Leveraging contribution margin

May 14, 2019 -  By

Graph: Ken ThomasMost landscape business owners understand the value of gross margin as a key performance indicator. Gross margin is the total dollars remaining after you have covered your direct cost of goods. Gross margin can be measured in dollars or as a percent of revenue. In our industry, healthy gross margins fall within the range of 45-55 percent of revenue for landscape services, based on work mix and location.

In our consulting business, we work with companies all over the country, both small and large, and we’re starting to see a common trend. Companies are hitting reasonable gross margins but not realizing their net profit goals. The question is why, and the answer is simpler than you think: They have gotten fat in the middle. In other words, their indirect expenses have gotten out of scale with revenue. Expenses on the income statement can be broken into three main categories:

  • Direct costs;
  • Indirect costs; and
  • Fixed costs.

Direct costs appear at the top of the statement and are defined as expenses that can be charged directly to a specific job, including materials, labor and equipment.

Fixed costs appear on the bottom of the statement and are associated with rents, utilities, owner compensation and facilities. They are easy to budget and typically fall between 15-20 percent of revenue.

Indirect costs appear in the middle of the income statement and can be described as expenses that are needed to produce the work but can’t be charged to a specific job. Indirect costs are mostly composed of fleet and equipment expenses and operations management, including account managers.

As companies grow and struggle with getting the work done, it’s not uncommon to throw resources in the form of equipment and managers at the problem. Unfortunately, this can inflate indirect expenses if top-line growth does not keep up. A reasonable target for total indirect costs is 22-25 percent of revenue. Operations management, including account managers, should remain below 8 percent.

A key metric in measuring how well a company is leveraging its indirect expenses is contribution margin (CM). CM can be defined as the amount of dollars/profit remaining to cover fixed costs and make a profit. A healthy CM percentage in our industry is anything north of 27 percent. The key to reaching a healthy CM
is to manage your indirect expenses.

If your gross margins and fixed cost percentages are in line, but you’re not hitting your net profit targets, take a hard look at your contribution margin. You may have become fat in the middle.

This article is tagged with and posted in 0519

About the Author:

Thomas, founder of Envisor Consulting, has owned three of Atlanta’s most successful landscape companies. Reach him at kenthomas@envisorco.com.

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