Blog: The Changed Gross Margin?
In the physical product world, that I call touch and feel it has been established that the gross margin equals the revenue minus the cost of manufacturing the product that includes the cost of goods – the labor, material and overhead, material, direct labor and the overhead costs. To be successful, the gross margin dollars must cover all the supporting costs including, administration, engineering, sales, marketing, and something left over for profit. The gross margin percentage equals the gross margin dollars divided by the revenue dollars. Margins of 40% can be healthy, but for electronic manufacturing companies, a margin of 6% might be acceptable.
In the move to software and internet product, after the product was developed, the gross margin can be above 90%. So for each product sold, the cost of goods, the memory stick, is shipped to the customer. Or in an internet cost for the product, the cost the time it takes for a download?
At the same time what can you do with the employees that did the development? Their costs must be covered or they can be let go.
Margins that high are very impressive, but it’s the real dollars that come into the company. I was on the Board of Directors of a company where a marketing presentation was made, and the presenter was dancing while presenting the product margin. My question was obvious to me, “How many units do you have to sell to cover all the costs in the company”. He had a forecasted sales number, but couldn’t tell how many units would be shipped to reach the sales number.
If my memory serves me, this the same guy who was bragging about his website. I upset him again by asking, how do you get people to come to it.
Companies selling a service or application on the Internet or utilizing social networks need to be more creative with margins. The accounting needs to figure out how much of the total human element is to be charged to produce the product in the pricing. Instead of gross margin consider the need to cover all the costs as added value. Therefore, it becomes necessary to have enough revenue to cover the added value as well as the profit desired.
In the Internet and social network companies, sweat equity can go a long way in a startup with a small team as human capital is basically all that is needed to obtain the revenue. As noted above, pricing is very important in developing the needed added value (costs) not only in place but in attaining future goals.
In startups many times staff is working numerous hours to get the products out, but then it becomes extremely important on how to price the product based on recovering the costs and profit.
- As an example I’ve had success with his in the past. This was related to a software company with a margin of 90% range. We decided to work from the bottom up.
- There were 10 employees averaging $50,000 a year for a total of $500,000 on a 40-hour week, using 2000 hours a year, per employee or 20,000 hours that could be billed.
- Most of the 10 work more than 40 hours a week, but it wasn’t necessarily in the exercise to pay them beyond the 40 hours.
- All the other costs for operating were $450,000 including marketing, engineering and the general administration. The total cost of the company annually was $950,000.
- Using the 20,000 hours the $950,000 the cost per hour was turned out to be $47.5 per hour, the breakeven point to cover the costs. The breakeven sales would be $950000.
- There was a desire for a 25% profit so this increased the cost per hour to $$59.37 an hour to recover all costs and profit. The extra $11.875 cost per hour would yield $237500 or 25%.
- On an annual basis breakeven sales would be increased to $1,187,500 a year or $98958 a month. Now everybody knew the targets needed and they were posted on a big six-foot thermometer that was put up on the wall beside the outside of the restrooms. This way any customer contact and pricing was pushed to get the most possible. For instance, if an engineer was selling time, he made sure he got $59.37 an hour.