 60 in five to 5.3 seconds. That's kind of a standard metric for car buffs is how fast can my car get from zero to 60 miles per hour? And for a baseline Mustang with 310 horsepower, that's about five seconds. 410 horsepower, that's about five seconds. If you increase that horsepower to 450, and you can decrease the time from zero to 60 to less than four seconds, everything else is the same, the car is the same, the weight, the tires, the interior, the music you're playing it all stays the same. And if you're racing and, let's be honest, business is kind of like a race, a lot of times is a race Would you rather have a 310 horsepower Mustang or 450 horsepower Mustang, the 450, right? Well, your business is the same way. You want the higher horsepower as you can possibly get in your business.
Scott Geller:So let's think about it in your business, if you have a 20% gross margin on a $1 million business, you are making $210,000 in gross profit. So that's $1 million. With a 20% gross margin, you get $200,000 in gross profit. If you have a 22% gross margin on a $1 million business, you're making $220,000 in gross profit. You just increase your gross profits from $200,000 to $220,000. And, just like that car, you didn't have to do anything else. In your business, if you can improve that gross margin, you just raced forward by $20,000. Your business is better by $20,000 by purely improving that gross margin. Now, yes, it's way easier. It's also way easier to make net income with higher gross margins than increasing the top line, mathematically speaking. Of course, now, maybe it ignores market effects, competition, other pieces of the business and other aspects of the business that, yes, can come into play. But, just purely speaking, you can race your business forward just like that, mustang to the higher profits with a better gross margin. You can make more doing the same work. All right, scott, this is great.
Scott Geller:We talked about gross margin, why it's important, but how do I get to my gross margin in my business? So let's talk about that. The first so just to recap, it's revenue minus cost of goods sold gets your gross profit and you divide that gross profit by your revenue. The revenue should be the easy part. Almost everybody I talk to they know their revenue number. What they don't always know is their cost of goods sold, and it can be tricky, but it's critical to get that cost of goods sold right in your business. If you don't include everything, or if you include items that are not cost of goods sold, it will impact what you think your profitability is and it can lead to making wrong decisions about your business.
Scott Geller:So what is cost of goods sold? Well, the cost of goods sold is any expense that is required to get that dollar in sales or revenue. So let's talk about some examples for that. It might be inventory, it might be parts that you put together to sell. Maybe it's a good, it might be people. A lot of times there's people, they're directly related to that revenue number. It can be tech spend that's directly related to that revenue number. It's really anything that's directly related or required to generate that revenue, that dollar in sales.
Scott Geller:So let's talk about a couple of examples for cost of goods sold and one is consulting. So let's talk about a consulting business example for what's in cost of goods sold and that is primarily the people time spent working to provide that service. It's the time that is spent providing the service to that end client. So does that include administrative time? If it's the same person, let's say the same person does client work and they do some administrative work. Well, guess what that client times, the hours spent on the client, goes to cost of goods sold. The administrative hours, nope, they're not. So think about, even if it's invoicing the client, if it's collecting on the receivables for that client, those hours are administrative. They were not generating that dollar in revenue, that revenue, so no, they should not be in your cost of goods sold. Time spent on planning for the business, even if you're talking about clients, even if you're planning how many clients you're going to get, who you're going to target, that time did not generate the revenue. So no, that does not go in your cost of goods sold.
Scott Geller:Let's say you're coding a new product feature. Well, are you selling that product feature to the client or is that feature for the client? Then, yes, that does go into the cost of good soul. If you're coding a new product feature for the business, for your business to sell, nope, that does not go under cost of good soul. That is an investment within the business. Let's move. So. Let's move on to another example.
Scott Geller:I work with a lot of goods sold. That is an investment within the business. Let's move. So. Let's move on to another example. I work with a lot of staffing companies. So let's talk about what falls into cost of goods sold for staffing companies.
Scott Geller:The biggest piece for a staffing company are the hours you are paying the individual. So you place an individual for a period of time at a client's location let's call that. You know you call them a traveler provider placement, whatever that individual. The hours you pay that individual via payroll or however you pay them, goes into the cost of goods sold. Reimbursements Maybe you're paying the individual travel expenses or other type of reimbursements, training reimbursements that is cost of goods sold. Allowances maybe you have some allowances that are part of the pricing deal. That goes into cost of goods sold.
Scott Geller:Payroll taxes boy, people forget about payroll taxes. Yes, cost of goods sold. If it's related to in a staffing company, the hour that you're paying, it goes in Workers comp for that individual that you're paying, goes in Workers comp for that individual that you're placing. Yes, cost of goods sold let's say you provide benefits to your placements. Cost of goods sold yes, it does. Two others that people sometimes forget if you're paying VMS fees, yeah, you're passing them through that VMS or that MSP. That's how you're getting that individual placed. Cost of goods sold. Referral fees Maybe you're paying somebody a referral fee. Well, you're not going to get that revenue if you didn't pay that referral fee. So, yes, that goes into cost of goods sold.
Scott Geller:What you don't include are operating expenses. So expenses that keep the lights on in the business, if you will. If you want to hear more about operating expenses, so expenses that keep the lights on in the business, if you will. If you want to hear more about operating expenses and how that breaks down, check out episode 10. It's another one where I chatted, I talked about I just did myself and I talked about planning for your operating expenses, so you can check that out. So how do you? What do you like? What do I Scott? What do I use this gross margin for? Well, you incorporate it into and you compare it with your pricing. You feed that back into the pricing machine so you understand what's happening in your business and what's happening with your pricing is one Another is forecasting.
Scott Geller:It's critical in forecasting. So let's talk about that for a little bit. There's a few ways to forecast your gross margin. So this whole podcast is around forecasting. Right, how do I plan for my business? So how do I plan? How do I forecast my gross margin? So let's talk about a couple of different ways. The first way to forecast your gross margin is using a trending. Let's take a look over the last three, six, nine, maybe 12 months and let's average out per revenue. So let's see what the average of my cost of goods, what the average gross margin, has been over the last six let's say three, six or nine months and I would recommend a rolling average there and then use that to project it out. So if your you know so if your revenue is X, going to be X and the trailing six months of cost of goods sold was 76% of revenue for actuals. Then use that same 76% as your cost of goods sold and go moving in the future.
Scott Geller:Another way is to create targets. What do you think your gross margin should be? What are the targets at, maybe different levels? So maybe you think your gross margin is going to be 20% for the next six months and because you're instituting, you're giving yourself, you think you can price a little bit differently. Starting month seven through nine, you think you can get it to 21%. Month 10 through 12, you can get it to 22%. So you can use it as targets. What are your target gross margin? And then you apply that to the total revenue. You could also apply it per product, say at a client level or even a service or good level, and then roll all that up into the total cost of goods sold.
Scott Geller:Think about another way to forecast. Gross margin is by a category. So break your gross margin into maybe there's a fixed component, maybe there's a variable component. So determine using historical information with that fixed component. Let's say it's a fixed component is 10 grand per month. So put in 10 grand every month. Then you have a variable component and let's say, the variable component is 68% of your revenue. So you have 10 grand as a fixed component and then you have a cost of goods sold number that's 80, 68% of your revenue. And then you know, flow the math through to find out what your cost of goods sold and then your subsequent gross profit and your gross margin. In that way, you know, in this method of using it in the categories, you really want to think of what the drivers are for each of those and really dig into whether it is a driver between with fixed because at some point it's probably going to change a little bit and then the variable.
Scott Geller:So what do you do with this? Well, like all the finance folks, you input those into financial model. Yes, start with projecting the revenue and then you're projecting the cost of goods sold and then you're tracking the gross margin. What is critical is you stay at it, you keep at it, you keep reviewing it, if not monthly, at least quarterly, and then you compare it to the actuals. Okay, so what did I say the gross margin was going to be? And then I need to compare that to what the actuals really were so that I can use that to improve the forecasting and improve your financial education within the business. Determine.
Scott Geller:Then the next step is determining the what, how and the whys. The actual gross margin differed from the projected gross margin. Just saying it differed is okay, great. But unless you take that next step of understanding the how and the why, what good is that going to do you? It doesn't. It's not going to help you make better decisions in the business. And then compare your methodology, change it every now and then see what you can do to, to to improve that and again, feed those learnings really important. Feed those, those learnings back into your pricing. So at the end of the day, your pricing is rolling into is going to tell you what your gross margin is. All right, accounting.
Scott Geller:Let's talk a little bit about accounting the impact on gross margin. The first is let's make sure you have your chart of accounts set up so you have your revenue, you have your cost of goods sold and then you have your operating expenses. Then you need to understand whether you are a cash or accrual-based business. If you're calculating your gross margins and your gross margin looks like an EKG reader, you're on cash accounting more than likely. So think about this If you have a margin that is 60% one month and then negative 10% the next month, 24% the month after that, 60% the month after that. Is your business really losing money one month and then making a ton of money the next month? Odds are it probably isn't. And that's an indication typically of cash accounting, whereas if you go accrual accounting, the idea is you're lining up all the revenue that is for the work performed in that month to generate their revenue, all the cost of goods sold as related to the revenue that was generated in that month, and then you compare that. So you're comparing apples to apples, whereas in cash which is important to look at cash a lot of times compares apples to oranges. A quick example would be think about if you're a service business and you pay payroll weekly or bi-weekly. That's probably captured within the month, right, but you may not bill that client for 30 days after that and then they may not pay you for another 30 or 45 days. So the revenue is hitting several months down the road, but the cost for that work is falling months before you realize that revenue. So it's really going to mess up your margins. So on the accounting side, think about the chart of accounts and think about the cash flow in a first accrual accounting. All right.
Scott Geller:Why is this important, scott? Well, it's important in understanding your business. It's a huge lever in your business. If you can keep your operating expenses flat but you can increase your gross margin, that extra money goes straight to the bottom line. It goes straight to you. Think about that $20,000, or example you can just make $20,000 more on just increasing your gross margin. Then that's $20,000 in your pocket. It's really important scenario planning and what ifs. What if we raise prices but we lose clients? Well, it might be okay, because you can sometimes make more money that way. Can we afford to invest more in our operating expenses if we can increase our margin? Well, maybe we can. So it's really important in that scenario planning. You know.
Scott Geller:What's also really important is if you go to sell your business, because if you go to sell your business, the individuals or the companies or private equity, whoever it is that's interested in your business, they're going to want to know what the gross margin is. And if you don't know, or you give them financial statements that show that you know, going back to the EKG reader, where they're up and down and all over the place, well, it's not going to look good and you're going to be more valuable, as the value of your business is going to be higher, if you know what the margins are and you tell them, rather than asking an acquirer, an interested acquirer, what they are. So, gross margin, please calculate it correctly, use it for planning, use it to make financially informed decisions. It is absolutely, in my opinion, one of the most important metrics, or in numbers, to know in your business. Well, I feel like I've run on long enough with gross margin and I always like to wrap up shows with one to three media takeaways that our listeners could literally put into action as they turn off the podcast. And today, since gross margin is the topic at hand, here are three initial steps. Step number one structure your chart of accounts correctly between the cost of goods sold and the operating expenses. Step number two check your accounting methodology. Know if you're accrual or cash so that you know if your gross margin is real or not. Hint, cash does not give you a good gross margin or an accurate gross margin. Three calculate and know your gross margin percent every month.
Scott Geller:I also like to share a good podcast or book recommendation. Today, I'm going to share a podcast of two Bobs the number two, and then Bobs, with David C Baker and Blair Innes. I think it's really targeted toward creative agencies, but I think it's fantastic for general business knowledge pricing, making big decisions in your organization. It's just a really interesting. They're usually pretty quick, but I always get something out of it. All right, folks, that's it for today. Thank you for indulging my gross margin talk and if you liked the show or found something useful, please text somebody else and tell them hey, I've got this show, budget your Business. I want you to listen to it and help somebody else learn something about planning for their business. I'm Scott Geller and I hope you join me next time for Budget your Business.