In this episode, we are joined by Jamie Nau, Nicole Carlton, and Jody Grunden to go into detail on gross profit. The gross profit is the revenue you produce minus the cost of goods sold. It’s important to split out the different types of revenue line items so you can focus your conversation and get important information about the health of your business. Listen to find out how to use your gross profit metric to make strategic decisions about your agency.
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“We split out the different types of profit in order to focus our conversations.” - Jamie Nau
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Jamie Nau: Hello, everybody, welcome to today's podcast. Once again, you have Jamie and Jody here from Summit CPA. Today we are joined by one of our rock star CFOs, Nicole Carlton. So we're going to deep dive into a topic that we've touched on briefly in the past. We did do a podcast on how the net income statement breaks down. During that podcast we talked about one topic in particular. I think it's important that we go into a little bit more detail on that, and it’s the importance of gross profit. So that's what we're going to talk about today. Really dive into gross profit, how it's calculated, the ways you can look at it, and why it's so important. So Nicole, we're going to start with you. Why don't you give us a definition of gross profit, and how we here at Summit CPA calculate it for our clients.
Jody Grunden: Nicole, before you do that, tell us a bit about yourself.
Nicole Carlton: Yes. Thank you for letting me join today. I've been with Summit CPA for 4 years now. I am a CFO here and I am based out of Texas for the time being. I actually started here at an accounting level, and then kind of worked my way up from there.
Jody Grunden: So time being, you mean you're going to move? Does that mean you're going to look for a different job?
Nicole Carlton: No, I will not be looking for a different job. That is not in the plans at all.
Jody Grunden: One of the cool things about working distributed is you can actually move really anywhere you want and still not really miss a beat for the most part. Are you moving to a different state?
Nicole Carlton: We're moving to right outside Omaha, Nebraska. It's definitely been a little bit of a security blanket knowing that I don't need to change jobs.
Jody Grunden: I didn't mean to put you in the spot there. So, gross profit.
Nicole Carlton: Yeah. So gross profit is going to be the revenue that you produce, less your cost of goods sold, which is what it's supposed to take you to produce that revenue. So it's kind of suppose to move in proportion with your revenue. I'll leave it at that and get into some of those caveats a little bit later.
Jamie Nau: So most our listeners are in the agency realm, which we work with a lot of clients in that realm as well. So give us some examples of those production costs, or costs of goods sold for agencies.
Nicole Carlton: So the biggest thing for most of our service space agencies is going to be the cost of their producers. So that's going to be their signer's, their developers. Sometimes the people that are managing those people, to some degree, that's going to be the biggest one. The next one that we see kind of falling into the cost of goods sold category for those agencies is going to be any subscriptions that they use to kind of produce that billable work. And I think those are probably the top two along, with your contractors. That's a huge one that kind of falls in there with the cost of your work being produced.
Jody Grunden: Yeah for sure. I would add to that the burden cost of those employees. Not just the employee expense by themselves, again she's only talking about producer expenses, not the admin or marketing team. But we're also looking at the burden costs. What taxes are, the payroll taxes. You know, if you have a stipend for your team, like, for instance, we offer a technology stipend, it might be something similar in your organization where, you know, two thousand dollars maybe over the years dedicated to that person, and then maybe an education stipend, because obviously we want educate our team, we don't want somebody else doing it for us. So we want to make sure that our team doesn't walk away uneducated. So in educating the team, making sure that there is an education stipend. So all those different things that really go into the variables of the employee, the 401(k) plan, obviously health insurance is included as well, we feel that's about typically about 1.2 times their revenue. So if you're thinking through your payroll costs and you don't know off the top of your head, you can pretty much take your payroll costs times about 1.2, and that's going to be typically what we're looking at as our production costs. And you know, as Nicole said, contractors, obviously, you're going to slide those in there. Again, we're talking about contractors that are in the production process, and then also talking about any kind of subscription that you might end up using for that. Now again, we're talking about the service based industry, right? So for media companies it's a little different. With media companies, you start at the top line, the revenue, which includes all your media spend, and then you subtract out your media spend. And some people call that your adjusted gross income. We call it net revenue stream. Same thing, same term. It's just different terminology. So you would shrink that into your, net revenue, AGI, then you take out your cost of sales like we talked about right now, and that comes up to that gross profit. So there's a couple of different variables, a couple of different ways of looking at it. It comes out the exact same number and the importance of that number is that we're taking those numbers and we are calculating all the rest of our percentages off that gross profit. The revenue in the gross profit. That's going to be key as we go in on in the discussion, to make sure everybody is on the same page, understands what we're talking about, an apples to apples comparison.
Jamie Nau: I think it's important the way you define revenue there for the media and companies, because we are going to talk a lot about gross profit and a gross profit percentage. And if you have those direct media costs in your cost of goods sold, then obviously gross profits going to look a little bit worse than what we're talking about here. So I think what you said, there is a great distinction because we want to make sure that people are not like oh, no, Jody said my gross profit is supposed to be 50 percent, mine's only 20 percent, what's wrong? Again a really good distinction there. Hopefully our listeners understood that. And then one of the things I want to point out too, is a lot of times when it comes to payroll you want to make sure you work with your payroll company. A lot of times payroll companies will bucket your payroll people into different accounts. So you will have to do all the work yourself. So you could say okay, these nine employees are my production employees, these are my admin employees, these are my marketing employees, that way you can have that bucketed to begin with. Now, what we will do occasionally is someone split. We will split their costs. So if you have an employee that is a project manager, but they're also really good at sales, so they spend half their time managing projects and they spend half the time in sales, we don't want all of those costs going into cost of goods sold. We want half of those costs going into marketing so they can truly understand it. So that will require a journal entry. But a lot of times the payroll companies will work with you in terms of getting those costs split out when it comes to a per payroll, benefits as well. So let's dive into, know what we understand the definition, I mentioned 50 percent, Jody do you want to talk a little bit about that 50 percent and why it's important?
Jody Grunden: Yeah. So typically we see agencies running right at about 50 percent, those that spend more money on their team you're going to have maybe closer to 45 percent gross profit, meaning the remainder goes to their team. Those that maybe aren't spending as much on their team, you know, you can have the opposite. But we're going to find that average of 50 percent. So what we want to do is we want to ultimately drive or come down to 20 to 25 percent net income. And so how do we come up with that? We hit our 50 percent gross profit. I would say about 10 percent roughly. I'd say seven to 10 percent of that's going to go towards marketing and sales and marketing. And that's assuming the sales person, you know, that sort of things included in their marketing person, whatever. And then the rest of it's going to be the admin costs. and admin costs are typically going to be the owners unless the owners having the production than the owner needs to go up in the production calculation there. If they're having a marketing or having the admin again, that's going to go in there. We're going to find out that about 30 to 35 percent tops is going to actually be the combination of both of those. So you're looking at admin, marketing, and I forgot about a facility course, a facility that's going about three to four percent. So the combination of all that should be no greater than 35 percent. So you take your gross profit minus 35, your minimum net income should be 15 percent. So if you're not hitting at least the minimum, then you've got some things to work on. Typically, you find it's not in the sales and marketing is not in the admin. Typically we find out it's in the gross profit.
Jamie Nau: That is a great definition there Jody. Nicole I am going to give you a little head time on this, normally what I like to do is throw a pop quiz to our CFOs that come on here. I am going to ask you to talk about some conversations you've had with your clients about gross profit. But I'll give you time to think about that while I explain that a little bit. So what Jody mentioned there is that we split them out. And the reason we split them out and that we have those percentages we work on because it gives us the opportunity to focus our conversations. So if I'm trying to talk about the whole income statement, I'm dissecting every line item it could be a very complicated conversation. But if I can see that your gross profits falling behind, that can have some very specific conversations. I can talk about job profit. I can talk about which jobs you're doing well on, which ones you aren't. I can talk about your employees. Which ones are producing and which ones aren't. So that really helps us to limit our conversations. Now I am going to through it over to you Nicole, to give us some examples of conversations you have with clients around gross profit and how those conversations have gone.
Nicole Carlton: Yeah, I think the most common conversation we have around gross profit is whether our cost of goods is the right size for the revenue that we're producing. So really it’s centered a lot around is your team size. Is your producing teams sized accurate to do the work that you're getting through revenue, but it's not too large or too small. A lot of times we get out of sync on our revenue and the size of our producers. So especially like right now, I don’t know when this will air, but we're kind of at the tail end or maybe even in the middle of the coronavirus. We're in a period where a lot of teams are inflated beyond their revenue. Then there's times like now where it's just something that we weather through. Then there's times where your team is really built wrong and it's not built for the size of business that you are and we need to right size. And sometimes it's positive. Sometimes you have way too much work and you need to rapidly scale out. But that's in, our kind of day to day, that's the most common conversation we have around the gross profit.
Jamie Nau: That's a great example. Just to give people a great example here is like, the math is pretty simple when you're talking about gross profit. So if you know your cost of goods sold or two million and you know your gross profit needs to be 50 percent, you can easily back into what your revenue should be. Your cost of goods sold is 2 million, divide by 50 percent or multiply by 2, the revenue should be around 4 million. If you typically operate around 3 million cost of goods sold is just too heavy. So you need to do one of two things. You need to let people go, or find the way to become that 4 million company that you want. So that's a great example. Jody do you have any examples there as well?
Jody Grunden: Yeah, I think that's been the big discussion. When we meet with our clients weekly, at least in one of those meetings we're talking about the forecast. Looking against a forward looking concept. We're looking over the next six, seven, eight months, three months, whatever that timeframe is. We're always looking at do we have enough revenue to support our team? And like Nicole said, is our team built for the revenue that we want to achieve? So we may be in a growing stage and maybe today we don't have the revenue. We know we're going to have it tomorrow or next month or whatever, because we got this big contract that's going to be signed. And so it's one of those deals that's not a oh, no, today we are not hitting our number, we need to let people go. It's not one of those type of deals. It's one of those deals where we look forward and say hey, based on what's going to happen over the next few months and based on having these five things fall in place for us, we should have enough revenue to be able to support our team. Then it becomes the fact if we don't that's a normal thing. Maybe we are staff too much. Maybe look at our contractors and say, can we get the short term contractors in here? Kind of fill in some gaps for us so we don't have that long term employee that we're going to have to eat a lot of their bench time for when it comes to a slow time. So, again, I think it's always a forward looking thing for us. And any conversation with a client, they look forward to that conversation because it really is where they get excited about where their company is headed. Knowing what their company is looking like next year, not just on the revenue side, but what cash is going to looking like. If they are going to be in a situation where they have to borrow a line of credit and three months they would rather know now, than three months now where they can't get a bank loan because the financials are looking really bad. So it's important be forward thinking all the time, and gross profit is key to that for sure. 99 percent of the time when you are not hitting your bottom line it is because it's in your gross profit.
Jamie Nau: Yeah, definitely. Oftentimes one of the first conversations we have with our clients because, you know, everybody's coming in and they're talking about revenue and they're talking about how big of a company they are, I think defining how big of a company you need to be is important because it helps you take those next steps. I think it's definitely one of the first conversations that we have. And after listening to this podcast, it wouldn't be too hard to go back to your books and maybe do some allocations and look at it and figure out like, how big should my company be based on the cost of goods sold? And then the fun part comes in. The part comes in trying to make those decisions to right size your company. That’s where the work comes in. But getting the question first thing, that answer comes from those numbers that we're talking about.
Jody Grunden: I'd also caution, you know, if we're saying 50 percent is the gross profit you need. But you know what? If you're bottom line, you're getting 25 percent, that's cool. I wouldn't change a thing up at the top there if I'm getting 25 percent and my gross profits is only 40 percent or whatever, you know, that means that you just really lean on the admin and marketing side. That's there's nothing wrong with that either. So don't go back and say black and white, hey, Jamie told you, because it wasn't me, Jamie told you that it was going to be 50 percent or you're in trouble, look at that bottom line also. If that bottom line is where it's an acceptable amount then your gross profits acceptable. You know, I've had many clients that they're like, you know what? We're going to pay people more than everyone else. So our gross profits are going to be 45 percent. We're going to live with that. We're cool with that. And if they're cool with that, that's perfectly fine. Then it is what it is. Let everything flow to the bottom. And now that you're going to be generating maybe a 20 percent net income based on how things are going. If you're OK with that, I'm okay with that. And so, again, it's not a black and white thing necessarily. So keep that in mind what you are looking at it. Look at the culture, the team and so forth. But if it's way out of whack and you know, your gross profit is very, very dinky as a service based company then you definitely have to do some right sizing for sure.
Nicole Carlton: I think that it's just important to know it. If you know that you are a low gross profit company, but you don't have a lot of sales needed because you're working on some referrals or current companies, I think it's good for you to have it in mind so that when the next thing changes in your business, you've automatically got kind of some parameters around okay, this is what I need to do because this just happened.
Jamie Nau: Yeah. I like to look at it as buckets. You know, you kind of have four buckets that Jody talked about. You have your cost of goods sold. You have your marketing, you have your admin and you have a facility. And if your cost of goods sold bucket is going to be super large, you are going to have to decrease the size of your other buckets. That's fine. Every business runs differently. But the big thing is, you want to make sure at least that bottom line 15 percent is correct, because if you aren't making at least 15 percent, we talk about, you know, 10 percent be the new break even, the 15 percent gives you the opportunity to grow, gives the opportunity to do those fun things that all business people want to do. There's very few business people that get into the business just because they want to always run a million dollar company and make no changes. A lot people come into it because they want to try new things. They want to hire more people. They just met someone on the street they this is going to be a great salesperson. We want to make sure we have the ability to make those hires as you grow. And you can't do that if you're just pulling in 8 percent each year. You won’t have the opportunity to do that. So I'm going take a quick second to throw our email address out there. So we use this email address, we've actually started to get a lot more traction so we appreciate people reaching out to us. We want to make sure that our listeners are telling us what we should talk about. We're always looking for new topics, looking for new guests. We're hopeful in the next couple of weeks to bring some clients on here to kind of talk about how our agreement, how our services actually work. So we'd love to hear from you. We'd love to hear from the listeners on what you want to hear. So the email address is vcfo@summitcpa.net. We appreciate anyone reaching out to us. So one more question for you Nicole. We talked about contractors. Can you talk about the different decisions some of your clients have made in terms of hiring a contractor versus employee? Obviously, both of those go into gross profit, and there's different thoughts you need to have in terms of going down either one of those paths.
Nicole Carlton: The times that I see contractors come in are when you're you know, you've got a project going on and your team is just a little bit short on capacity. So we need somebody for the duration of this project but maybe not indefinitely. Or, you know, we think we're going to get there, but we would feel more comfortable without a strong commitment. A lot of our clients care pretty deeply about not bringing someone on and then letting them go three months later when a project end. So that's kind of scenario one. A short term increase where you need the capacity. The other time is when you don't have the right seats inside your business. So maybe all your designers are full, but you need a designer for a short period of time or vice versa, you need a developer for a short period time. That's the other time where you either just don't have the right seats as far as you don't have that specific skill and you don't normally do it, or all of your people with those skills are just fill for the time being. Those are probably the two biggest instances where I see it.
Jamie Nau: Especially on the production side. I think those are great examples you gave. I think another thing that I've seen done some somewhat successfully recently is, the contract to higher path. If you think you're about six months away from hiring a new employee, maybe you start now to try and can find someone who would come in and try it out. Maybe it's someone who's just coming out of college, or whether it's someone who's been a contractor for a while who might be looking for that full time work. I've had a company that's been pretty successful with their last six or seven hires, having them be a contractor for three to six months, really trying them out. Making sure that our company is a good fit for you, and also making sure that you're a good fit for us. So that's worked pretty well for one of my companies. But it is hard to time it right. That's where it gets tricky. Oftentimes, you know, contractors are often more expensive, depending on the type of contractor you hire. If you're going to hire someone for a three month project, you might have to pay 100 dollars an hour and when you bring them on as a salaried person they're only going to be getting 50 to 60. So that's where it gets a little challenging sometimes. There is that, you know, because you have that safety of them only being on for three months you do have to pay a little bit more for that.
Jody Grunden: Also be careful, know your state laws too. For instance, California has a lot of contractor laws out there. You just want to make sure you don’t find yourself having an unintended tax situation if you go that route. But I completely agree. Contractors are awesome to use to fill in the gaps. And I see it, especially as Nicole had mentioned, that, you know, you may have enough people for the job. You may not have the right people for the job. And that's what the contractor with a specially can come and to help things out. so hugely, hugely used, and definitely a good concept to keep in your tool bag.
Jamie Nau: I know we've covered quite a bit here, and I think it's all been really good information. Any final thoughts, Jody? Any areas we missed that we should make sure our listeners understand when it comes to the gross profit area?
Jody Grunden: Yeah I'm so in tuned with the gross profit. That’s the number one thing I look at every single month when I close out. Where is our gross profit at? Where is it at now and where is it going to be at going forward? I look at that more than I do at my net income, because my net income, for the most par I think with any company it’s pretty fixed. It's pretty, pretty steady there. We've got a pretty good grasp on marketing expenses. We've got a pretty good grasp on the admin. Owners don't usually randomly pull money out, so it's usually it's pretty steady there, too. I'm constantly looking at it, and so much so that we've developed our profit sharing plan based on that. You know, it's like, you know, for our CFOs. If they maintain, you know, gross profit of a certain percentage, again it's never going to be that 50 percent, because when you look at the profit for employee, or profit per client you are always going to look at a higher percentage. I’d say, 60 to 75 percent per company, because you always have that downtime, the time that you can't bill clients and so forth that's still stuck in your gross profit there. So we always look at that and we incentivize our team. Our CFOs, our accounting team, our auditing team, all the different branches of our team we try to incentivize it and base on the gross profit. That's how important the gross profit is, because we know that if we hit that 50 percent gross profit and maintain it there, then everything's going to naturally go down to the bottom, we are going to have the cash to build things up, to have fun time to do fun stuff like go on team retreat, that sort of thing. So we know that's going to happen if we maintain that gross profit. So if I were to incentivize people, I would say, you know, take a close look at incentivizing based on gross profit versus net income. That can be dangerous. You know, if your admin and marketing fluctuates dramatically, that could change a lot. But for most companies out here listening, I don't think that's the case. If that's not the case, then I would definitely take a look at that for sure.
Jamie Nau: What I have noticed at Summit, and I've noticed this with our clients as well is, when you make the incentives at the gross profit level and as a company culture we just talk about gross profit a lot, a lot of times the people who are doing the work are the ones who are going to help you find those efficiencies. So since we've moved our gross profit as our incentive, we've had some awesome conversations as a team where our CFOs have brought up ideas, our accountants have brought up some ideas because they're the ones doing the work. So they're really going to understand where those improvements are. It's really hard for Jody just to sit back and think about how can I improve our gross profit? Sure he has a lot of great ideas, but if Nicole is on the frontline and she sees something like, you know the one area is killing everyone in my jobs is there a way we can fix it? She may not have the solution but at least she is bring it up. I think are great thing about focusing on an area like gross profit is that if you get that fixed, to Jody’s point, everything else is just going to get improved. I think it's really helped us as an organization. Would you agree Nicole?
Nicole Carlton: Yeah, I think putting the gross profit in front of us and empowering us to kind of tweak things in our own workflow is really a huge driver. I mean, it's totally different than saying we're going to incentivize you on net income, which has all these costs that really you can’t impact. I mean, the gross profit, which we can work on day in and day out at every level of business just through tweaking our own processes. So I think it's been a really big game changer. Especially in the mentality of how we look at our work, and how we take ownership for our work.
Jamie Nau: Especially if you have an owner that loves to take retreats, and it's like every time we take a retreat everyone is like, oh there goes our net income goal.
All: Laughing [in audible]
Jody Grunden: What it does come down to is there are things that people can control to make that gross profit better. There's three things: you’ve got your people. Tools, the right tools to get you to that gross profit. By that I mean software, that sort of thing. Then the process. So is your process designed to get to that gross profit? So if you're not there it's going to be one of those three areas. It's going to be the people. Do I have the right people in place? Tools. Do I have the right tools to get there? Processes. Do I have the right processes in place in order to generate that profit margin? So those are the three different areas you need to look if you are not getting that gross profit. And again, incentivizing the team around that, I think really helps define that, and helps pull those things out pretty naturally. You'll start hearing about it hey, this tool everyone is using is garbage. Can we find something better? You know, I can definitely get this done quicker if I had that tool to use or whatever. That gives our team a chance to actually correct that. We're as if we're not really focused on it, maybe we’ve used that tool forever. We always have had that bad lag time and people just put up with it, I think if you make that and incentive it really helps getting everybody on the same team. Everybody's incentivized by different things. Money is not the only way to incentivize. Maybe it’s not gross profit on money. Maybe it's a gross profit on A, we do X, Y, Z, if we can get this done. Maybe it’s other things like the team retreat is at a different place. There's a lot of things that motivate people. You have to figure out what motivates your team. Whatever that motivation factor is I would set it around gross profits.
Jamie Nau: Just to expand on that a little bit more. Something else that I feel like we've done that's been super helpful is not only do we talk gross profit, we talk other incentives that help you hit that gross profit. So for us, it's obviously the amount of clients you handle. So as a CFO, you can handle one more client that's going to be very helpful. What kind of changes do I need to make the call on to give you another client? That's the conversations we have. I think with our design and dev shops you could say hey, I need you to finish this type of project in five weeks. It normally takes seven weeks. What's it going to take to cut a week or two off that project? And that kind of spurs those right conversations. Instead of just talking about dollars and cents. You're talking about time. You're talking about efficiencies, you're talking about tools. Because we're not just focusing on the dollar amount. We're focusing on real day to day decisions I have to make as a CFO if I needed to add one more client what I really need is this. And then we could have those conversations. Or if I needed to cut off a week on a project, I really need this. And then you can kind of have those conversations and just try to figure out what it takes to do that. So I think not just focusing on the dollar amount, focusing on some other numbers is helpful.. Nicole any other areas of gross profit we missed?
Nicole Carlton: I will remember when we get off of here…
All: Laughing [in audible]
Jamie Nau: Well I appreciate your time on this. I think this was a great topic. As always listeners, reach out to us with any questions. Thanks for listening.