Your sales margin needs to cover all expenses as well as your working capital. You also need to create free cash flow for investments and dividends. All easier said than done. Let me explain how much sales margin you need for different businesses and why.
But, before we dive into the details, here are the short answers ahead of my explanations: SaaS businesses 50-60% sales margin, industrial OEM circa 20%, industrial systems or products 10-12%, industrial subcontractors 4-7% and off the shelf products 3-7%.
I will give you examples why different stakeholders has different views on what sales margins you really need to strive for. Customers, salespeople, owners and investors clearly have different views on the sales margin necessary.
One of the most intensively discussed topics on board meetings are pricing and sales margins. Salespeople are notorious advocates for not losing business opportunities while CFO’s argue for price increases to improve financial performance. Both are right, but also wrong. In this article I will try to explain what I mean and what a healthy sales margin can be, relative growth opportunities.
We shall also discuss why you do not need to have the same sales margin in all your projects or business lines.
To be fully aligned, I will refer to your gross margin when we talk about sales margin. Your revenue deducted with your cost of product sold. That is material and components for a manufacturing industry, and IT operations cost for a SaaS business.
Blue collar salaries and other fixed costs are not included in your sales margins.
So, let’s start discussing what sales margin you need, for different segments and in different situations.
First, different business models need different sales margins
Let’s start with some basic school theory, so please bare with me. Different business models require different sales margins. For example:
- A drop-ship retailer with online advance payments, needs a relatively low sales margin. Trading gods with a drop shipping model can result in slim stock holding. Collecting advance payments also mean that you have low levels of outstanding accounts receivable which is low need for working capital. All this mean that your expenses and your working capital is relatively limited once you have paid for the gods to be sold. You sales margins does not have to be very large
- A tier-1 industrial system sub-supplier to global OEM’s, needs a relatively high sales margin. Sales processes are relatively long and expensive and you need to engineer, source components, assembly and deliver before you get fully paid. Typically, you will need 35 – 45% sales margin to cover for sales cost, engineering cost, sourcing and working capital.
You need enough sales profit, sales margin, so you that can pay for marketing, sales, overhead cost and working capital. Still making a profit. No one else than a company’s sales will pay these costs. At least in the long term.
Which B2B industry has the highest sales margin
Highest B2B sales margins can be found in SaaS businesses since their products are sold over and over again. Lowest margins are found with subcontractors or retailers adding relatively little value to a products value chain.
SaaS businesses, software as a service, will achieve very high gross margins once sales reach critical volumes. The product is reused by everyone, delivery does not cost much extra for every new customer. It’s a very scalable online business model and the reason why SaaS attract venture capital investors.
Industrial OEM, system and product suppliers on the other hand need to cover specific costs for each sales and delivery, and their share of the total overhead cost. Sales, engineering, sourcing, production and delivery lead times cost a lot of money. This line of industry delivers a positive free cash flow at 35 – 45% sales margins. Every sale and every delivery are a struggle, though. Being productive and efficient in sales and operations is there for key to long term growth capabilities.
Finally, subcontractors is the most challenging business segment. Subcontractors cannot achieve very high sales margins. Entry barriers are low, hence a more competitive business, and value added to gods of product sold is limited.
|Industry||Typical Sales Margin||Typical EBITDA Margin||Other main expenses than cost of goods sold|
|SaaS||50 – 70%||30 – 50%||Sales, development, overhead|
|Industrial OEM||45 – 55%||Ca. 20%||Sales, engineering, operations, overhead, working capital|
|Industrial systems or products||35 – 45%||10 – 12%||Sales, engineering, operations, overhead, working capital|
|Industrial sub-contractors||15 – 25%||4 – 7%||Sales, engineering, operations, overhead, working capital|
|Off the shelf products||25 – 50%||3 – 7%||Sales, operations, overhead, working capital|
You can see from above table were venture capital and private equity prefer to invest: Businesses with high sales margins and a high operating margin.
What sales margin to strive for?
Sales prices and sales margins are often controversial topics. In the end however, the need for a specific sales margin comes down to the need for a long-term, sustainable cash flow. Cashflow to pay for sales, engineering, operarations, overhead cost and working capital while still making a profit.
The typical argument used by salespeople when they believe sales margin requirements are too high, is that high prices will run you out of business. That might be true sometimes. However, expenses still need to be paid or there is no justification for the business.
In the real world, there are few free profit opportunities. Therefor you need a pricing strategy and to operate as lean as possible, in sales, administration, and operations. Being lean and efficient means you can create free cash flow for growth without stretching you sales prices beyond what’s acceptable.
Your position in the value chain determine your sales margin potential. Tier-1 system suppliers that design and supply their own product can earn higher sales margins than contract manufacturers that addilimited value other than operations.
A common sales margin discussion is which cost to be paid by sales, and the short answer is all cost.
The second most common topic when discussing sales margin requirements is that some businesses subsidize others. I will come back to that in a short while.
Different stakeholders usually have different views on what sales margin you need:
Customers usually do not discuss your sales margin but focus on price, unless there are specified cost-plus items in your bill of materials.
You however shall discuss the need for a healthy sales margin with your customers. In particular if purchasing teams are pressing too hard. Most customers appreciate healthy and long-term stable suppliers, which is your key sales margin argument.
Salespeople: One should not generalize but salespeople usually care most about closing, and low prices is the easy way to sell. Sales margin targets are there for often an uphill battle with sales teams.
Owners that are sales focused more than anything else, or product engineering wizards, sometimes struggle to focus on cashflow generation. The lack of profit at year-end is a commonly heated debate in these circumstances.
Experienced entrepreneurs know to focus on sales margins. They know healthy sales margins means a sustainable free cash flow and possibility to invest for the future.
Investors on the other hand are always focusing on sales margins, knowing that a good margin is important to fuel sustainable growth.
Venture capital investors can shed operating margins for the benefit of investing in marketing and sales. But sales margins always need to be high since sales profit covers company costs and generate investment capabilities.
Shall I have the same sales margin in all business lines?
You can have the same margin in all businesses if you have one product, one type of customer and operate in one market.
Usually however, the are a few key factors that make it necessary to have different sales margin targets in different businesses:
Your first early adopter sales
You need to be cautious about sales margin targets at your first sales. That’s how reality is although you need to generate cash flow to pay your expenses. Short-term however, sales margins may need to stay somewhat low to help you secure those first sales contracts. Those first sales will be your reference sales.
My advice is to accept low sales margins for early adopter sales even though you need higher sales margins later.
Importantly, you need to budget for these early low sales margin deliveries. You need capital resources to cover for cash flow losses that these low sales margins create.
Small sales transactions need higher sales margins (in percentages)
Small sales transactions need high sales margins, in percentages, to cover their share of comapny costs and working capital.
This may sound challenging in percentage terms, but even small sales require processing, which cost real dollars, not penny’s, nor percentages.
Sales margins in high volume deals do not need to be as high, in percentage terms, as in small volume transactions.
You may want to introduce minimum contract-values to get away from tough small percentage sales margin discussions.
For entry sales to enterprise customers you often need to accept low sales margins
An entry sale is when you make your first sale to a new customer. Large enterprise customers are sceptic buyers and will press you hard in the initial sales phase. It’s almost always necessary to accept relatively low sales margins to become relevant as a new supplier.
You can step up your sales margins once you have become a trusted partner. Add on sales, change orders and up sales are much less price sensitive once on the inside of your enterprise customer. Here is where you build your true sales margins.
New product areas may need relaxed sales margin requirements
New products often need to be treated similar as your first early adopter customers. You lack references and your first new products sales are important for any future sales.
For those first customers you may need to accept lower sales margins than usual. Don’t get stuck on those low sales margin levels however. Remember your pricing strategy and keep a close eye on your free cash flow.
Sales margin cross-subsidizes between businesses
Cash cow product areas that produce high sales margins may sometimes conflict with low margin product areas or businesses.
Lower sales margins should be fine however, as long as those low sales margins are strategic. Meaning they are entry sales with new enterprise customers, the launch of a new product, reference customers, or similar.
All business of any size has a cash cow in their line of business. It does not necessarily mean that businesses with less sales margins need to be shed. Just be careful about poor sales work, poor operations or too expansive overhead costs. A professional customer will not pay for these kind of expenses.
How to decide what sales margin I need?
Sales margins need to be high enough to create free cash flow after all expenses are paid, including working capital. All businesses need positive cash flow to survive. More money coming in than leaving the company.
For specific periods of time investor capital may bridge cash flow deficits but you shall really see this as a temporary expense cover. Bank lending may be another financing source, but can be devastating if it overshadows an underlying cash flow generation problem.
You need less sales margins if you operate lean. Remember that your sales margin shall cover all your company expenses, no one else will.
Your business model, the industry you’re in and the competition you meet determines the maximum sales margin that you can charge. Most often however you find yourself on the low side of sales margin potentials because sales become easier. Customers love low prices. Deal closing becomes easier.
Too high sales margins make you lose on price, and no one likes to lose a possible deal. To low sales margins on the other hand makes it impossible to generate healthy free cash flow for long term investments and dividends.
New and experienced entrepreneurs alike know that sales are easier with low prices. You need to calculate your needed sales margins, however. Make a realistic financial budget that take all company expenses in mind.
Focus on free cash flow, not profit. You do not want to end up with empty bank accounts because you charged to low prices.
Businesses with high risk or sales with low probability need higher sales margins than average, to contribute to company target.
Repeat businesses and add on sales can be made with lower sales margins because of less marketing and sales efforts needed. These businesses are your chance to catch up sales margins from your low margin entry sales.
Conclusion: Now you know what sales margins you need, and why
The challenge with different sales margins with different sales situations is to make salespeople understand the concept of free cashflow.
Sales margins decide how much free cash flow you generate, after all expenses are paid and working capital set aside. Free cash flow is what you can use for investments or dividends. You need a financial plan to understand your sales margin needs.
Salespeople will always argue that you need to accept lower sales margins, or you will lose businesses. But sometimes you need to lose a business, because of price, to know that you do not give away sales margin opportunities.
You need a company budget and a reasonable but best effort sales budget to know what sales margins you shall target.
It’s often the finance manager that makes the financial budget while sales plans are the secrets of the salespeople. Make them talk to each other.
It’s notoriously difficult to get best estimates from salespeople but it’s an absolute most to make a viable financial and operational planning.
Too low sales margins reduce your free cashflow and eventually prevent you from investing for the future. At worst, too low sales margins make you lose money. Too high sales margins make you lose business opportunities. You need to know what sales margins you need and can charge.
I hope you appreciate this article. Needed sales margins is a difficult topic. Remember though, if you never loose one deal than you do not really now where the market price is.
Good luck growing your sales. Use pricing sensitive, an analytically.
Read more what makes a good sales strategy.