Gross margin is one of the most important metrics across all types of businesses. Many investors in public and private companies weigh gross margin heavily in valuation calculations and investment decisions. For professional services firm leaders, it is critical to understand gross margin and track it at a few specific levels within the firm.

Before tackling the concept of gross margin, we first must first define a couple of other accounting terms:

• Cost of Services Sold (or “COSS”) – The COSS is the total cost of delivering the services to the customer. In a product company, this is referred to as the Cost of Goods Sold (or “COGS”) and can more generally be referred to as the Cost of Revenue (or “COR”). Any cost that you incur to deliver services to your clients goes into the COSS figure. This primarily includes the labor costs of the delivery personnel (including payroll taxes and benefits) but it can also include sales commissions, shipping costs, and the like. If you removed any element of COSS, you wouldn’t be able to deliver services to clients in the current manner.
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• Gross Profit – The gross profit is simply the revenue generated from services minus the COSS. So, if a project generates $200,000 in services revenue and costs $125,000, the gross profit would be $75,000.

To calculate gross margin, we simply divide the gross profit by the services revenue. In our example above, the $75,000 in gross profit would be divided by the $200,000 in services revenue to yield a gross margin figure of 37.5%. Note that gross profit is always expressed in terms of dollars while gross margin is a percentage.

At first blush, $75,000 of “profit” on a $200,000 project might seem like a fantastic outcome. But that $75,000 is before the company has paid any of its operating expenses related to sales, marketing, accounting, human resources, administration, legal, income taxes, office leases, and other related expenditures. By the time all of those other costs are absorbed, the $75,000 in profit could be zero, or less than zero.

Different companies can have vastly different operating expenses and thus a gross margin of 37.5% might be low for one firm and high for another. For example, if Firm A has 5 salespeople, a CFO, a controller, 5 marketers, and a lot of office space in a premium part of town, it could easily be losing money on a gross margin of 37.5%. But Firm B may run remotely (no office space), have no salespeople, a junior marketing person, one HR leader, and an outsourced accountant. Firm B has tiny operating expenses compared to Firm A and could generate a healthy operating profit on the same 37.5% gross margin.

Where to Measure Gross Margin

For services companies, it is important to measure gross margin in three distinct areas – at the individual project level, the practice or project type level, and the firm level. Each of these are covered below:

• Project Level – Project Gross Margin allows you to compare one project to another. If one project has a 40% gross margin and a similar type of project has a 20% gross margin, it likely indicates trouble with the second project. It is important to compare projects of similar types and also compare projects to their estimated (planned) gross margin. Before a project has begun, it should have a planned gross margin and the project manager should track performance against that margin throughout the project. Note that it may not be useful to compare the gross margin of projects of different types. For example, a staff augmentation contract will likely have low gross margin but minimal risk and maximum billable utilization over a long period of time. So, it’s okay for that staff augmentation project to have a lower gross margin than a traditional project that is shorter in length and carries additional risk elements (like “scope creep” and bench time after the project ends).
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• Practice Level – If the professional services firm is large enough to have different practices or different types of projects, it is useful to track gross margin across those practices or types. For example, if a management consulting firm has a Mergers & Acquisitions practice and a Spend Optimization practice, it is helpful to evaluate the gross profit and gross margin of each practice. These figures can inform company leaders as to which practice to prioritize in terms of growth investment.
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• Company Level – At this level, the gross margin is a roll-up of all of the services revenue and costs over a period of time. By analyzing gross margin at the company level, firm leaders can compare one financial period to another (i.e. Q4 this year compared to Q4 last year).
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It is nearly impossible to make intelligent strategic business decisions without a solid understanding of gross margin. It is imperative that company leaders understand the concept and work with their controller or CFO to ensure that it is being tracked accurately at each of the three levels above.