How to Accurately Calculate Gross Margins (and Understanding Their Importance) at Professional Services Firms

By Kelly KittrellPublished On: January 22, 2024

If you’re considering the sale of your consulting or professional services business, you should understand that buyers will be examining your Gross Margin as an indicator of the value of your firm. In situations where two companies have similar EBITDA, the one with the higher Gross Margin will normally get a higher transaction price, other things being equal. Why is this?

When calculated accurately, Gross Margin is a good indicator of the overall value of the services the company provides to its customers. Higher Gross Margin companies typically provide complicated, high-level consulting for which they can bill at a premium rate per hour. These high-value services can often generate true Gross Margins of 35% to 45%. By comparison, if the services offered are more widely available, then margins might be closer to 20% to 30%, as competitive pressures put a lid on the rates that can be charged.

Professional services companies make money by billing out their experts and consultants at rates higher than the employee cost. The bigger that gap, the bigger the Gross Margin. So, business owners often try to show the highest margin possible.

But there are rules about how to calculate that. It’s important to understand them so you don’t mislead yourself—or any potential buyers who may be interested in buying your company.

First, a common accounting error businesses make is only classifying an employee’s billable hours under Cost of Services or Cost of Goods Sold in the income statement. If your client service employee Mary, for example, works 1,000 hours in a year, but has the capacity to work 2,000, then her utilization rate was 50%. Some owners will only include half of Mary’s salary in Cost of Goods Sold, (as those were the only hours where Mary generated revenue) and put the rest of her salary in Sales, General and Administrative (SG&A) costs, below Gross Profit/Gross Margin.

While the final net income number may still be correct, your Gross Margin is overstated, because Mary’s full salary should be included in the Cost of Goods Sold.

Second, other costs directly associated with employees in a client-service role must be included in Cost of Goods Sold. That includes payroll taxes associated with those employees as well as their benefits costs. therefore, those items in SG&A expenses is incorrect and overstates your Gross Profit and therefore your Gross Margin.

Finally, if the owners of the business are also in a client service role and are not paying themselves a market rate for their salary, Gross Profit (and EBITDA) will be overstated, especially for how the business will be accounted for as part of an acquisition.

Bottom line: Be prepared for a thorough discussion of Gross Margin, in addition to EBITDA, when you are talking with your sell-side financial advisor or a potential buyer about the sale of your business.

Kelly Kittrell has more than 30 years of merger & acquisition and corporate finance experience. He advises business owners on sell-side and buy-side transactions, valuation analysis, corporate finance and equity and debt financing. Contact Kelly at [email protected].

Kelly L. Kittrell has more than 30 years of merger & acquisition and corporate finance experience. He advises business owners on sell-side and buy-side transactions, valuation analysis, corporate finance and equity and debt financings. He is based in Dallas. Prior to joining FOCUS, Mr. Kittrell served as Ankura Consulting’s Head of Development and Acquisitions. His main responsibility at Ankura was completing acquisitions of companies in the professional services and consulting industry. He reviewed dozens of acquisition targets while at Ankura, preparing valuation analyses, negotiating financial and legal terms in letters of intent and closing documents, and performing due diligence. Ankura grew by acquiring six professional services firms during his tenure. Mr. Kittrell also served as Ankura’s CFO from inception through 2016. Before his work at Ankura, he held the following high-profile M&A positions: As Managing Director at Bank of America’s private company advisory services, he was a mergers and acquisitions advisor for clients in the strategy, analysis, and sale of client businesses. Mr. Kittrell developed and made presentations to clients and bank associates and generated sell-side mandates and valuation assignments, as well as led execution teams. As a Director in Ernst & Young’s Corporate Finance practice, he provided strategic advice for clients in all aspects of M&A transactions, advising sellers in diverse industries including the sale of a large automobile retail chain and a newspaper publisher. He performed valuations on more than 50 going-concern companies, including a major commercial airline. In addition to his M&A experience, Mr. Kittrell served as a Senior Litigation Consultant at Dallas law firm Bickel & Brewer, where he analyzed companies in litigation to determine valuations and damages, identified and worked with expert witnesses regarding financial testimony, and determined fallacies in opposing expert valuations, financial reports and damage claims. He also served as the Chief Investment Officer for a private investment family office and as the Chief Financial Officer for one of its portfolio companies, a publicly-traded acquirer of direct selling businesses.