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Profit Margin Drivers for a Service Business

Profit Margin

Many service businesses are small, privately owned firms with one owner or a few partners. While many aspire to grow, profitability is more critical because:

  1. The paychecks of the owners depend on the profitability of the business.
  2. They are not venture capital-backed companies that can afford to lose money for an extended period of time.
  3. Most service businesses need to be profitable to stay in business.

Unfortunately, many small businesses struggle with profitability.

Of course, well-managed and profitable service firms can manage profit margins of 10% to 15% or higher. How do they do that?

Let’s dive in and understand what drives profit margins for a service business.

Profit Margin Components

Let’s start with review of key profit margin components in a service business. Here’s an example: ServicePro delivers $100,000 per month of revenue and has the following breakdown of operating expenses and profit margins:

Accounting Segment Monthly Amount % of Revenue
Revenue $100,000 100%
Cost of Goods Sold ($10,000) 10%
Gross Profit $90,000 90%
Cost of Services ($50,000) 50%
Contribution Margin $40,000 40%
Sales Expense ($10,000) 10%
General and Administrative Expense ($20,000) 20%
Net Profit $10,000 10%

The 10% net profit margin is good. Many firms have low single digit margins and strive to get to this level. But how did this firm get to 10% net profit? Let’s look at the components.

Profit Margin Drivers

To have a 10% net profit margin, the firm needs to net $10,000 per month after all expenses are paid.

Assume General and Administrative Expense (G&A) consists of the owner’s salary, a modest office, and prudently managed overhead costs that add up to $20,000 per month.

Keep a close eye on these administrative expenses when doing these calculations yourself! You might find significant areas of inefficiency. Make sure these costs are identified and included in your expense calculations.  

Anyway, back to our example.

Assume Marketing and Sales consists of online marketing costs, attending trade shows, and a CRM system that add up to $10,000 per month. (The owner also does the selling and his/her salary is in G&A).

This brings Total Sales and General/Administrative Expense (SG&A) to $30,000 per month:

Marketing and Sales Expense $10,000
General and Administrative Expense $20,000
Total SG&A Expense $30,000

Now that we know how much SG&A expense the firm has, we know how much Contribution Margin the firm needs to generate. The following table shows how the company needs to produce $40,000 of Contribution Margin in order to cover these costs and yield a $10,000 net profit:

Contribution Margin $40,000
SG&A Expense ($30,000)
Net Profit $10,000

If you want to learn more about driving profit in your business, check out our guide below.

A Practical Guide to Driving Profitability for Your Professional Services Business