In Focus

Gross Margins: Service Related Industries

Note: This article focuses on Step 6 of the Chicks' Dozen. For articles focusing on other Steps, see the links listed at the bottom of the page.

Wow, what a Calculator party we had yesterday! I've took my little black dress to the dry cleaners and I never want to see another glass of wine. (Until we get to the Flow Ratio, which takes a whole bottle.) As we discussed yesterday, it's simple to understand how to calculate the Gross Margins for a company that has a product to sell. The Chicks Dozen requires that a business make at least twice as much on the sale of their merchandise as they spend on making it. But what if they have no product? What if they don't have anything to sell that we can hold in our hands? How do we calculate the Gross Margins if our company is in a service industry like Federal Express?

Let's say the Chicks were going to sell their new information in home building. We learned so much in Americus, Georgia last week building a Habitat for Humanity home, that we have decided to take our expertise on the road. We will sell our handiwork and teach others to build (for a fee of course). We will call our new company The Chicks Nest®.

Much to our surprise, Habitat for Humanity has decided to book us through next July 2001. We will be touring the country and teaching women to build. (This is made-up by the way.)

Let's speed ahead to the end of July 2001 and see how the Chicks have done. Wow, it looks like there are quite a few sore muscles, tennis elbows and some broken nails. Now, not as important as the last sentence, let's see how the Gross Margins came out. How would you figure Gross Margins when the "product" was a service? Our product was our knowledge, our superior know-how in teaching women how to build a home.

We need to get a couple of numbers from the financial statement..

The Chicks Nest® Income Statement thru July 2001

Total Sales 20,000

Cost of Sales 18,000

It looks like Habitat paid us $20,000 for teaching our butts off. This number is reflected in the Sales. (Please remember this is FICTION.)

On the flip side, it cost us something to get the job done. Each Chick had to fly from their home city to the teaching location, we had hotels to pay for, and we had cars to rent. This is the Cost of our Service, and would either be called the Cost of Service, Cost of Goods Sold, or the Cost of Sales. It ended up costing us $18,000 to do this job. (They were really nice cars and hotels. Call us the "Snobby Chicks.") Cost of Sales = $18,000.

To compute the Gross Margins for a Service Industry, here's the calculation:

(Sales - Cost of Sales*) / Sales

Let's do The Chick's Nest's® Gross Margins:

($20,000 - $18,000) / $20,000

so that equals

$2,000 / $20,000 = .10

To change it to a percentage, which is how we report our Gross Margins in the Chicks Dozen, we multiply our decimal answer by 100.

.10 x 100 = 10%

The Chicks Nest has Gross Margins of 10%.

If you can believe this, The Chicks were almost doing their job for free. Our cost of service was almost as much as what we were paid. We don't want to see this. We want our companies to be making money on their service. We want them to be making at least twice as much on their service as it costs them to serve it. If they were, their Gross Margins would be 50% or greater. Luckily for the Chicks, our Income Statement isn't under the scrutiny of the Chicks Dozen, or the public. But if it were, The Chicks Nest® would not make the cut.

Remember, Gross Margins are figured the same for both a product industry (cars, drugs, computers, anything tangible) and for a service industry (internet, communications, and banks). The only thing that is different is the wording on the Income Statement. In a service related business, it will be called Cost of Service, Cost of Sales, Cost of Goods Sold, or Cost of Revenues. Simple as that!

I want you to know that this whole story was totally made up. Habitat did not pay us for working for them, nor would they ever. But, if you believed this Chick's Nest story, I'd like to invite you to my Black Tie party.and bring your calculator.

*Also called, Cost of Services, or Cost of Revenues

For more on how to find the Numbers on an Income Statement, check out Getting to Know the Financial Statements.

Articles focusing on the 12 Steps of the Chicks' Dozen:

Step 1: Buy What You Know

Step 2: Keep It Simple, Sister (K.I.S.S.)

Step 3: Industry

Step 4: Leader In It's Field

Step 5: Repeat Profitability

Step 6: Gross Margins, GM: Service Related Industries

Step 7: Net Margins

Step 8: Cash To Long-Term Debt

Step 9: Flow Ratio

Step 10: Increasing Growth

Step 11: Strong Management & Operating History

Step 12: Buy On Sale