Understanding Your Finances: Overhead Percentage

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 Percentage

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.

For example:

Turnover: £500,000

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


And therefore:


Net Profit ÷ Total Revenue = Net Profit Margin


In a well-performing business, the critical percentages would look like this (highlighted in bold):

Turnover: £500,000

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)


The Insight

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
Google

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5 thoughts on “Understanding Your Finances: Overhead Percentage

  • Good, clear, wise words.

    It’s hard to imagine that people who support this forum would not have a good grasp of the issues you cite. Particularly given many may be advising clients about them.

    Do you happen upon many small IFAs where these issues arise?

    I know a few from my study group who run “lifestyle businesses”, with no intention of onward sale. They’re very profitable to the extent they are fulfilled and enjoy a good life. I doubt, however they add back (or need to add back) an allowance in the expenses line for notional basic salary.

    I guess many IFAs like us, extract very satisfactory profits using dividend strategies while hopefully leaving behind a strong balance sheet for compliance. At the same time, keeping eyes open for future mergers or sale opportunities. When such times arise, I can see the case for ensuring your business generates enough for a decent salary and for plenty of excess profit to compensate the buyer.

    Interesting stuff.

    Paul

    Reply
    • I find this is the norm, Paul, I explain it quite a lot (and always use the £100k figure). I agree it might only be an issue for some on sale but I know a few firms who’ve not picked up on it Andrade very little on an earn out as a result. There’s a fair few advisers who don’t even red the terms of their own business sale agreements.

      Reply
  • I find almost no advisers understand this stuff and I’m not certain they are advising clients about it. Typically they are good at pension and investment issues and the strategic thinking clients need.

    It’s fine to be running a lifestyle business but I’d still be reporting to yourself on this basis. You may well discover you’re earning an income and having a great time, whilst making no real profits. Nothing wrong with that if that’s your objective. But as Phil says, this has ramifications down the track in terms of sale value.

    It also has implications in a range of other areas that require the business to be strong financially. Typically business owners act as the bank and so a strategy that sees you only earning an income puts that very same income under pressure in tough times or if a stronger financial position is demanded by regulators.

    I think even lifestyle firms ignore understanding genuine profitability at their peril. Personally, I think it’s still important to run a business on good business principles regardless of size or ambition.

    Reply
  • For our business the most important outcome of regulation since its first incarnation,( for us at least,) as NASDIM and subsequent pathway to todays FCA has been this very discipline which we were forced to embrace.

    Although we had very successful sales careers the availability of indemnity commission tended to encourage us to work within very short time frames and to react to any financial hiccups with increased sales activity.

    Over time we knocked ourselves into a structured business with all of the disciplines so well described by Brett and can now look back with great satisfaction on more than thirty years of profitable audited accounts.

    I am not sure about profitability having any impact on the value of a business in our industry as I have yet to find any business which has actually been bought with real money as opposed to having existing income recycled back over time as a purchase price.

    Hopefully over time the industry will focus on profitability over turnover and a sensible market will evolve for business sales.

    Keep banging the drum Brett – you have to win in the end !

    Reply
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