Last week, I participated in CompTIA's IT Channel Management Executive Workshop, and while the two-day training was jam-packed with actionable lessons, one of the biggest eye-openers for me was that MSPs often don't understand their own finances. Here on the blog, we're always offering advice on services to add or relationships to leverage to grow your bottom line, but what does that actually mean? What goes into that metric? Revenue and profitability are two different key performance indicators (KPIs), and it's vital to know what impacts both in order to grow and scale your MSP business.
Understanding Your Income Statement
In order to understand your business's various line items, we'll look at a sample income statement:
image source: http://financetrain.com/income-statement/
Let's examine each of these in greater detail:
This is a figure you already understand because it represents what you make in sales. It's the amount you invoice for each of your customers.
Cost of Goods Sold - though often defined as Cost of Goods and Services for MSPs - (COGS)
COGS measures the direct expense associated with the products and services you sell. As you can see in the sample above, this number breaks down into the cost of materials, labor and overhead.
Note: Gross profit and gross income are synonymous with one another. Here is the first key formula you need to know in order to think like a CFO:
Revenue - COGS = Gross Profit
That's right, gross profit represents the difference between the first two metrics above because it gauges how efficient a company is at using labor and materials. According to Investopedia's definition, gross profit "considers variable costs, that is, costs that fluctuate with the level of output."
Gross Profit Margin
While not included on the example income statement, this is another term to be knowledgeable of. To calculate your gross profit margin, simply follow this formula:
Gross Profit/Revenue = Gross Profit Margin
You always want to monitor this metric because over time, gross profit margins can decline while gross profits increase. What's the takeaway then? If for instance your gross profit were higher in 2015 compared to 2014, but your gross profit margin was lower in 2015, you know your use of raw material and labor during the production process in 2015 was not as efficient as it was in 2014.
Operating expenses cover the cost of maintaining business operations daily. These are typically fixed costs that you must pay even when no sales occur. What we often really care about when looking at operating expenses, however, is selling, general and administrative costs (SG&A). These are costs such as advertising, rent, utilities, insurance, benefits, etc.
Operating Income or Profit
Note: Operating income and operating profit are used interchangeably. To calculate this metric, we use two of the others we've already found:
Gross Profit - Operating Expenses = Operating Income
Note: You technically also deduct depreciation and amortization, but we'll keep it simple for the purpose of our example.
Investopedia defines operating income as "the amount of profit realized from a business's operations after taking out operating expenses."
Similar to calculating your gross profit margin, to find operating margin, use this equation:
Operating Income/Revenue = Operating Margin
Operating Margin measures your MSP business's operating efficiency. Following the same logic as earlier, it's not enough to only look at your operating income over time. You have to know how your margins behave in order to make adjustments.
Other Income & Expenses & Income Before Tax
Then, you'll notice in the example that we add other income and expenses (like interest) to operating income to find income before tax. From there, we apply the tax rate and deduct it from our income before tax to find net income.
At last, we've reached the bottom line item on your income statement! Net income is an important metric because it tracks how profitable a company is over time, hence why it's also referred to as net profit.
Revenue - COGs - Operating Expenses - Interest and Taxes = Net Profit
Gross Profit - Operating Expenses - Interest and Taxes = Net Profit
Operating Income - Interest and Taxes = Net Profit
This is the number you want to pay close attention to, as it tells you "how much of each dollar earned by the company is translated into profits" according to Investopedia.
Note: For longer descriptions and examples of each of these line items, check out Investopedia's full dictionary of terms.
So How Can You Increase Your Net Margin?
Alright, we've covered a lot of good financial information so far, but none of it matters if you can't apply it. We've explained all of the variables that determine your net profit and net margin, but how can you manipulate these individual line items to increase your margins and grow your bottom line?
To do this, you can increase the price of your managed IT services or you can add additional revenue streams, such as backup and disaster recovery (BDR) and mobile device management (MDM) to your portfolio. We can even take this one step further and say that to increase revenue, you have to become better at selling and increase your close ratio. Since a true channel vendor is invested in your success, they should help you achieve this.
One way to influence COGs is by receiving a discount on the managed IT services technology you buy from vendors. Often, MSPs are incentivized to sell more with the promise of a bundled discount. In this case, you can increase revenue and decrease COGs at the same time!
The most obvious way to decrease COGs, however, is to decrease the cost of labor. Now, that doesn't mean you should go fire all of your techs, but consider the following two cases that increase COGs and deter business growth:
- you experience high technician turnover, and have to replace each employee to maintain productivity
- you staff techs through the night because you don't know when an alert will come in
In the first scenario, you can reduce payroll without reducing headcount. By working with an RMM vendor that offers fully managed support, the team of highly skilled and certified technicians at your network operations center (NOC) acts as an extension of your IT staff, but at a fixed cost that you can scale over time. What is a NOC? We explain here.
Using a fully managed IT services platform means you also receive 24x7x365 coverage without having to pay to staff techs through the night. The less hours you have to pay for labor, the lower your COGs.
With this new outsourced solution on the table, let's consider revenue again. Have there been any projects that you were unable to complete because you didn't have the bandwidth or expertise on staff? Working with a team of NOC technicians lets you meet these demands and add back that revenue.
Decrease Operating Expenses, in this case SG&A
Recall our example of high tech turnover from the COGs example. If you didn't have to replace each of these employees, how would that impact your SG&A costs? Well, think about it. Each employee you staff requires their own insurance, benefits, training materials, recruiting fee and equipment. Yes, even that extra Office 365 license you purchase for their replacement adds to SG&A and decreases net profit. Again, with an outsourced solution, you can cut these costs and grow your margins.
Alright, so let's recap some of the big themes we've learned in this post.
- You can't hope to grow your business and scale for that growth if you don't understand your business financials.
- A channel vendor who's a true partner will do everything in their power to help you optimize your Profit and Loss (P&L).
- Growing revenue is good. Growing profitability is better. You have to look at both!
- Your profitability is dependent upon the business partnerships you form and the models you adopt. If you're not working with vendors who are helping you grow your margins, it's time to evaluate another solution.
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