Last week we looked at gross profit margin. This week we’re looking at overhead percentage and how both these figures determine your eventual net profit. More importantly, you’ll see how you can use these figures to highlight key issues in your business and save months, or even years of time wasted by working on the wrong issues.
A Quick Recap:
As discussed last week, the starting point for understanding your financials are the three critical figures:
a) Gross Profit Margin
b) Overhead Percentage
c) Net Profit Margin
Here’s a very quick refresher on how to calculate your gross profit.
Turnover – Direct Expenses = Gross Profit
Make sure that you calculate your Direct Expenses correctly, especially when it comes to including a genuine market salary for working directors. Take a look at last week’s article if you haven’t already, for a step-by-step guide on how to do this.
Overhead comprises all other costs of running your business, after direct expenses.
The overhead percentage is critical. Poor management of your overhead costs means you will end up with unsatisfactory net profit levels. Calculating your overhead is simple:
Total Expenses – Direct Expenses = Overhead
Then it’s one extra step to calculate your overhead percentage:
Overhead ÷ Total Revenue = Overhead percentage
In a business that is performing well, an overhead percentage that does not exceed 35% of total revenue is considered favourable.
In small or growing firms, the overhead percentage is usually the critical figure that is of concern. It is often compensated for by the owners accepting less than market salary, then convincing themselves they are making acceptable profit margins. This is a key pitfall to watch out for.
In the following example, we have two working directors who draw only £60,000 of salary and/or dividends each per annum. Yet with each of them bringing in £250,000 of annual revenue, they should be receiving far higher levels of remuneration.
Despite their overhead percentage being well above benchmark (55% instead of 35%), their bottom line net profit comes in at a respectable 21%; potentially misleading them into thinking they’re making an acceptable net profit.
Less direct expenses: £120,000
Gross profit: £380,000 (Margin = 76% or £380,000 ÷ £500,000)
Less Overheads: £275,000 (Percentage = 55% or £275,000 ÷ £500,000)
Net Profit: £105,000
Net profit margin: 21% (£105,000 ÷ £500,000)
However, if they were both drawing a genuine market salary (say £100,000 each pa), their true net profit figure is only 5%.
Net Profit Margins
Net profit is what remains after direct expenses and overhead are paid. This is the owner’s reward for the risks of running a business, over and above their market salary/drawings, which are fair compensation for the job they perform within the business.
Favourable performance within an advisory firm is a net profit margin of 25%. High performance firms can even exceed this level of profitability. The vast majority of UK firms don’t hit this basic profitability level, after the owners take a fair market salary (i.e. what they could be paid if they took a job down the road with one of their competitors).
Total Revenue – Direct Expenses – Overhead = Net Profit
Net Profit ÷ Total Revenue = Net Profit Margin
In a well-performing business, the critical percentages would look like this (highlighted in bold):
Less direct expenses: £200,000
Gross profit: £300,000
Gross Profit Margin: not less than 60% (£300,000 ÷ £500,000)
Less Overheads: £175,000
Overhead Percentage: not more than 35% (£175,000 ÷ £500,000)
Net Profit: £125,000
Net profit margin: 25% (£125,000 ÷ £500,000)
By understanding and analysing these three critical figures you can begin to identify if you have a profitability issue, and if so where you need to focus your energies.
- Is it a gross profit margin issue (paying away too much to advisers); or
- Is it an efficiency and productivity issue (needing too many people in the back office to process the work)?
Simply pinpointing the problem can be a giant leap forward. Take a look at these three critical figures in your own business and see how things are looking.
It might be a real eye opener.
By Brett Davidson