Gross Profit Margin Vs. Net Profit Margin for Service Businesses: What You Need to Know
By: Shay James
You may have started out as a solopreneur, but eventually realized there were only so many hours in the day. As a solopreneur, your earning potential eventually maxes out since you’re operating on a time-for-money model.
Thus, your creative agency — complete with a team and all — was born. Now to run your business successfully, you have to acquire new skills that help you ensure profitability and success.
One of the skills necessary for agency owners to learn is tracking and analyzing financial information. To track the profitability of your business, you have to familiarize yourself with certain metrics, including your profit margins.
Different profit margins give you different information about the health of your business. For example, you’ll need to understand the difference between your gross profit margin versus your net profit margin.
At this point in your business, you may not know how to calculate each one or why they matter. That’s okay, and it’s actually quite common. We’ll discuss in detail what the gross margin for your service business tells you as the owner and what you can learn from your net profit margin.
Gross Profit Margin vs. Net Profit Margin
To determine the overall financial health of your business, knowing your profit margins is key. Sometimes you hear people bragging about how much revenue their business generates in a given year. But in and of itself, revenue is more of a vanity metric than an indication of success because it doesn’t take expenses into account.
Profit margins are a better indicator of how well your business is doing because they show the numbers that actually matter. And what matters isn’t how much money you make, but how much you keep. To figure out your margins, you need the following information:
Cost of goods sold (COGS)
All other business-related expenses (operating expenses, interest, taxes, etc)
Once you have these figures on hand you can run the calculations to see what your business generates in gross profit margin vs. net profit margin. Your net margins will tell you the overall profitability of your business as a whole, while the gross margins will tell you the profitability of an individual service that you provide.
Understanding Gross Profit Margins for Service Businesses
Calculating the gross margin for a service business rather than a product-based business is a bit different. The distinction is made by how you define the cost of goods sold (COGS). For a product-based business, the cost of physical goods includes the direct expenses associated with manufacturing that product, which are typically materials and labor.
Gross margin for a service business can be calculated by replacing the cost of goods metric with the cost of sales or cost of revenue. Your cost of sales includes all direct costs involved in delivering a service.
So what does that look like in real terms?
Let’s say you’re a creative agency specializing in website design and development. Your in-house team includes graphic designers and web developers, but you outsource copywriting because some of your clients prefer to provide their own copy and just have you implement it into their site. Your cost of sales, therefore, would include the labor expense for both your in-house team members and the outsourced copywriter (as needed).
Gross Profit Margin
By tracking the gross profit margins of the services or packages you offer, you can determine the profitability of each. Maybe you’re a business that provides three different service packages. Calculating the gross margins of each will tell you the profitability of each one individually.
With that information, you might see that two of your three packages are performing considerably better than the third. You can then decide to increase the price for the third service to make it worth the time and effort your team puts into providing it. Alternatively, you might decide to eliminate it altogether, freeing up your team to work on higher income-producing services.
Knowing your numbers empowers you to make informed decisions to improve the health of your business, and calculating gross margins is a great place to start. Calculating your gross profit margins is simple. Subtract your COGS or cost of sales from your total revenue, divide that number by your revenue, and multiply the number by 100.
(Revenue – COGS / Revenue ) x 100 = Gross Margin
Let’s use a simplified example to use in the formula: If you price your signature service at $1000, and it costs you $600 to provide that service to your customers, you are left with a 40% profit margin.
($1,000 – $600 / $1,000) x 100 = 40
The number that you get when you plug your numbers into the formula reflects 40% gross profit after paying the expenses directly related to the product or service you sell. Gross margins are how you know if your prices are where they need to be for your business to remain profitable.
Net Profit Margin
Net profit margins are a better indicator of the overall health of your business than gross margin. That’s because you’re not only accounting for expenses directly associated with the services you sell, but rather the expenses of the business as a whole. In addition to the cost of sales, your business may also have costs such as:
To calculate your net profit margin, add all the above expenses (including your cost of sales) and subtract the total from your total revenue. This provides you with your net income. Then divide your net income by total revenue and multiply it by 100 to get the percentage of profit your company is generating after all expenses are paid. The formula looks like this:
(Revenue – Total Costs / Revenue) x 100 = Net Margin
To see the formula in action, let’s say you’re halfway through the fiscal year and your business has generated $150,000 in total revenue. The grand total of all costs associated with the service you provide and your business as a whole is $129,500. Running those numbers through the formula shows that your net profit margin for the first half of the year is 13.7%.
($150,000 – $129,500 / $150,000) x 100 = 13.7
If your net margin isn’t where you’d like it to be, evaluate which expenses may have crept up or if prices might need to be increased. This metric is also a key tool in forecasting future profits.
Why You Need to Know Your Margins
With clear and consistent financial information, you’re better able to make the best decisions for your agency. Using key performance indicators like gross and net profit margins, there’s no guesswork about the health of your business. You know exactly where you stand in terms of profitability.
Gross margins tell you if your service (or services, if you offer several) is profitable. Net margins tell you if your business as a whole is performing as well as you’d like it to. With this data, you can decide if you need to increase prices or cut costs — or both! You can also determine more easily if it’s time to expand your team or offer additional services to increase revenue.
If at any point you decide to take on investors or borrow money from a lending institution, your profit margins will be important. They will want to see evidence of the health of your business which will help them determine if it’s safe to invest or loan you money.
Get Support With an Outsourced CFO
If you’re having a hard time making sense of your gross profit margin vs. net profit margin or don’t like the margins you’re seeing, help is available. Bringing in outside set of eyes to review your financials can help you spot important trends that you, as the business owner, are simply too close to the project to see.
We can help you identify if you’re within a healthy range of net and gross margin for a service business. And if you’re not, we can help you develop a plan to improve your numbers.
At Lamplight Advisors, we offer fractional CFO services for creative agencies like yours to help you increase the overall health of your business. To see how we can help you increase your profit margins, click here to schedule a conversation today.