The 80/20 of business profits

The main thing that drives your profits is a simple number that most business owners don’t pay enough attention to. This post talks about that number, how to easily work it out for your business, what it should be, and how to improve it.

The last post listed all the things that your prices need to cover.

It was a big list, so make sure your prices are high enough above your delivery costs to cover the rest.

That gap between the price and delivery cost of your product/service is called “margin”.1

Margins are the 80/20 of business profits.2

Why margins matter to your business

Getting your margins right is the difference between:

  • Working exponentially harder as you sell more or hire help VS working less than normal hours if you want to.
  • Managing a small team yourself VS affording managers and larger teams.
  • Little funds for marketing VS lots of warm leads.
  • No time or money for growth projects VS a virtuous cycle of reinvestment.
  • Burning out and going broke VS growing wealth and pride in your success.

A client of mine is so good at keeping his margins healthy that his team runs his business and he doesn’t worry about little things going wrong.

Another client went from in the red to $100k profit from the year by focusing on their margins.

How to quickly calculate your margins

You can do this using detailed bookkeeping data, or a simple back-of-the-napkin calculation.

Done is better than perfect, for now, so here’s the quick steps:

1) Pick the most common service or product you offer, and write down the price (or prices).

2) Subtract all the delivery costs, e.g. the team that does the service work (not their admin or training time), or the cost of materials, manufacturing and shipping for products. Don’t include overheads like rent, insurance, accounting, admin team, marketing, bank fees, etc.

3) Now you have the difference, convert it into a percentage by dividing it by the price from step 1. This makes it easy to compare among products/services you sell and against the ideal benchmark we’ll get to later.

How to improve your margins

Quick recap: margin is the gap between the price you charge and the cost to deliver that product or service to your customer. Often divided by the price to become a percentage.

So there are two sides of the gap you can work on: raising prices and lowering delivery costs.

In a previous post, I talked about the main fear with raising your price, and ways to minimise the risks.

Here’s a few quick tips for lowering delivery costs:
1) Productivity: time is money, so it’s better if you or your team need less time to get things done.
2) Team cost: check that you’re not paying too much for the tasks you need done.
3) Supplier costs: negotiate better deals with your suppliers.
4) Alternative suppliers: useful not just for the cost benefit, as other suppliers might have a system that helps your productivity.

Which side are you going to focus on to improve your margins (and thus your business profits): raising prices or lowering delivery costs?

The ideal margin for your business

The ideal margin depends on what you’re selling, e.g. an ebook has much lower delivery costs than a physical product, so the potential margin is much higher.

It also depends on your niche. In a highly-competitive niche, a business may need a high volume of sales so that economies of scale enable reasonable margins, e.g. any cheap plastic product.

I suggest my clients be a premium provider in their niche and stay out of price wars, to protect their margins.

The higher the margin the better, until you don’t have enough sales volume to meet your goals, e.g. a small business website priced at $1m probably won’t sell.

Here’s the ideal margin: more than two-thirds of the price, or using the calculation above: 67%+.

Or put another way: delivery costs should be less than one-third of the price.

How do your margins compare?

  • The ideal seems low, compared your margins? Great! Keep doing what you’re doing.
  • The ideal seems high? You’re probably working harder/longer than needed to hit your goals. Also, don’t stress: you don’t have to get to the ideal in one day.

A margins example

Now let’s go through a simplified example.

Alex runs an agency that designs and builds websites, with a team of 3 contractors, and spends time stressed out fighting fires and racing between getting work in and getting work out.

His business profits are very small and he barely has enough money to cover his personal expenses.

Here’s the calculation for Alex’s margins:
Website price: $2,000.
Costs to deliver: typically $1,500, including the designer, developer, rework, and a below-market rate for Alex’s time designing and building the site.
So the margin is $500 or 25%.

That margin is supposed to cover:

  1. Alex’s time marketing, selling, and managing
  2. Marketing costs
  3. Admin assistant
  4. New computers
  5. Accounting, bank fees, software, rent (optional) and other overheads
  6. Training time/cost
  7. Alex’s time improving the systems in the business or other growth projects
  8. Profit

However, the first item in the list soaks up the margin, unless Alex accepts $10/hour, so selling more websites isn’t the answer.

Here’s a few ideas on how Alex could improve the margins:

  • Raise prices: $2,000 is a low price for a custom website. With a little bravery, and a little sales training, this will be the most effective way for Alex to improve margins and profits. At $4,000 per website, that’s a massive improvement in margin, even if Alex puts in a little extra effort to “justify” the higher price.
  • Remove unwanted inclusions/features: wasting time doing unnecessary or unneeded things means more cost and worse margins.
  • Standardise processes to improve productivity: less work and faster work means less cost, which means better margins and profit.

Alex chooses to raise prices, as that doesn’t require doing more, just doing things differently (10 seconds of bravery on a sales call), and gradually moves up to charging $4,000 per website. That’s still a low price for a custom website, but the margin of $2,500 (62.5%) is an enormous improvement over the $500 (25%) previously.

Alex was completing two websites per month, and maintains this at the new price, so that’s an extra $4,000 per month of profit (because there were no extra costs with the price rise)!

Alex hires more help in the business; a project manager to liaise with clients and make sure the team completes the work on time and at the right quality level. Alex works less on client work.

Alex spends $750 of that on marketing, and is able to bring in at least one extra website client per month, so that’s another $2,500 of margin per month that didn’t exist before. A portion of this extra money is re-dedicated to marketing, and the virtuous cycle continues.

From overwork, stress and low income, Alex is now free to spend more time and money on improving and growing the business, while working less and earning more.

I didn’t make this up! It’s based on a real client, with a few details changed to protect their privacy.

Action steps for you

There’s a lot of important info in this post, even though I’ve tried to keep it as simple as possible.

So here’s a summary of the action steps for you:

  1. Calculate your margins, at least for your most popular offer.
  2. Compare your margins to the ideal number.
  3. Brainstorm ways to increase your margins.

There’s an extra optional step: get in touch if you need help with this. If you’re not sure that you’re calculating your margins right, or not sure what to do about them, I can help. Just send me a message.

Footnotes are fun:
Note 1: There are lots of different names for margins but let’s keep the jargon to a minimum and go with “margin” for now.
Note 2: ‘Pareto’s principle’ suggests that most of the results (80%) come from few inputs (20%). This has been popularised as “80/20” and used to encourage people to focus on the few things that really matter (such as margins!).

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Ben McAdam

Hi, I'm Ben. I uncover hidden profit opportunities for small business owners. I've been advising business owners in Australia, the US, Canada, the UK, Europe and Asia for over a decade on how to grow their business, and their profits, faster. Book a free call to see if we're a fit, or see here for different ways we can work together...
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