There are lots of areas of your financials that deserve attention: revenue, equipment, salaries, tools, rent. But few are more important than gross margin – a key metric that determines your company’s financial success. It’s just as important as revenue, cash flow and accounts receivable.
Remember that without the right amount of gross margin, you won’t be able to pay your overhead costs and have enough left over to make a net profit.
The gross margin of your company pays the overhead, which includes indirect costs like gas, equipment, vehicles, supervisors and mechanics, as well as SGA costs (sales, general and administration) like salespeople, office staff, administration staff, yard rent and your salary.
Whatever is left over after paying for the overhead costs is net profit. Without achieving the right amount of gross margin, we just become very hard working folks making a living and not a profit.
And, ultimately, you are in business to make a fair and reasonable profit. Profit is not a four-letter word. If you don’t focus on gross margin at the beginning of your pricing process, you will go out of business.
Getting to know gross margin.
Understanding gross margin requires a keen understanding of your direct costs – what it costs to actually perform the work you’ve sold. These are the out-of-pocket costs or the costs that were included in your estimate to perform the work.
In the landscape industry, labor costs are the greatest expense line item. Normally, materials will range from 2-6 percent of revenue in maintenance operations and as much as 30 percent of revenue with installation operations. However, the labor to perform the work will range from 25-55 percent of revenue, depending on the type of business you have. These direct costs are the foundation of understanding and calculating gross margin.
The goal for gross margin.
Generally, the combined gross margin of a company needs to be a minimum of 45 percent (and preferably 50 percent) to make a fair and reasonable net profit. Remember: Gross margin is the financial furnace that keeps the company warm. So first, let’s discuss how to calculate this important metric.
- Step one: Determine total net revenue. Take the total combined revenue of your organization less subcontracted revenue and its associated costs to get to net revenue or sales.
- Step two: Subtract out your direct costs. Now, subtract out your cost of labor plus your burden (payroll taxes, workers’ compensation costs associated with the labor costs) plus your material costs. Some companies can retrieve this pretty quickly, but most will have to search through their P&L to determine all of these costs.
- Step three: Math! Subtract direct costs from revenue to get your gross margin. Then, take this dollar figure and divide it by net revenue to get your gross margin as a percentage. Assume $100,000 net revenue (from self-performed without subs) minus direct costs of $57,000 gives you $43,000 of gross margin. Divide that by the gross revenue and you get 43 percent gross margin. So now we need to see if this is enough to pay for your overhead expenses and have enough left over to make a net profit.
- Step four: Calculate the gross margin per revenue stream. In step three we found that the overall gross margin is 43 percent. The next question is: What gross margin are you making per revenue stream? Most companies we work with have not taken the time or don’t have the ability to separate the revenue streams and their gross margins. This requires setting up a chart of accounts that spread the associated costs (labor, burden and materials) to the specific revenue streams.
So in our example of $100,000 total revenue and a margin of $43,000, we now want to find out what the gross margins are for each separate revenue stream. Your sources of revenue may include maintenance, enhancements, lawn care, irrigation, installs, tree work, snow, etc.
Take the revenue total for each of these revenue streams and then repeat the four steps mentioned previously. The gross margin for each stream will be different, but as a whole should average out to your company’s gross margin goal.
3 drivers of gross margin.
When looking at reasons for achieving low or high gross margins they can be traced back to three areas. We usually find it’s a combination of all three of these that eat up gross margin.
1. Estimating. This is where it all begins with your accurate assessment of what it will take to do the job with the needed labor and materials.
2. Pricing. After you have accurately estimated the total direct costs to perform the work, you need a method to arrive at a price that will achieve the right gross margin and also be competitive within your marketplace.
3. Efficiency and execution. OK, after the first two parts are completed, you now must go execute the work on budget, make the customer happy and collect the money.
Estimating for gross margin.
Start with determining your HAWs – hourly average wages including burden for each separate revenue stream. Some types of revenue streams require different rates of pay and have different worker compensation levels. For example, a tree climber would be paid more than a gardener. The workers’ compensation rate for tree climbers is a lot higher because of the safety and exposure factor.
Add together the base pay rate for each person within a revenue stream and divide it by the number of employees to get the average wage. Then, add the burden rate plus workers’ compensation rate to arrive at the hourly average wage.
Top Gross Margin Destroyers
Here are some of the most common things that can eat up a landscape company’s gross margin. How many do you have?
Here’s an example: You have a three-man crew made up of a foreman who makes $15 an hour and two crew members who make $11 and $10 an hour. Their total hourly pay is $36. Divide that by three people to get an average hourly rate of $12.
Now add payroll taxes and workers’ compensation insurance rates. Assume these add up to 25 percent of labor, so add $3 to the $12 and you get an average hourly wage of $15 per hour.
Set your estimating process.
Now you will need to determine how many hours or HAWs it will take to perform the work you are estimating. Try to establish some time standards or production rates to perform the tasks needed to perform the work. See where you can work smart and efficient, and trim your time down to the most “tightened” down cost you possibly can. Next, determine the materials needed and the cost of these. Get really good at this because this is at the very core of your pricing when we are at the next step.
The key takeaway here is to get this estimate of your direct cost as accurate and as tight as you can get it. Don’t leave any unneeded cost.
Pricing for gross margin.
Review the estimate and make certain all of the costs are accurate and achievable. Let’s assume your direct costs are $1,000 and you have decided that you want a 45 percent gross margin. So you now need to mark up your costs in a manner that the sales price will deliver you a 45 percent gross margin as a percentage of sales.
To do that, use this simple formula: Take your costs and divide them by the reciprocal of the desired gross margin.
Example: Take your $1,000 cost and divide by .55 (the reciprocal of .45). That gives you a sales price of $1,818. Working backward: A sales price of $1,818 minus costs of $1,000 equals $818 in gross margin. Divide the $818 gross margin by the $1,818 sales price and you get 45 percent gross margin.
If you need an hourly charge-out price, use our example of an hourly average wage of $15 per hour. If you want to achieve a gross margin of 45 percent, take your HAW of $15 and divide it by .55. That gives you an hourly charge-out rate of $27.27.
When you set your prices with gross margins in mind, it allows you to be even more competitive. Ask yourself: What types of work get lower mark-up opportunities? Higher mark-ups? Why? When and why do you mark up work at a higher rate? A lower rate?
Keep in mind that gross margins are not the same for all revenue streams or even for all jobs. You will need to determine the desired gross margins by considering the overhead costs associated with the revenue along with what the fair market value is for the work being performed.
Efficiency and execution.
This area will always need some keen scrutiny. It deals with how well your budgeted times to complete work compare to the actual time it takes to finish the job. Obviously, the more you beat the budget, the better. Keep in mind that if you easily beat the hours all the time, then you may be over-estimating the hours to complete the job. Always look for areas to improve your time to complete.
Even the best-laid plans and estimates will have some hiccups or unexpected costs; others will have some victories. Always be on alert as the job unfolds for things that will whittle away your gross margin. Focus on your budgeted hours and materials, and keep track of how you are spending your time on the job.
Look for the best and most efficient means to accomplish the work on budget and with the desired level of delivery by your clients.
Now you have the tools to figure out and monitor one of the most important financial metrics in your company. Remember that if you don’t plan on the correct amount of gross margin for each division, you won’t have enough at the end of the day to make any money.