Gross Margin For Profitability
When you sell products, calculating your gross margin is easy. It’s the difference between how much you purchase a product for and how much you sell the product for, stated as a percentage. For example, if you sell a bait station for $30 and it cost you $18, your gross profit is $12, and your gross margin is 40 percent.
As I explained in my article, “Are you ready for 2018?”, this number is important because the total gross profit on all products sold initially is used to pay off overhead (fixed costs). Once overhead is paid off, also known as the breakeven point, you begin to make a profit at the rate of gross margin multiplied by the sales price of all items sold in excess of breakeven. The gross profit contributes to paying off fixed costs, and once paid off, the gross profit contributes to the net profit of the firm. This is why many accountants refer to gross margin as the contribution margin. This concept is known as breakeven analysis, and is one of the elementary cost control and pricing strategies taught at business schools.
As you increase or decrease selling prices while holding direct costs constant, your gross margin rises or falls. Therefore, your breakeven point in number of units to be sold decreases or increases based on selling price.
Understanding your Gross Margin For Profitability: Applying it to your Pest Control Business
OK, so this breakeven analysis is some powerful stuff, but you are in the pest management business and you offer a service, not a product. How do you make this calculation for a service, where no products are being sold? How do you calculate gross margin and breakeven point?
To employ gross margin as a key performance indicator (KPI) in a service business, we must define a unit of measure that we sell since we don’t sell products. In the pest business, we sell time — the time it takes to take care of the customer’s problem, as well as retreatment time as needed. If we define our unit of service as one hour, we can begin to calculate our direct cost (the cost to provide one hour of service before applying any fixed costs).
In pest management, we usually look for material cost of about 5 percent to 8 percent; technician labor to be about 20 percent to 22 percent; and other direct costs such as vehicle costs, workers’ compensation, uniforms, etc., to be about 20 percent. Taking these direct costs together, the most efficient companies have direct costs of about 45 percent to 50 percent, making their gross margins between 50 percent and 55 percent. By understanding the actual direct costs per hour, we can back into our selling price per hour while targeting the gross margin percentage of these most efficient companies.
For example, assume our direct costs are $50 per hour. A selling price of $100 per hour would yield a 50 percent gross margin. By contrast, a direct cost of $45 per hour with a selling price of $100 per hour would yield a 55 percent gross margin.
Performing break even analysis is fundamental to business success. By looking at selling price, direct costs, gross margins, fixed costs and net profit, you can determine whether you are making an adequate profit compared to your past results or others in the industry. If you’re not, is the problem pricing, direct costs associated with performing service, or costs to run the office?