Think Like a CFO: Understanding What Impacts Your Margins
Last week, I participated in CompTIA's IT Channel Management Executive Workshop, and while the two-day training was jam-packed with actionable lessons, one of the biggest eye-openers for me was that MSPs often don't understand their own finances. Here on the blog, we're always offering advice on services to add or relationships to leverage to grow your bottom line, but what does that actually mean? What goes into that metric? Revenue and profitability are two different key performance indicators (KPIs), and it's vital to know what impacts both in order to grow and scale your MSP business.
Understanding Your Income Statement
In order to understand your business's various line items, we'll look at a sample income statement:
image source: http://financetrain.com/income-statement/
Let's examine each of these in greater detail:
This is a figure you already understand because it represents what you make in sales. It's the amount you invoice for each of your customers.
Cost of Goods Sold - though often defined as Cost of Goods and Services for MSPs - (COGS)
COGS measures the direct expense associated with the products and services you sell. As you can see in the sample above, this number breaks down into the cost of materials, labor and overhead.
Note: Gross profit and gross income are synonymous with one another. Here is the first key formula you need to know in order to think like a CFO:
Revenue - COGS = Gross Profit
That's right, gross profit represents the difference between the first two metrics above because it gauges how efficient a company is at using labor and materials. According to Investopedia's definition, gross profit "considers variable costs, that is, costs that fluctuate with the level of output."
Gross Profit Margin
While not included on the example income statement, this is another term to be knowledgeable of. To calculate your gross profit margin, simply follow this formula:
Gross Profit/Revenue = Gross Profit Margin
You always want to monitor this metric because over time, gross profit margins can decline while gross profits increase. What's the takeaway then? If for instance your gross profit were higher in 2015 compared to 2014, but your gross profit margin was lower in 2015, you know your use of raw material and labor during the production process in 2015 was not as efficient as it was in 2014.
Operating expenses cover the cost of maintaining business operations daily. These are typically fixed costs that you must pay even when no sales occur. What we often really care about when looking at operating expenses, however, is selling, general and administrative costs (SG&A). These are costs such as advertising, rent, utilities, insurance, benefits, etc.
Operating Income or Profit
Note: Operating income and operating profit are used interchangeably. To calculate this metric, we use two of the others we've already found:
Gross Profit - Operating Expenses = Operating Income
Note: You technically also deduct depreciation and amortization, but we'll keep it simple for the purpose of our example.
Investopedia defines operating income as "the amount of profit realized from a business's operations after taking out operating expenses."
Similar to calculating your gross profit margin, to find operating margin, use this equation:
Operating Income/Revenue = Operating Margin*
Operating Margin measures your MSP business's operating efficiency. Following the same logic as earlier, it's not enough to only look at your operating income over time. You have to know how your margins behave in order to make adjustments.
Other Income & Expenses & Income Before Tax
Then, you'll notice in the example that we add other income and expenses (like interest) to operating income to find income before tax. From there, we apply the tax rate and deduct it from our income before tax to find net income.
At last, we've reached the bottom line item on your income statement! Net income is an important metric because it tracks how profitable a company is over time, hence why it's also referred to as net profit.
Revenue - COGs - Operating Expenses - Interest and Taxes = Net Profit
Gross Profit - Operating Expenses - Interest and Taxes = Net Profit
Operating Income - Interest and Taxes = Net Profit
This is the number you want to pay close attention to, as it tells you "how much of each dollar earned by the company is translated into profits" according to Investopedia.
Note: For longer descriptions and examples of each of these line items, check out Investopedia's full dictionary of terms.
So How Can You Increase Your Net Margin? Keep reading!
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scottalanmiller last edited by
Well it should not be too surprising: Most MSPs are SMBs, most SMBs have no grasp of finances. It's pretty general. As an MSP, if we talk to our customers, they often have no idea about finances.
Just look at things we run into all the time in the field: blatant disregard for the sunk cost fallacy, disbelieving in the concept of value and looking at price as a proxy for value (in randomly either direction), no idea of the time value of money, unable to look at risk as a cost and use this to evaluate needs, pushing CFO duties onto other departments that lack training and insight into the books, buying products without regard for suitability, paying for advice that is ignored, buying without planning...
SMBs don't just lack the knowledge of the complex stuff, they often lack the knowledge that we expect children to have. The struggles are often with the most basic concepts, not advanced ones. Ones that don't require training, just general knowledge.