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Why Gross Margin Doesn’t Really Matter

[caption id="attachment_1378" align="alignright" width="300"]I can see the numbers, but what do they mean? I can see the numbers, but what do they mean?[/caption]

I spend quite a bit of my time working with sales and business leaders on the commercial structure of ICT deals.  The most common question they are asked is: “what is the gross margin on this deal.”

The answer is, of course, who cares?

If this is the measure you use, then you are almost certainly making bad business decisions.

Gross margin is an easy shorthand to use when describing a deal.  However, it is not a particularly useful measure, as it ignores three key variables (and maybe a few more besides)
1. Delivery risk varies enormously by product
2. The cost of money, and time to cash, makes more difference to your return than a few percentage points of gross margin
3. It is more or less impossible to forecast margin on professional services

Lets look at each one in turn.

Delivery Risk Varies by Product

The delivery risk in a product sale is relatively low. As the product is defined, and the terms are flowed through to the customer, the level of variance in cost from quote to invoice is low. Your execution risks are limited to warranty replacements and returns, administration risk (if you supply the wrong thing), and customer credit risk.

The delivery risk in maintenance and other standardised managed services is moderate. You carry cost estimating risk (how many incidents will the customer raise), cost of living risks (wage inflation, primarily), and capacity risk (e.g. If you invest in service desk capacity and tooling, will you win enough customers to cover the initial investment).

The delivery risk in projects and professional services is high. It is not uncommon for project cost over-run (out turn to quote) to be in excess of 100%. Just ask the suppliers involved in the National Programme for IT.

So, the gross margin that you will accept steps up across these categories.  Just as the buyer will pressure you on price, there is a point where you are better off walking away rather than accepting the risk – and that walkaway point is very different across the different products and services.

If you sell £10m of hardware at 10% you should be delighted (if you are reseller, that is).  If you sell £10m of professional services at 10% you should be in despair.

Cost of Money Matters

Gross margin also ignores the cost of money, which if very different between products and service.  Take the following scenarios:
– Sell £100k hardware at 5%
– Sell £100k maintenance at 20%

Question: Which is better business?

Answer: the hardware deal, by a mile.

If you sell £100k hardware at 5% on 1 January, you will get paid by 1 March (if you manage your billing right). You then sell another 100k on 1 March, get paid 1 May etc. By the end of the year, You have made a return on capital of 30% (more if you compound the capital, but I’ve ignored that for now).

If you sell £100k of maintenance at 20% on 1 January, you will get paid in stages over the year, and incur the equivalent costs over the year. On 31 December, I have made a return on capital of 20%, as well as borne more delivery risk (per my point above).

Professional Service margins are only visible in the rear view mirror

Take a further scenario:

– Sell £100k professional services project at 40%, or
– Sell £100k hardware at 5%

Question: Which is better business?

Answer: nobody knows, as professional services margins are about as accurate as your horoscope.

Professional service rate cards are built on assumptions about salaries, overheads, utilisation rates and target margins.  The third of these: utilisation rate, is more important than the other three combined.

For example, it is usual to budget on 75-80% utilisation.  If your target margin (built into the rate card) is 40%, and you hit the utilisation target, you make 40% margin.  If you hit 95% utilisation, you make 80% margin.  If you hit 50% utilisation, you’re losing money.  From month to month, the actual margin you make will vary dramatically.

This means that a project at £100k can be profitable, breakeven or unprofitable, without reference to whether or not the solutions team have estimated the resources correctly in the first place. They won’t, of course, but that’s a separate topic in its own right!

It only matters whether or not you are managing the flow of business so that your people are continuously employed on billable work.  You only find out how much money you have made at the end of the year.

Still think gross margin really matters?