Set a gross margin goal and close the gap three ways

1. Why a few points of margin decide so much

One practice here is to think about this a lot, and whenever a price is set. If price is among the strongest drivers of lifetime value, the reasoning goes, then this deserves close attention.

A rule of thumb here. If what you sell is a white-collar or knowledge-based service (marketing is the example), gross margin should be 80 percent. Section 3 restates it as a preference: 80 percent or higher.

Business A and business B. Both bring in the same revenue. A runs a 65 percent gross margin and B runs 80 percent. Suppose, hypothetically, that A ends up with 15 percent net profit. B then makes twice the profit. A gap that reads as 15 points is the difference between one take-home and double it.

A common reply. Owners whose numbers were worked through used to argue this. Told at 65 percent that the business had to be at 80, one would reply that 15 points was not far off. The answer: it was off by twice what they earned.

What gross margin is for. It is the money left once the cost of delivery has been paid, and so it is what pays for everything else: the money you use to run the business and to grow it. One habit here is to obsess over gross margin above anything else. It is also the core of lifetime value, which is nothing but gross profit earned again and again; so the subject here is, more or less, gross profit itself.

Beside the other pages. For gross profit on one sale and across a customer's lifetime, the calculation is SOP 55 — Compute lifetime gross profit and the ratio that gates spending. Its section 3 gives eighty percent as the floor for a service business, local or national. SOP 5 — Cut costly pieces from an offer and bundle the rest, section 5, holds a service to the same 80 percent. Here the rule is stated for knowledge services, and section 3 below notes that the figure might be different for other kinds of service.

2. The order to work in

The order: know what your gross profit is now, decide on the level you want, and then act to close the gap between the two. As the example is worked, some of you can run your own gross margin alongside it, and frame the question the same way: what would lift this to 80?

There are three ways to close the gap, labeled A, B and C below. They are high level. The tactics under each are not covered on this page.

3. The worked business at 67 percent

The example is account work: a marketing agency doing search optimization, because everyone understands one. The figures are suppositions:

Item	Figure
People on the delivery team	Five
What they cost in total	$1 million, or $200,000 a head, hypothetically
Customers those five can handle	50
Price	$5,000 a month
Revenue per customer	$60,000 a year
Revenue	$3 million a year
Gross margin	67 percent (gross, not net)
Gross profit	$2 million

One simplification. For simplicity's sake, the $1 million is assumed to cover software, rent and everything else, though it is mostly payroll. That is a shortcut for the example; which costs belong in the cost of delivery is set out in section 1 of SOP 55.

Why $2 million is not the profit. Is the $2 million net profit, then? Probably not, because it probably still has to pay sales commissions, pay for the marketing that brings new customers in, and probably a good deal else besides.

Where sales costs belong. This question comes up all the time. Everything spent to win a customer counts toward the cost of acquiring one: sales commissions, all marketing spend, the salespeople, the marketing managers. Delivering the service counts toward lifetime value. In this example the service happens to be marketing, and doing that marketing for customers is still delivery. The full list of what goes into acquisition cost is in section 1 of SOP 56 — Define and compute what a customer costs to acquire.

Is 67 good enough? Most people shown these figures would call 67 percent a great gross margin. The view here is that it is fine; the rule of thumb here is still 80 or higher. Treating 67 as good enough, in this view, is how a business stays at 67. The squeeze shows if you want the business to run at a 50 percent margin: with 67 percent gross, everything else has to come out of 17 points. That might sound good to someone who does not know better or is content to earn less, and that is fine; this is simply the practice here.

The gap in this example is 13 points: 67 up to 80.

Other kinds of service. Not every service business is a knowledge service; home services are a little different. Whatever the service, the ways of closing the gap stay the same; for other services the goal itself might not be 80 percent. The walk-through uses a knowledge service.

4. What 13 points is worth

This is a very important point. Go back to the owner who called 67 and 80 close. On the same $1 million of cost, 67 percent is $3 million of revenue and 80 percent is $5 million. Is a business taking $5 million on that cost base significantly different from one taking $3 million? The difference is big.

5. Option A: hold the cost, raise the price

Freeze the cost. To reach 80 percent, take the total cost of delivery and multiply it by five: the $1 million becomes $5 million of revenue on the same cost base. With the customer count unchanged, $5 million over 50 customers is $100,000 each a year. Divide by 12 and the monthly price has to move from $5,000 to $8,300, on average.

Granted, this is a big change; a big change is what bigger money takes.

6. Option B: hold the price, serve more customers with the same team

Freeze the price and bring in a further $2 million of customers, all at today's rate, without adding anyone to the delivery team. At $60,000 a year each, $2 million means 33 new customers, so the business goes from 50 active customers to 83 with the same people doing the work.

Both options reach $5 million of revenue on the same delivery cost.

7. Options A and B, per customer

The same sums, per customer and per month, are sometimes easier to follow than the totals:

	Price a month	Cost to deliver a month	Gross margin
Now	$5,000	$1,650 (33 percent of $5,000)	67 percent
The goal	$5,000	$1,000, leaving $4,000 of gross profit	80 percent

Side by side, 67 and 80 look very similar, yet moving from one to the other means doing something to the business.

• Option A freezes the cost at what it is now and raises the price, to the monthly average in section 5.
• Option B freezes the price and spreads the same total delivery cost over more customers, 83 instead of 50, until the cost for each comes down to $1,000. The headcount needed to deliver stays as it is.

8. Option C: sell a better tier that costs nothing more to deliver

The third way to reach 80 percent is an upsell: a better-quality service that adds no cost to delivery. Deciding whether to launch a new tier, service or product is a real decision owners make, and this is how to make it. There are unlimited ways to hit the number; here are two versions, as an exercise. The second could be a $25,000 tier in place of the $10,000 one.

New tier	Share of the 50 who must take it	The working
$10,000 a month	66 percent, or two-thirds	33 of 50 at $10,000 and 17 at $5,000 give the same average as option A
$25,000 a month	18 percent	Nine of 50 get to around 80 percent; the numbers do not come out clean

Which is likelier? Put to one group, most picked the $25,000 tier. The view here is that a 66 percent take rate on an upsell like this one is very uncommon. It is also said not to be available on the front end when the ticket is lower, with no detail given. A take-up of nine in 50 at $25,000 is more likely, in this view, for a B2B service some months into serving customers at $5,000 a month, because pricing is fractal. Fractal pricing and how to set the tiers are not covered on this page; that is the ground of SOP 224 — Set fractal price tiers and read price off the close rate.

Why it matters. Many owners do not think their pricing through this way, and as a result they make less than they want and cannot outcompete others.

9. Moving customers up: a gym's switch

Back to option C: how to get more customers onto the higher average price, with a case offered as a tactic, and a great way. The case is a gym, introduced as a 66 percent take rate on a tripled price.

• Before: $99 a month, one coach to many members.
• After: $299 a month in small groups, one coach to six or to eight; which is not settled. The service changed along with the price. The view here is that $299 was still too low: it should have been $400 or $500.
• The letter. Everyone got a long letter. It said the goal was to help them get in shape and that the gym felt it had been failing at that; that, in the gym's view, everyone really needed the skills of weight training and of tracking macros; and that the gym only wanted to sell what it was fully convinced of, and was more convinced of this than of boot camps. That belief was, reportedly, genuine.
• The trial. Everyone got a 14-day trial of the expensive service.
• The result. 70 percent stayed and 30 percent left (the case is also put as two-thirds staying). Three times the price for a third fewer customers comes to double the revenue, not nine times. Revenue doubled. Overhead fell as well, because the 30 percent who left no longer had to be served, and those who went were also the cheapest customers.

The takeaway. For some of you, this might be the way: roll out the new tier without even claiming it is amazing, ask people to try it, and let them stay on it if they like it. The view here is that it is a great way of raising lifetime value.

The same price rise, with its customer counts, is told in section 3 of SOP 82 — Set price from the pricing rules and the three models; the letter and the trial are what this page adds.

10. Money math

The sums on this page are only multiplication and division. The thought to hold is that getting to grips with the math is worth a lot more money to you. Call it money math, as distinct from ordinary math. Take a $100 sale: whether it costs you $20 or $33 to deliver makes a very big difference to what kind of business you have and how far it can scale.

The view here is that this and the margin walk-through are the concepts that should shape your decisions; the tactics come afterward.

11. What this page does not decide for you

• Which margin the 50 percent is. A 50 percent margin business is named without saying whether that is net. Not established on this page.
• What cannot be had on the front end. Whether "it" is the 66 percent take rate or the upsell itself is not said. Not established on this page.
• The group size. One coach to six or to eight. This page does not settle which reading is right.
• Whether the $99 service stayed on offer. Not established on this page.

12. The checklist

Step	What to do
1	Work out your gross margin now: gross, not net
2	Set a goal; for a knowledge service the rule of thumb here puts it at 80 percent at least, and for other services it might differ
3	See the gap, as a practice here, in revenue on the same cost as well as in points: on $1 million of delivery cost, 67 percent is $3 million and 80 percent is $5 million
4	Option A: freeze the cost; for 80 percent, multiply the cost of delivery by five, then divide by customers and by 12 for the new average monthly price
5	Option B: freeze the price; work out how many more customers the same team has to serve
6	Option C: price a better tier that costs nothing more to deliver, and work out what share of customers must take it at each price
7	Judge which take rate is realistic: the view here calls two-thirds very uncommon, and a small share at a much higher price more likely for a B2B service some months in
8	To move customers up, as in the gym case (for some, it might be the way): say plainly why you believe in the new tier, give everyone a trial of it, and let them stay if they like it

13. What this page does not cover

Fractal pricing is SOP 224. Margin goals for separate revenue lines, industry averages, and holding the margin once it is set are SOP 227 — Hold the margin line with targets, not industry averages, sections 2 and 6. Lowering what delivery costs is SOP 127. The tactics under each option are not covered on this page. Whether money per customer is your constraint at all is the question on SOP 225 — Pick your war and check lifetime value is the constraint.