Gross Margin is often viewed as a simple way to ascertain a company’s profitability. Our view is that in its common form, a single percentage, it is largely meaningless. But viewed through the right lens and tracked over time, it is an extremely useful measure. Understanding this distinction is critical for any owner, operator, or M&A practitioner evaluating the health and scalability of a services business.
The Formula Is Simple; The Definition Is Not
Gross Margin is a non-GAAP measure, so its definition is not universal: it is derived by the individual company with no external validation or audit. While Revenue has a clear definition, the standardization of Cost of Sales depends heavily on the industry. Services businesses, which must attribute personnel-related expenses to revenue-generating activities, have significant subjectivity in their calculations, particularly as people do more than billable project work.
At Bravery, having deep P&L experience across hundreds of professional services businesses, we don’t put much weight on a company’s GM snapshot, say 65%, but do take seriously GM over time.
The Classification Problem
While it sounds straightforward to determine which service delivery costs belong in Cost of Sales, it quickly becomes subjective. Consider the classification challenges for each of the following in a typical services firm:
- Billable hours: Clear, any hours that directly lead to revenue should be included in COS, whether employees or subcontractors
- Non-billable hours for billable staff: Is all their time COS, or only billable hours, or only client-related hours? Where does PTO, company tasks, and sales support go?
- Account management (non-billable): The effort supports ongoing delivery of revenue: is it COS or overhead?
- Methodology or IP development: SG&A investment, or a bench project that belongs in COS?
- Software and hosting supporting delivery: Should it follow the revenue it enables?
The classification of these scenarios is made by the individual company and varies considerably, a perfectly acceptable state of affairs that creates precisely the problem: Gross Margin is simultaneously a meaningless and useful metric.
GM Is Meaningless (In Isolation)
A company at 65% GM is not necessarily more profitable than one at 40%. It may simply have accounted for things differently; burying costs in SG&A that another firm classifies as COS. Without knowing the underlying definitions, the percentage communicates almost nothing.
GM Is Useful (Over Time)
Comparing a single company’s GM% over time is extremely valuable. An improving GM% shows the business is beginning to scale: each revenue dollar costs less to deliver on average. A declining GM% signals something is causing diminishing returns.
Incremental GM Is Really Useful
To make GM% genuinely forward-looking, calculate its differential or rate of change: the period-over-period incremental GM per dollar of incremental revenue. This reveals the marginal cost of delivering incremental revenue, rather than the average cost.
A business can show a slightly improving overall GM% while it is actually taking increasingly more spend to deliver each incremental dollar of revenue. The overall average looks healthy; the trend is concerning. Incremental GM exposes this before it shows up in EBITDA.
Consider a services business growing at 20% with a slightly improving overall GM%. Closer inspection reveals the incremental cost per dollar of revenue is increasing year-over-year; it’s just that the incremental GM% happens to be higher than the average, masking the deterioration in the margin on new work. This is the single best leading indicator of whether a business is scaling or grinding.
Best Practices for GM Classification
- Never assume consistency: Definitions changing over time make no measure of any use. Verify the methodology before drawing conclusions
- Understand the drivers of scale or diminishing returns: If GM is improving, know exactly why: it is your best indicator of future performance
- Pick a logical construct and stick to it: Every role is either COS or SG&A. All associated costs flow accordingly. Account Services is either COS or it isn’t; the key is consistency
- Formalize IP development budgets: Product or IP development with a formal budget can legitimately be treated as SG&A. Informal bench projects belong in COS
Gross Margin is extremely valuable in the right context, but that doesn’t make it valuable in every context. A business’s gross margin is only meaningful in the context of its underlying definitions and its change over time. In M&A due diligence, this distinction is the difference between a metric that confirms quality and one that obscures it.