Regularly checking your margins is crucial for keeping your business financially healthy. Your gross margin is the gap between your income and expenses. You can analyze it from various perspectives, such as individual, project, or overall company. Gross margin differs from net margin, which factors in allocated overhead and indirect costs.

Through calculating and regularly monitoring your margin, you gain valuable insights into the financial health of your business.

Learn more: What margin should my firm have?

In this article, you’ll learn:

• The difference between gross margin and net margin
• What to include in gross margin calculations
• The definition of a load factor
• Whether you should create a load factor
• How to account for practice leadership time in your margin calculations

How do margin definitions change when talking about services firms?

At a high-level, services executives might discuss four different types of margin, moving from the account level right up to the company’s overall margin, or EBIT/EBITDA.

Account Margin

Account margin will be of particular interest to account and project managers in your company. This measure helps you figure out which clients are most profitable and which ones might be losing you money.

When calculating account margin, you are solving for the margin of a single account (or client). To do this, you subtract any costs associated with the account from the revenue generated by that account.

Calculation: ((account revenue (single account) – costs to deliver the work) ÷ account revenue (single account)) × 100 = account margin %

Remember to include direct costs, for example software required to deliver a project.

When calculating account margin, each firm decides whether to load in the indirect costs per person here or at the gross margin level.

To load in indirect costs, you’ll need to create a load factor.

Creating a load factor

Load factors account for additional employee costs, like payroll taxes and benefits. They are often realized by applying a percentage to employee costs. A load factor helps you to determine the true cost of an employee.

You may not be aware that there can be different levels of load.

• Basic - payroll taxes, benefits, PTO/leave
• More advanced - training time, practice development (e.g. interviewing to build the firm)

Gross Margin

In contrast to account margin, which calculates margin per account, gross margin calculates the margin across all accounts in your client portfolio.

Gross margin is a good indicator of the overall health of your client work. If your gross margin is strong, then scaling your business is worth investment in sales and marketing (which would come out of operating margin).

To determine gross margin for your company, simply add together your account margins across all accounts, then subtract the costs to deliver the work. These include the costs that are part of your cost of goods sold (COGS). This typically includes practice leadership, bench (team members not on a billable project), and any other non-billable time.

Calculation: ((account margin across all accounts – direct costs to deliver the work – bench costs – practice leadership costs – any other non-billable time) ÷ account margin across all accounts) × 100 = gross margin %

What to include in your gross margin calculation

Direct costs are those you incur when delivering a specific project, and may include:

• Consultant wages
• Subcontractor costs
• Material costs (expenses)
• Travel costs (expenses)
• Project-specific tools (e.g. a software purchased to complete the project)

Gross margin for your company doesn’t factor in the following costs:

• General and Admin operating costs
• Marketing and Sales costs

Including practice leadership time in gross margin calculations

Because practice leadership staff are often working at a strategic level, it can be difficult to know whether to include their hours in certain margin calculations. In the example provided here, you should factor practice leadership time (and therefore costs) into your gross margin calculation across all accounts.

The rationale for this is that practice leadership is part of creating the service you provide to the customer, or part of your cost of what you sell.

Operating Margin

Operating margin measures how profitable the company’s core operations are (separate from one-time revenue such as government incentives, and/or non-recurring expenses like moving offices or large legal fees). It takes into account general administrative costs and the costs incurred by your marketing and sales functions.

A positive operating margin is a good sign - it means your core business is operating well. If your margins are above average for your sector, you have a great core business that will likely scale successfully.

Calculation: ((gross margin – general and admin costs – marketing and sales costs) ÷ gross margin) × 100 = operating margin %

What operating margin doesn’t measure is whether your company’s admin and your go-to-market are healthy.

Net Margin

Finally, we reach net margin. Net margin is also known as company overall margin, and takes into account all non-standard (or indirect) costs. Indirect costs include office rent, utilities, taxes, etc.

Company overall margin is also known as earnings before interest and taxes (EBIT).

Calculation: ((operating margin – all non-standard costs) ÷ operating margin) × 100 = net margin %

A company’s net margin will be of particular interest to private equity investors, because it provides a clear picture of your profitability (and therefore value as a prospective investment). Net margin is typically seen as the gold standard for figuring out what a firm is worth. You’ll often see private equity firms use a multiple of EBIT and the growth rate to determine the value of a firm.

How to automate margin calculation

The most difficult part of calculating your margin is gathering all the relevant information. Using PSA software, you’ll be inputting all the data you need in one place through timesheets and invoices. That data is then gathered in real-time to show you your current profit margin, often expressed as a percentage—no manual calculations needed!

For a predicted profit margin of your project, you’ll also want to use PSA software, as it can be a confusing process to manually calculate what revenue you expect to bring in from any given project once you’re underway. Data from your timesheets, invoices, markup on expenses, revenue forecasting, and your future resource plan all connect to produce a predicted profit percentage.

Common mistakes to avoid

Calculating profit margins for professional service firms can be complex, and various errors can compromise your accuracy. Here are 3 common mistakes to avoid:

1. When calculating gross margin, subtracting admin/general and marketing/sales costs.
2. Failing to invoice in a timely manner. If you’re struggling to get invoices out and paid on time, consider using PSA software to support the process.
3. Outdated information can give the wrong idea of the business's financial health. This is because it may not show the current costs, market conditions, or revenue patterns.

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Knowing your margin is vital for your business

In summary, calculating and understanding your gross and net profit margins is crucial for the financial health of professional service firms. With a clear picture of margin, you can better price and resource projects. Adopting sound margin calculation practices, such as using a profit margin calculator/gross margin calculator, ensures a clearer financial picture and informed decision-making for sustained success.

If you want to know what a good net profit margin might look like for your unique business model, click here to read our benchmarks for professional services firms.