Margins Matter: Learn This Formula for Success for Your KC Small Business
By Guest Contributor Jack Harwell, Business Adviser, Kansas Small Business Development Center
Margin. It’s the most important word in business.
Margin is the fuel that drives profitability and provides the flow of cash you need to pay for overhead and put a little (or hopefully a lot) of money into the pocket of the owner. (That’s YOU.) Plus, who doesn’t want to manage their business better and be more profitable? All it takes is a little math.
OK, so margin can be a little tricky to understand, but it can provide powerful insight into the financial performance of a business (and honestly, the math isn’t that tough). To get the right footing with this concept, you should know how to calculate margin. And we’ll show you how. Once you’ve mastered running those numbers, you’ll be better prepared to manage the profitability and growth of your business.
If you want to skip straight to how you can figure out your margins, call KCSourceLink at 816-235-6500 or tell us a bit about what you’d like to do here, and we’ll connect you with the organizations in Kansas City, like the Kansas Small Business Development Center, that can help you work out your business finances and a more. (Plus, our services are free.)
Formula for success
Most businesses have two kinds of costs: variable and fixed. (We’ll get to fixed costs later.) Variable cost is the money spent to make and deliver a product or service to the customer. This category of costs, also known as cost of goods sold (COGS for short), is proportionate to the amount of sales dollars you bring in. When you double sales, variable costs will also double.
For example, if you buy merchandise to sell to your customers, the cost of merchandise is your COGS. Let’s say you sell T-shirts you bought from a wholesaler, and the cost of each shirt (COGS) is $8. You sell your T-shirts for $20, and since your COGS is $8, that’s 40 percent of the sales price of the T-shirt. You have $12 left over after COGS, which is your margin. If you sell two T-shirts, your cost of goods doubles to $16 ($8 x 2 shirts), and you get $24 ($12 x 2) in margin.
Regardless of the amount of T-shirts sold, out of every sales dollar you get from the customer, $0.40 goes to COGS, and the rest is margin.Think about it this way: Imagine if you tore off 40 percent of every sales dollar you receive and set it aside so you can pay the T-shirt vendor. The other 60 percent of that dollar is your margin from the sale.
And as you sell your shirts, that 60 percent margin starts to pile up—except that’s not all pure profit. You’ll use some of those dollars to pay for other costs of doing business, such as rent and utilities. These are your fixed costs, otherwise known as overhead. Your rent is the same every month, so it’s easy to see why we call it a fixed cost. Utility bills vary depending on the season, but we still say they are fixed because the cost of utilities is not affected by how many T-shirts you sell. After you’ve paid all of your fixed costs, that’s when you get to pocket any of the left-over margin. This is your net profit.
When things can get messy
COGS aren’t always exactly proportionate to sales as in the T-shirt example. Consider a pizza parlor, where the pepperoni, cheese, sauce and dough are all COGS. The more pepperoni pizzas sold, the higher the COGS. Twice the pepperonis for twice the pies. But this is only true if all cooks make the same exact pizza every time and, for example, put the same number of pepperonis on every pie they make. But here’s the thing: That doesn’t always happen because we’re human, not robots. Another reason the proportion of COGS to sales might vary is because the pizza parlor has several meat and vegetable combinations and not all ingredients cost the same. Also, COGS as a percent of sale may be different at different times of the day and for different items on the menu. This means different margins for each pizza.
It gets even fuzzier when looking at the labor involved in delivering a product to a customer. In the pizza parlor, the cooks’ pay is COGS because they make the pizzas. However, the amount of labor used to make a pizza varies quite a bit. During a rush, the cooks are frantically putting toppings on the pizzas and throwing them in the oven. When the rush slows down, more time is spent on each pizza. Sometimes, there are no customers in the building. Because every day has a different flow of customers, the amount of labor spent making pizzas is different.
One way to deal with labor variations in COGS is by scheduling the cooks so they are working when there is an expected rush of customers and not working in periods of slow business. Schedule more cooks for the rush so they have time to make the pizza right, and then send them home the minute the rush is over. This management of production costs has one goal in mind: Tear off as little of the sales dollar as possible for COGS. (Better margins!)
Not all labor costs are COGS; only the labor actually involved in producing the product or delivering the service. Other labor costs, such as the manager, are labeled as overhead. You may have sometimes noticed the manager of a restaurant preparing the food. This could be to reduce the amount of labor cost and to achieve better margins. Like a good manager, they want to tear off as little of the sales dollar as possible to pay for COGS, leaving more for overhead—and, perhaps, more for their bonus.
Your margins will probably vary month to month. Sometimes you can have an impact on this percentage, and other times you have no control. Become familiar with your average COGS and average margin so you know when something is off. The goal is to reduce the variation and your overall average COGS.
Two concepts: Same name
“Wait a minute," you say. “The term ‘margin’ is confusing because I’ve heard it used to describe an amount of money and a percentage. Which is it?”
Yes, it is confusing. It can go either way depending on the context. Gross profit is the money left over from the sale after paying for COGS. This is margin. If you divide gross profit by sales, the resulting percentage is also called margin. Here’s the deal: Whether an amount or a percentage, margin is great for business, and you want more of it.
You can find margin on the profit-and-loss statement, where it’s labeled gross profit. Margin is just below COGS and above overhead costs. The first step in managing your margin is to make sure you have identified all COGS in your accounting system. Once your profit-and-loss statement correctly reflects COGS and margin, you can compare it to others in your industry to identify areas of opportunity.
Every business is different, but margins in an industry are normally within the same range. An advisor at the Kansas Small Business Development Center can help you identify your COGS and margin and compare it to others in your industry.
Now you that know what margin is and how to calculate it, you can use it to manage your business better and be more profitable. We use margin to calculate break-even, to identify which product line is most profitable and to justify the purchase of new equipment or hire a new employee. Because margin is the fuel for profitability, a smart owner will manage it more closely and more frequently than they manage overhead. There’s A LOT to cover here, so we’ll be tackling these topics in future articles. Stay tuned!
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