A steady gross margin can hide a collapsing profit
Ask a business how it is doing and a lot of them will tell you their gross margin. It sounds like an answer. It is one of the few numbers that will barely move while the business gets into serious trouble.
The worked example
£200,000 of revenue. 40% gross margin, so £80,000 of gross profit. £70,000 of overheads. Net profit: £10,000.
Now have a ten per cent quieter year.
- Revenue falls to £180,000.
- Cost of sales falls with it, because it scales with sales.
- Gross profit falls to £72,000.
- Gross margin is still exactly 40%.
- Overheads are still £70,000, because they do not care how busy you were.
- Net profit: £2,000.
The headline ratio did not move by a single decimal place. Eighty per cent of the profit has gone.
Why the gross margin does not move
It is not a coincidence or a rounding artefact. Gross margin is a ratio between two things that both scale with sales. If revenue drops ten per cent and cost of sales drops ten per cent with it, the ratio between them is mathematically identical.
That is what makes it a good number for pricing decisions: it tells you what each job contributes, independent of how many you did. And it is exactly what makes it a useless number for "are we all right", which is the question it usually gets asked.
The number to write down
Break-even revenue: overheads divided by your gross margin. On the example above, £70,000 ÷ 0.4 = £175,000.
That is a 12.5% drop from where the business is. Twelve and a half per cent between a going concern and taking home nothing, and the gross margin would read 40% the whole way down.
It does not appear on a profit and loss account, which is a good part of why so few businesses know it.
It works upward too, and that is the argument for a price rise
The same leverage runs in your favour. Ten per cent more revenue on that business takes net profit from £10,000 to £18,000. An eighty per cent improvement from a ten per cent change, because the overheads were already paid for.
Which is why a thin net margin is an argument for looking at prices rather than at costs. On a 3% net margin, almost none of an extra pound of revenue is going anywhere except the bottom line. Cutting a cost by a pound saves a pound; adding a pound of price on the same margin adds most of a pound of profit, and there are usually more pounds available in the second place.
Two things people put in the wrong box
Your own wages belong in overheads. If you take money out to live on, the business carries that whether it is busy or not. Leaving it out gives you the net profit of a business whose owner is paid nothing, which is not your business.
Rent and insurance are not cost of sales. Putting them there inflates the cost of sales, deflates the gross margin, and hides the divergence this page exists to show, because the overheads then appear to scale with revenue when they do not.
Common questions
What is the difference between gross and net margin?
Gross margin is what is left after the costs that move with sales: materials, subcontractors, direct labour. Net margin is what is left after everything, including the overheads that carry on whether you work or not. What matters is not the definition. It is that they move at completely different speeds when revenue changes.
Why does my gross margin not move when sales drop?
Because it is a ratio between two things that both scale with sales. If revenue falls 10% and cost of sales falls 10% with it, the gross margin is mathematically unchanged. That is not a rounding artefact, it is the definition. Which makes gross margin genuinely useful for pricing decisions and useless for answering "how are we doing", the purpose it gets quoted for most.
How much can net profit really move?
A lot, and people find it hard to believe until they see it. Take £200,000 of revenue at 40% gross margin with £70,000 of overheads: that is £10,000 of net profit. Drop revenue by ten per cent and the gross margin is still exactly 40%, while net profit falls to £2,000. The headline ratio does not move at all and four fifths of the profit has gone.
Why does that happen?
Because overheads do not shrink when you are quiet. Rent, insurance, the van and the software cost the same in a slow quarter as a busy one. So every pound of gross profit you lose comes straight off the net profit, and when net profit is a small slice of gross profit to begin with, it does not take many pounds.
What is my break-even revenue?
Overheads divided by your gross margin. On the example above that is £70,000 divided by 0.4, which is £175,000, or a 12.5% drop from where you are. It is worth writing down because it is the number a quiet quarter is measured against, and it does not appear anywhere on a profit and loss account.
My net margin is only 3%. Is that bad?
It means a single bad job, a late payment or one quiet month is the whole year's profit. It also means something more useful: on a thin margin a small price rise is worth far more than a large cost saving, because almost none of the extra pound is going anywhere but the bottom line. The price change tool works out how many customers a rise could afford to lose, and the answer is usually larger than people expect.
Where should my own wages go?
In overheads, and it is the commonest omission on this page. If you are taking money out of the business to live on, that is a cost the business carries whether it is busy or not, and leaving it out produces a net profit figure for a business whose owner is paid nothing. The break-even calculator makes the same point with its own separate field for exactly this reason.