In an earlier post, we were introduced to the concept of gross margin. Let’s play this through with the help of our heroic entrepreneurs who are helping the students and faculty of Premier Law School to achieve their dreams (or at least, to stay awake during class!) If you need a quick overview of the caffeine delivery ecosystem, you can take a look at the posts where we introduced Alpha, Beta and Gamma and analyzed their business models.
Example: Alpha’s coffee cart
Alpha runs a bare-bones operation. He’s a one man band, a lone hero. Let's look at Alpha's income statement at the end of a week of operations. By looking at his management accounts at the beginning of the week and at the end of the week, he can tell that:
- he has collected 2,000 bizcoins in revenue from his customers, and
- he has used 800 bizcoins in ingredients. (For simplicity's sake, we will ignore the value of the entrepreneur's time in each example.)
| Revenue | 2000 |
|---|---|
| Cost of Goods | 800 |
| Net Profit | 1200 |
This means that his profit for the week was 1,200, and his margin was 1,200/2,000 = 60%
Example: Beta’s sit-down coffee scene
Beta runs a more sophisticated operation. His coffee comes with seating, music, biscuits and slow, curling rings of academic cigarette smoke. And he earns a lot more money: His revenue for the same period was 4000, but he has spent 1800 in coffee, sugar, milk and matches and glucose biscuits. He also had to pay his cousin for helping out during the week, and the watchman for keeping an eye on the spot. Here’s his income statement:
| Revenue | 4000 |
|---|---|
| Cost of Goods | 1700 |
| Salaries | 100 |
| Facilities upkeep | 200 |
| Net Profit | 2000 |
This means that Beta's profit for the week was 2,100, and his margin was 2,000/4,000 = 50%.
Drilling down into gross and net margin
At first glance, it looks like Beta's business is a lot less profitable than Alpha's. But what happens if we start to pull apart these mini income statements so we can see gross profit and net profit?
Alpha has no expenses beyond the week's ingredients, so his income statement remains unchanged. We can just say that in this case gross profit is equal to net profit. Alpha’s gross margin is the same as his net margin, which is 60%.
But Beta's income statement has more expense items, and can be separated into direct costs and indirect costs. If we make the distinction, and introduce our “gross profit” line as an analytical rest-stop, his income statement will look like this:
| Revenue | 4000 |
|---|---|
| Cost of Goods | 1700 |
| Salaries | 100 |
| Gross Profit | 2200 |
| Facilities upkeep | 200 |
| Net Profit | 2000 |
Beta's gross margin is now 2,200/4,000 = 55%.
Pictures are nice. Let’s look at a picture:
55% is closer to Alpha's margin of 60% but it still lags. Why? Because as we know, Beta is running a more sophisticated business with more costs: There’s an extra person to pay, and he is giving away matches and biscuits to customers in order to win business and increase customer loyalty.
Using gross margin to peer into the future
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| A source of experience-enhancing ambience, paid for by gross margin |
Gross margin tells you at a basic level whether a business creates value or not. It is also the first test of long-term commercial viability. Why? Because the world changes, and businesses need to adapt in order to keep up. Spending on marketing, controls, research and development (yes, even a coffee cart can experiment with new flavors, new recipes, and new strategies) will all be paid for from gross margin. The funds for expansion and adaptation need to be either generated by the business itself, or paid for by investors (which is often perfectly fine, at least in the short term.) And there is a certain amount of basic reinvestment that is required, just to keep the business running as is. Gross margin needs to cover all of this, and still have something left over to return to the shareholders.
We can easily see this in our examples: Beta has begun spending some of that margin on maintaining a larger infrastructure that is helping to deliver scale. But even Alpha will eventually have to allocate some of his gross profit to non-core activities and expenses: A week from now, the kettle will need to be cleaned. A month from now the cart will need to be repaired. A year from now the cart and kettle will need to be replaced. (For those of you who remember your accounting, the assets are depreciating.) All these things cost money, and the business needs to pay for this out of the gross margin it generates.
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| A fully depreciated asset |