Hold the margin line with targets, not industry averages

1. Know your number now, and the number you want

Where you stand. The first aim is that you know your current state. Asked what their lifetime value is, and their lifetime gross profit, owners who have not yet worked through these numbers reportedly say they do not really know. A business can grow only by getting more customers or by making each one worth more; to be in the dark about either half of that sum ought to scare you. The frame itself belongs to SOP 225 — Pick your war and check lifetime value is the constraint.

The hope is that you come away at least with a figure you can work from. There are ways of calculating it, back and forth; they reportedly differ only in degrees of accuracy.

Where you want to be. Second, set a desired state: an actual goal. Examples: our lifetime value is this today, and we believe we can take it to that. Or: our gross margin is this, and we believe we can take it to that.

Close the distance. Third, act to bridge the gap between the two. Raise the gross profit each customer brings, choosing the steps most likely to succeed. That, in the end, raises earnings per click, which is called, online, the auction everyone is taking part in. The same three steps, in the same order, open section 2 of SOP 226 — Set a gross margin goal and close the gap three ways, whose later sections work a service margin through them.

2. A gross profit target for every revenue line

In one company, each line of revenue carries its own gross profit target. The reason given: as the business grows, you will want the ability to keep expenses in check against those targets.

One example of such a line: it "should not exceed 85%", and the business should "never get into 82, 80". Both readings are set out in section 9.

The bigger the business, the more attention this takes, and the more controls you need to hold it. Not every reader is at that point, and this section goes no further. How a target is set and used comes up again in section 8.

Breaking gross margin and lifetime value out product by product, so that you can see each line, is a step on SOP 154 — Get granular financial data, section 2.

3. Run the math before you launch anything new

Lifetime value is called a more advanced subject but a valuable one. Many people bring out new offerings and never think through the take rate, or the cost of goods sold, to see first whether the idea will work and, more important, whether a working version would make money or be worth the trouble.

Skipping that math, it is thought, is why half of business owners earn nothing, a further 40 percent earn barely above the minimum wage, and real money goes to a tiny fraction of one percent. These are estimates, and hedged.

The aim of all of it is sounder choices about what goes on sale and to which buyers. How to work out the take rate a new tier needs is in section 8 of SOP 226.

4. The case: ads that doubled their money and still lost

A case from a business that shipped meals to its customers. The plan had looked large on paper; it did not roll out that way, and the business did much less than projected.

The ask. The team wanted to run ads, and the ads brought money back. They came to say that $10 in was making $20 back, so they should spend a lot more; could they spend $100,000?

The question to ask first. How much did the business make on each meal? A meal cost $9, fully loaded, to deliver, and it sold for $10. The reason given for the low price: food is called a pure commodity, and the owner reportedly had no idea how sensitive demand for it is to price. The meals had started at $15 each and demand was significantly smaller; the price came down to $10. The point is a gross margin of 10 percent. The same per-meal row, $10 against $9, sits in the table in section 2 of SOP 55.

What the ads really did. $10 of spend that sold $20 of meals used up $10 of profit to earn back $2 of gross profit. How many meals would that $10 really have to sell to be profitable? The answer offered is at least 100, and that would only be breakeven.

The warning. Without knowing your numbers and the math, a mistake of $100,000 can happen in an instant.

5. Margin in percent, profit in dollars

A physical product example: an item that costs $5 and carries a $20 price tag. The gross margin is 75 percent; the gross profit is $15, not 15 percent. This case is called easier than some of the other cases.

The reason to raise it is that the words matter:

• Gross margin is stated as a percentage.
• Gross profit is stated as an amount.
• People sometimes say gross profit margin and still mean the percentage.
• Someone asking for gross profit usually wants the dollars earned on every unit sold, and that is the meaning used here.

The preference here is that people talking to each other at least use the right words. SOP 55, section 2, draws the same line between the two.

6. Industry standards are not the bar

The meeting. In one example, an adviser met with a half-billion-dollar company, very efficient, running an old-school model. The entrepreneur running it wanted parts of how it acquired customers looked at, and the leaders were walked through what needed to change. The leader responsible for probably at least half of that work kept replying that they were meeting industry standards, and grew flustered and offended as the weak points and the poor numbers were pointed out.

The answer. Would you want to get up every morning and say your company is average? Average means half the companies are better than you and half are worse. Going into business to be average is not the point, in the view here. The average business, it is said, makes almost no money. So why use industry standards, or industry averages, at all?

The push-back. This is said because owners resist some of the margin figures given here: it is different in heating and cooling, different in search optimization, different in trucking or in logistics. The answer here is that it is not.

The pull to spend. An idea credited to a business mentor, from many years ago: when money is there, spending it is common and normal, and that is why most people have none. Once a company makes money and starts to succeed, that success meets a constant pull back toward normal. So someone has to hold the line: spend no more while revenue keeps rising; win more customers without hiring more people; work out how to look after these customers better than you looked after the previous ones.

A rule to live by. The encouragement here is to live by this: unless physics itself rules it out, treat industry standards as limits your competitors choose to accept and grade themselves against. They are not a suggestion, not a recommendation, and certainly not a law. Those limits become a gift to you once you are free of that belief. Anyone content to be average can use industry averages; most businesses at the average, in the view here, perform poorly. The route to being the best, it is said, starts from physics and math, worked backwards.

The same answer, given to a home-service owner whose margins match the trade's, is in section 10 of SOP 205 — Run the home-services playbook stack. SOP 196, section 3, and SOP 225, section 6, put the industry average to another use: a first check of whether lead cost is where the problem lies.

7. Decide on the data you have

Asked how you know what customers will buy at a given price, the answer is: test it, ask, or simply assume.

This is called an important point. The vast majority of the time, any decision you make in business rests on incomplete data. Assuming you need complete data first will make the business too slow, because data and attribution typically lag what you did by about a year. At best the data shows a direction; the rest you fill in from first principles and from patterns you remember.

That, in the view here, is why people who are good at entrepreneurship make excellent decisions: they are the people most firmly grounded in reality, and they make good guesses from what they have seen. This ties to rules of thumb and patterns you have come to recognize, such as the pattern that what customers can pay moves with what they earn. That pattern might, it is said, rank among the more important points. For that pattern and the price tiers built on it, see SOP 224 — Set fractal price tiers and read price off the close rate.

SOP 189 — Get the numbers and decide fast on reversible bets carries the same starting point in section 3, deciding with direction rather than complete data, and in section 4 how fast to decide on a bet you can undo. What this page adds is the lag of about a year, and the fill-in from first principles and remembered patterns.

8. Set a gross margin target and hold leaders to it

From all of this, the aim is for you to set gross margin targets. Once the business is bigger, each profit-center leader can have one. This is reportedly how it is done in one company. As decisions spread out from the top (this applies probably to bigger businesses), the targets can guide what each leader buys and what gets reinvested.

An example. A leader goes to finance asking to buy new cameras for media. Finance answers that the leader has a gross margin target.

Setting one. The minimum given on SOP 226 is 80 percent. A target could sit at 87; it could sit at 92; it could be any figure your math supports. The reasoning runs like this:

• we think we could staff it with 10 people who could do the work;
• we think we will have to pay them this much;
• software, in total, should cost this much;
• we think we can reach this many customers;
• so the gross margin should come out here.

That line is the target, and the leaders are held to it: if they want to put money into something that pulls them below it, the answer is no.

The 80 percent rule of thumb itself, and what it is worth to close the gap to it, are on SOP 226. A written procedure naming who may spend how much, and budgets for each department set from what it really spends, are on SOP 167 — Delegate spending with approval limits, department budgets and cards, sections 2 and 3. A standing review, every quarter or so, that pushes out unused tools and people is SOP 171 — Cleanse expenses, re-shop vendors and move cash into yield accounts, section 2.

9. What this page does not decide for you

• The line at 85. "Should not exceed 85%" reads as a ceiling; "never get into 82, 80" reads as a floor. This page does not settle which reading is right.

10. The checklist

Step	What to do
1	Find your current lifetime gross profit, at least as a figure you can work from
2	Set the goal: the lifetime value, or the gross margin, you believe you can reach
3	Close the gap with the steps most likely to succeed
4	Give each line of revenue a gross profit target and manage expenses around it
5	Before launching an offer, work out the take rate and the cost of goods, and whether it pays if it works
6	Before spending more on ads, work out the gross profit each sale leaves, as in the meal case
7	Say gross margin for the percentage and gross profit for the amount per unit
8	Unless physics prevents it, do not accept the industry standard as your bar; work back from math
9	Decide on directional data, filling the rest from first principles and patterns
10	Reason out each target from people, pay, software and customers; if a purchase would take a leader below target, say no

11. What this page does not cover

The worked options for closing a margin gap are SOP 226 — Set a gross margin goal and close the gap three ways, sections 5 to 9. Fractal price tiers are SOP 224 — Set fractal price tiers and read price off the close rate.