We all love to talk about gross revenue. It feels terrific to brag when our gross revenue reaches new heights, but gross revenue just doesn’t matter. Profit is what counts. 

The real top line of your business should no longer be gross revenue, but the margin that the sale of your product or service brings into the business. This margin is first used to cover operating/overhead expenses and the remainder (after depreciation and interest) becomes pretax profit.

Everything you talk about in your business and every metric you watch should be based on margin, not revenue. Your sales team can generate a lot of gross revenue if you give them the ability to lower prices to make the sale. Instead, focus your sales team (and all of your team) on the margins they bring into the business.

Here are three key numbers you should be tracking as you focus your business on margin generation.

Gross Profit 

Calculate this as gross revenue less costs of goods sold such as materials and subcontractors. Do not subtract the labor used to create the product or service when calculating this number. We will need to track the direct labor number separately for some ratio work we will cover in a future column.

Contribution Margin 

Take the gross margin you just calculated and now subtract your direct labor costs to arrive at the contribution margin. 

Consider an employee’s labor as direct if they spend 50 percent or more of their time delivering the product or service. The contribution margin represents the dollars created from the sale of your product or service that can now be used to cover operating expenses and eventually become profit.

Pretax Profit

Take your contribution margin and subtract operating expenses, depreciation and interest to arrive at your pretax profit. Is yours as high as it should be? As it could be?

Of course, good and bad profit margins are industry specific, but if you’d like to get a general idea of how you are doing try this trick I learned from a book called “Simple Numbers, Big Profits” by Greg Crabtree.

Take your pretax profit and divide it by your gross profit, not your gross revenue. Remember to use gross profit or gross margin as we defined it earlier, with direct labor costs still in. 

This small change alleviates much of the differences between companies with large costs of goods sold (general contractor) and those with little (service companies). Now you can do a very simple analysis of your profitability using the following scale developed by Crabtree.

Five percent or less: Your business is on life support. Start making changes fast.

Ten percent: You have a good business.

15 percent or more: You have a healthy business and probably significant competitive advantages. Or you are a first mover in your niche and you can expect competition to come and cut into your profits soon.

If your business is really big (think Amazon) or in industries like distribution or grocery stores, this simple math will probably not work for you and you should be benchmarking against your industry and competition. These numbers are a great starting point.

I highly recommend industry groups consisting of non-competing peers that are willing to share financial data. Industry data is and always will be flawed by who reports the data and the accounting used to create the numbers. 

In a peer group, you can peek behind the numbers to understand the true profitability and operating costs of your peers. Peering beneath the numbers is how to uncover best practice practices you can use to grow your profits.

But if you are a small business, this simple math should give you a great idea of how you are doing.

Have a business growth topic you’d like me to cover or just want to talk margins? Send suggestions to cfowler@valuesdrivenresults.com.

Curt Fowler is president of Fowler & Company (http://valuesdrivenresults.com/) and director at Fowler, Holley, Rambo & Stalvey (http://valdostacpa.com/). He is dedicated to helping leaders create and achieve a compelling vision for their organization. He is a syndicated business writer, keynote speaker and has an MBA in strategy and entrepreneurship from the Kellogg School. He is also a CPA and a pretty good guy as defined by his wife and four children.

Jason Smith is a reporter at The Valdosta Daily Times. He can be contacted at 229-244-3400 ext.1257.