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Raise your profits by understanding and optimizing gross margins

Seeking ways to cut costs?

As a business owner or an independent contractor, you are always looking for ways to cut costs and optimize your profits (and/or increase your take home pay). At least I hope you are doing this – so let’s assume yes you are. There are basically two different types of expenses that you can cut: costs of goods sold (COGS) and business expenses. These were both introduced as part of a previous article on expense projections.

Gross margins are your total profits minus all of your costs of goods sold. In real estate, gross margin isn’t a commonly used term or measured metric. I’m not sure why – I believe it can be extremely valuable for the industry, brokers and individual agents. It should be one of the most important financial metrics to measure and optimize. This article will introduce why and how.

How to track your margins

COGS are variable, meaning that they will go up and down according to how much revenue you generate. Any cost you incur that is tied to a transaction is a part of the equation here. Examples are a referral fee paid to another agent, a split paid to an teammate and even a $500 flat fee paid to an assistant to help execute paperwork or another part of the transaction. You want to make sure that all of your variable costs are incorporated into a gross margin calculation, excluding general business expenses like gas, marketing or rent. It’s still important to carefully analyze general expenses, but not for this exercise.

Over time, you should settle into a fairly fixed gross margin percentage. If you have a gross margin of 50%, this means that half of your proceeds from a sale will move to become cash flow for your business. This cash flow is what you use to pay expenses and pay yourself, and the rest is pushed down to the bottom line as profit. As an independent contractor, obviously you just have the expenses and everything else is take home pay (your taxable income/profits for the year).

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It is important to know your gross margin so that you understand how much cash flow your sales will generate. It is also important to understand that no matter how many transactions you do, your gross margin will never change on its own. It is the maximum cash flow percentage your business will create in its current form.

Increasing your gross margins

However… If you can reduce your COGS – and therefore increase your gross margin – the impact on your business operations and value will be significant. As you grow your business, adding a few percentage points to gross margin will make a big difference for your profits. If selling your business is a goal, then gross margin is an essential metric for potential purchase. If you can create a growing business that has above average gross margins and solid profits, then you will be a very attractive acquisition target, and the high gross margins specifically will increase your price tag too.

Each business and independent contractor is different, but here are few ways to reduce COGS. This is not an exhaustive list by any means, but it is a good start. An important note: just because gross margins are increased doesn’t mean that profits will increase too – above all else a business must make sound overall decisions, including on all expenses.

Let’s move on to some options to increase gross margins. You can move some compensation for assistants or teammates from a commission/split to a fixed salary (this moves it from part of the gross margin equation to a general business expense). You can push some pay for teammates or assistants to a flat fee tied to a closing instead of a percentage of the transaction (it will remain part of COGS but if you are growing your average transaction size and/or doing more deals, this can have a strong positive affect on gross margins and profits). A third idea is the obvious one – negotiate small splits and referral fees. Perhaps add some other incentives to compensate for the change if you have to. Again, with all of these, make sure you are making smart decisions to net out the same or better for overall operations and not just gross margin. When appropriate though, reducing your COGS and moving the gross margin metric larger can have a significant and positive effect on your business in the short term, as you grow and if you want to sell.

I am a big believer in data and analysis, and believe studying and optimizing all kinds of data points is very effective and important for business. The gross margin can have one of the biggest impacts though, so dig in to it!

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Written By

Hoyt David Morgan is an entrepreneur, angel investor and business strategy leader. He is an investor and/or adviser to a handful of exciting and high growth companies, and has been a part of several high-value exits. He is passionate about customer experience, smart business and helping innovative companies grow... and sailing.

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