Impact of margin optimization on business growth

From: alexhormozi

Introduction to Margin Optimization

Many small to medium-sized business owners struggle with understanding the difference between gross and net margin, which is a critical factor in a business’s health and investment potential [00:14:09]. A lack of clarity on these concepts can lead to working an entire month only to find minimal profit in the bank account [00:00:00]. This video focuses on optimizing margin as a primary strategy for maximizing business profits [00:32:00].

Gross Margin vs. Net Margin

Understanding the distinction between gross and net margin is fundamental for business profitability [00:21:00].

• Gross Margin: This represents the money left over after deducting the direct costs of fulfilling goods or services from revenue [00:49:00]. It’s calculated as Revenue minus Cost of Goods Sold (COGS) [01:11:00].
  • For service businesses, COGS refers to the incremental cost of delivering an additional unit of service, such as payroll hours for the service provider [01:17:00]. It does not include fixed costs like front desk roles, HR directors, or rent [01:36:00].
  • To calculate the gross margin percentage, divide the remaining amount (Revenue - COGS) by the total revenue [03:05:00].
• Net Margin: This is the “chop” or “juice” left at the end of the month after all expenses are paid, including operational costs, marketing, rent, and non-essential payroll [01:51:00], [06:00:00]. This is the amount you take home [02:00:00].

While both are important, gross margin is considered the primary driver of net margin, making it a key focus for business improvement [02:08:00].

Impact of Gross Margin Optimization

Even small increases in gross margin can have a significant impact on a business’s net profit. For example, increasing gross margins from 66% to 80% can more than double (2.2x) net margins at the end of the year, potentially raising them from 12% to 26% [03:47:00]. This emphasizes the vital role of leverage and efficiency in scaling business operations [07:12:00].

For service-based businesses, a target of 80% gross margin is recommended as a rule of thumb [04:21:00]. Highly successful businesses often operate with 99% gross margins [06:16:00]. The difference between 80%, 90%, and 95% gross margins is substantial, as each increment doubles the profitability of the business [06:48:00]. This means a business can acquire twice as many customers for the same cost, enabling significant scaling business operations and managing growth [07:09:00].

Example Scenario

Consider a service selling at $60withaCOGSof$20, resulting in $40remaining.Thistranslatestoa66$40/$60) [02:51:00]. If the business aims for an 80% gross margin:

• The cost would need to decrease to $12($60 revenue - $12COGS=$48; $48/$60 = 80%) [04:40:00].
• Alternatively, the price would need to increase to $100($100 revenue - $20COGS=$80; $80/$100 = 80%) [05:12:00].

Methods to Increase Gross Margin

There are two primary ways to increase gross margin percentage:

1. Decrease the Cost of Fulfilling the Service/Good: This involves finding ways to lower the direct expenses associated with providing your product or service [05:04:00].
2. Increase the Price Charged: This involves raising the selling price of your service or product [05:12:00].

Entrepreneurs sometimes feel hesitant about charging more for services that don’t cost a lot to deliver [07:23:00]. However, failing to optimize pricing and costs can lead to insufficient profit for marketing, customer acquisition, and overall business growth [06:03:00]. Achieving higher gross margins is crucial for a business to scale and help more people [07:34:00]. This forms a core tenet of leverage and scaling in business growth [07:12:00] and is considered an effective business framework for growth [01:14:00].

Real-World Coaching Business Example

A coaching business paid its coach $4,000permonth.Eachcoachcouldhandle40clients,andpackagesweresoldfor$1,200 for three months, equating to $400 per client per month [09:57:00].

• Total Revenue per coach: 40 clients * $400/month=$16,000/month [10:50:00].
• Cost of Goods Sold (COGS): $4,000 (coach’s salary) [11:14:00].
• Gross Margin: $16,000(revenue)-$4,000 (COGS) = $12,000 [11:20:00].
• Gross Margin Percentage: $12,000/$16,000 = 75% [11:31:00].

Even though 75% seems high, bumping it to 80% could lead to a 25% increase in net margins at the end of the year [11:51:00]. To reach 80% gross margin, the business would need to:

• Charge clients an extra $20permonth(raisingclientcostto$420) [12:54:00], OR
• Reduce the coach’s pay to $3,200 per month [13:01:00].

This demonstrates the power of optimizing gross margin for overall business success and growth.