49. How to Explain: Profit Margins

Foreign.

Hey there. My name is Michael King. Welcome back to the CFO Report, where I talk about starting, scaling, and optimizing fractional CFO services. Now, as a fractional CFO or an accountant, you know how critically important healthy profit margins are to a successful business. But sometimes it can be a little bit difficult to explain profit margins in a way that our CFO clients can understand. And if they don't understand exactly what profit margins are and why they're important, it's hard to get them to take action actions to drive their profit margins up. So in today's how to Explain video, I'm going to break down the process that I use to explain profit margins to our CFO clients. I'm also going to include some examples along the way that make the explanation just a little bit more relatable. My hope for this video is it'll give you some ideas and inspirations on ways that you can explain profit margins to your clients, ultimately making them more successful. So, without further ado, let's check out the explanation on profit margins. You probably know that you should know what your profit margins are, but let's be honest, you they're kind of confusing. That's why I'm really excited to break down all things profit margins for you today so that you can better understand how healthy your business is. You might recall that revenue minus cost of services equals gross profit. In other words, gross profit is how much money you have left over after you pay for your cost of services or your direct labor cost. So we understand what gross profit is, but what about gross profit margin? So if we think about gross profit as being the amount of money that's left over after we pay our cost of services, then I want you to think about gross profit margin as being the percentage of money that that's left over after we pay our cost of services. Here's an example. Let's say that our business did $100,000 in revenue and we had $20,000 in direct labor costs or cost of services. That would mean that our gross profit is $80,000 or 80%. Here's the math so that you can do it on your own. Revenue minus cost of services equals gross profit. Gross profit divided By Revenue times 100 equals Gross Profit margin. So you can see that in our example, our gross profit margin was 80%. Now, you're probably asking yourself, what is a good gross profit margin? And the answer is, it kind of depends. But I'm going to rule of thumb that you can apply if you're an online business That's a service provider. Your gross profit margins should be anywhere from 60 to 100%. And that completely depends on how many cost of services you have. If your gross Profit margin is 100%, that's completely normal, especially if you're a solopreneur. But as you start adding people to your team, your gross profit margins are going to go down. But what I want to encourage you to do, especially if you're an online service provider business, make sure that your gross profit margins are always above your 50%. Why is that so important? In just a few minutes, I'm going to show you how your gross profit margin drastically impacts your income. But first, let's dive into net profit margin. Net profit is simply the amount of money that we have left over after we subtract out all of the other expenses in our business. We call those expenses overhead. How do we calculate net profit? We take revenue, subtract cost of services, and we're left with gross profit. We take gross profit and we subtract out our overhead and we're left with net profit. Okay, that addresses net profit, but what about net profit margin? Net profit margin is simply the percentage of money we have left over after all those expenses have been paid. And to calculate net profit margin, it looks a little bit like this. Revenue minus cost of services equals gross profit. Gross profit minus overhead equals net profit. Finally, we take net profit, divide it by our revenue, and multiply it by 100. Bam. We've got net profit margin. Now that you're an expert at calculating net profit margin, you're probably asking yourself, what's a good net profit margin? Here's two rules of thumb that you can apply to answer that question. First, if you're a sole proprietor or an LLC that is not taxed as an S Corp, or I want you to be targeting somewhere north of 40 to 50%. 40 to 50% is pretty high for a net profit margin. And the reason that I want you to target that is because you have to pay yourself out of that money that's remaining from your revenues after all the other expenses have been paid. So if your net profit margins aren't at least 40 or 50%, that means that you likely don't have much money left to pay yourself with. And that is an absolute travesty. Now, if you're an LLC that is taxed as an S Corp, I want you to be targeting 20% of net profit margin. And the reason that I want you to target 20% net profit margin is even though you've already paid yourself a salary out of your overhead. I still want you to have a little bit left on the table for things like retained earnings, a rainy day fund, and money to fuel future growth. Let's take a look at a real world example of an online business and see exactly how their margins break down. Let's consider Amanda. Amanda is the owner of Elevated Marketing and Branding llc. And Amanda has two people on her team. Christy helps with branding design, and Rachel helps with social media marketing for their clients. Now let's take a peek at their financials. Last year, Elevated Branding and marketing did $250,000 in revenue. The work that Christy and Rachel do is considered cost of services, since their work is part of what the customers are actually buying. In total, Amanda paid Christy and Rachel $62,500. That means Amanda's gross profit for the year was $187,500. We then calculate her gross profit margin by dividing her gross profit of 187,500 do by her total revenue of $250,000. We see that her gross profit margin is 75%. And that is well above the 60% mark I discussed earlier. Great job, Amanda. As we continue looking at Amanda's business, we see that she has a lot of overhead expenses like most of us do. Amanda has an EA that she paid $48,000 to last year. She spent $24,000 on a mastermind. She spent $6,500 on travel. She spent $5,500 on meals and entertainment. She spent $2,700 for online courses. And she spent $7,500 on subscriptions like Canva, Kajabi, Asana and others. Amanda also spent $6,200 on professional services like accounting. Finally, Amanda spent $7,550 in credit card processing fees. Thanks, Stripe. In total, her overhead was $107,950. And that leaves Amanda with a net profit of $79,550. We can then calculate her net profit margin by dividing her net profit by her revenue and multiplying by 100. And so we can see that her net profit margin is about 32%. But what story is this really telling us? Well, it's telling us that Amanda has $79,550 left over after all of the expenses that her business incurred have been paid. And that means she can take home close to $80,000, right? Not exactly. First, we know that Amanda is going to have to pay about $12,000 of that in payroll taxes. She's also likely to have to pay a big chunk of that in income taxes. Let's assume Those are about $15,000. That only leaves her with about $52,500 after taxes have been paid. And she can't even take all of that home. She's going to have to leave some money in the business for retained earnings and working capital after it's all said and done. Amanda can only take home $40,000 a year on a business that's generating a quarter million dollars. That absolutely hurts my heart. This example highlights why it's so important that every business owner be dialed into their profit margins. If I were working with Amanda, I would encourage her to look for ways that she could cut back on some of those non essential expenses so that she could get her margins up to somewhere between 40 and 50%. That could mean that she would get an extra 25 to $35,000 a year to take home and that would be an absolute game changer. All right my friends, that's it. How to Explain Profit Margins to CFO Clients if you haven't already done so, I would love for you to check out our how to explain video on the profit and loss statement. I'll include a link to that in the description below. In the meantime, I can't wait to see you back here next week on the CFO report. See you then.