ARE you uncomfortable using basic financial measurements? Dawn Fotopulos is the founder of Hidden Profit Prophet, an online resource site for small businesses. She is author of Accounting for the Numberphobic: A Survival Guide for Small Business Owners. This post is an adaptation from that book.
Reading the net income statement for a service business can be a little more challenging than for a product business, because cost of goods sold in a service business looks different. You’re not selling “stuff”; you’re selling your time, labor, and expertise. This makes it difficult to keep score on whether your gross margin is where it should be. Since more than 75 percent of small businesses are service businesses, we need to spend more time on how to think about gross margin for a service business.
#1 Scale Capacity to Grow Revenue. In a service business, the largest part of the project-related expenses (which is the same as the cost of goods sold in a product-oriented business) is primarily the cost of direct labor, which comes down to time, skill/expertise and effort. There may be some direct materials involved, but it’s the labor customers are paying for. It’s important that small business managers of service companies know exactly what specialized labor and time are required to deliver a particular service.
- It allows them to price their hourly rates for each type of labor and make sure they’re getting at a 30 percent gross margin on each rate to build a profitable business.
- Small business managers can identify strategies for completing projects more efficiently and managing a higher volume of projects.
#2 Change Pricing Structure. Please do not price an hour of time as if every hour of the day has the same value. They do not. Different hours have different values. An hour of time at 2pm does not have the same value as one hour at 10 pm. After 6 pm is personal time. If a client demands that a job get done on an accelerated time frame, where the service provider must work after hours and sacrifice personal time to get the job done, the provider must charge for that.
- If a service provider is a subject matter expert, this increases the value of their time and labor.
- Track the number of person-hours invested in projects so there is a correlation between what is being charged and how much it costs in time to deliver the final product.
#3 Diversify Your Client Base. Every small business manager needs to look carefully at who is buying from the business, what specific services they’re buying, and how much they’re buying in relation to total revenue. This helps to identify which customers have the most power to influence your revenues and, ultimately, your profits.
- Small business managers must learn to manage their clients so no one client can put a significant percentage of the company’s revenue at risk.
- With a diversified client base, the revenue is much more predictable and the risk is spread out among equals. Build a solid revenue foundation for the business with predictable clients before trying to grow revenue fast with large ones.
Adapted from Accounting for the Numberphobic: A Survival Guide for Small Business Owners by Dawn Fotopulos. Published by AMACOM books www.amacombooks.org, Division of American Management Association.
Dawn recently lead a breakfast briefing on “Facing Financial Phobia: Talk Numbers with Confidence” at the Women’s Leadership Center in New York City on Tuesday, January 26.
Optimizing revenue for your service business creates long term success. Build your financial expertise with these AMA resources and seminars.