Francesco Gizzi
Management control
Business profitability: how to read the numbers and decide better
Many business decisions look as if they are based on numbers, but in reality they were made beforehand. On gut feeling. The numbers come afterwards, as confirmation. It happens with price reviews, with choosing which customers to invest in, with opening a new channel. The owner feels that a customer is strategic, that a product is selling, that online is worth it. Sometimes they are right. Often not.
Reading your company's profitability properly exists for exactly this: to take the force out of impressions when impressions are not enough. You do not need complex models. You need to know which margin to look at, at what level of detail and with what question in mind.
In this article I focus on how to read your company's numbers by customer, product and channel, and how to turn that reading into decisions. If you are still missing the basic framework, meaning a management income statement, a budget and a reading cadence, I suggest starting from the guide to management control for SMEs.
Revenue, margin, cash: three numbers, three different stories
The first step is to stop using revenue as the measure of success. Revenue tells you how much you sold. Margin tells you how much you keep. Cash tells you when you keep it. They are three different stories and they often do not coincide.
Margin, too, is not just one number. I use three levels:
- Gross margin: revenue minus the direct cost of the product or service. It tells you whether the price covers what you produce or buy.
- Contribution margin: revenue minus all variable costs, including sales commissions, shipping, channel fees and discounts. It tells you how much each sale contributes to paying for the overhead.
- Segment margin: contribution margin minus the fixed costs dedicated to that customer, product or channel. It tells you whether that piece of the business stands on its own.
Many companies look only at the first. It is the easiest to calculate, but also the one that hides the most. A product with an excellent gross margin can become mediocre once you add marketplace fees, returns and the cost of after-sales support.
And then there is cash. A customer with a good margin who pays at 120 days can put a growing company under more strain than a customer with a lower margin who pays at 30. When you compare customers or channels, always keep payment terms next to the margin. You do not need a financial model: one extra column in the table is enough.
Profitability by customer: important does not mean profitable
The trap I come across most often is confusing an important customer with a profitable one. A large customer brings volume, visibility, sometimes prestige. It also brings requests for discounts, customizations, long payment terms and a support workload that nobody measures.
To read profitability by customer, it is best to start from revenue and subtract, in this order:
- the direct cost of what you sell them;
- discounts, year-end rebates and special terms;
- the cost to serve: support hours, order handling, rush deliveries, customizations;
- dedicated sales costs, such as account management, travel and tenders;
- the financial cost of payment terms, even if only estimated.
The result goes into a simple matrix: revenue on the horizontal axis, percentage margin on the vertical. Four groups emerge. Large, profitable customers, to protect. Small, profitable customers, to develop. Large, low-profit customers, to renegotiate. Small, low-profit customers, to rethink, perhaps with a standard price list and less service. This one table, built properly, changes how the sales team uses its time. It is one of the points I often start from when I work on sales consulting.
Profitability by product and by channel
Products and services
With products, the recurring mistake is judging them by volume. The best seller becomes the flagship product, even when it has the lowest margin. Meanwhile an add-on service that sells little earns three times as much and nobody pushes it.
Two practices help a lot. The first is to read margin in both absolute and percentage terms: a product at 20% that sells a lot can bring in more total margin than one at 50% that barely sells. The second is to take complexity into account. Variants, small batches and slow-moving SKUs eat up time and warehouse space even when the unit margin looks good.
Be careful with overhead allocation too. If you spread rent and administration across all products in proportion to revenue, a product with a positive contribution margin can look as if it is losing money. Eliminating it does not make those costs disappear: it shifts them onto the other products. First you read the contribution margin, then the specific fixed costs, and only at the end the shared overhead.
Sales channels
Store, agents, direct sales, e-commerce, marketplaces, distributors. Each channel has a different cost structure, and comparing them on revenue is misleading. An online channel can look more efficient because it has no agents, but it pays for advertising, payment fees, shipping, returns and customer support.
For each channel it is worth calculating customer acquisition cost and comparing it with the margin that customer generates over time, not just on the first order. For example, if acquiring a customer online costs €60 and the first order generates €25 of contribution margin, the channel is loss-making on the first purchase. It only becomes attractive if that customer comes back to buy at least two more times. Knowing how many customers really reorder completely changes the assessment. This is where marketing and management control meet. The return on a campaign only makes sense if calculated on margin: a campaign that brings in a lot of revenue on low-margin products can destroy value despite having brilliant numbers. It is the work I do in management control for marketing and sales.
From reading to decision
Profitability becomes useful when you link it to a specific choice. If you measure it out of curiosity, it stays an interesting piece of information and nothing more. To avoid that, I use a simple routine made up of four questions:
- Which decision would change if this number were different?
- Is the figure a one-month anomaly or a trend that has repeated for at least three periods?
- What is the context: sales mix, seasonality, purchase costs, the customer's stage?
- What is the smallest lever I can move to see an effect?
The levers are always the same, and it pays to know them in order of impact: price and commercial terms, customer and product mix, cost to serve, variable purchase costs, and only after that fixed costs. A numerical example helps. In a business with a 30% contribution margin, a 3% price increase at the same volume takes the unit margin from €30 to €33 for every €100 of price: 10% more margin. Few cost-cutting measures produce the same effect as quickly.
Every review should end with a written decision, an owner and a check date. The following month you look at whether the number has moved. That way profitability stops being a topic for meetings and becomes a management tool.
A practical example: the fastest-growing channel
Imagine a company that makes and sells household goods, with €4 million in revenue. It sells through three channels: retailers (60% of revenue), its own e-commerce store (25%) and a marketplace (15%). The marketplace is growing 40% a year and the owner wants to invest more in it.
Let's look at margins by channel, with hypothetical but realistic numbers:
- retailers: 35% gross margin, which after commissions and shipping becomes a 28% contribution margin;
- e-commerce: 55% gross margin, which after advertising, shipping, payment fees and returns falls to 24%;
- marketplace: 55% gross margin, which after fees, logistics and returns ends up at 11%.
The fastest-growing channel is the least profitable one. That does not mean shutting it down. It means deciding with full knowledge of the facts: putting only products with sufficient margin on the marketplace, raising the minimum price, using it as a shop window to acquire customers and bring them back to the e-commerce store. And reassessing the retailers, which gut feeling saw as an old-fashioned channel but which carry most of the margin.
The initial decision, investing in the marketplace, was not wrong in absolute terms. It was based on the wrong number.
Mistakes to avoid when reading profitability
- Looking only at gross margin. It ignores precisely the costs that distinguish one customer or channel from another.
- Stopping at the company average. An average margin of 30% can hide customers at 50% and customers who lose you money. The average reassures, the distribution informs.
- Mistaking an unusual month for a trend. Before changing course, compare at least three periods.
- Chasing absolute precision. A reasonable estimate of support hours per customer today is worth more than a perfect system a year from now.
- Keeping margins locked away in the finance office. If salespeople do not know the margin, they will sell what is easiest to sell, not what pays.
- Using long reports with no hierarchy. Thirty tables do not help you decide. A few views, always the same, read regularly, do.
Where to start
You do not need a complex model to stop deciding on gut feeling. Just choose one dimension of analysis, usually customer or channel, calculate the contribution margin with the data you already have and bring it to the next management meeting. The surprises almost always come on the first pass.
Sometimes the limit is one of perspective rather than technique: the team is too immersed in day-to-day work to look at the numbers with detachment. In these cases an outside view helps to question the assumptions nobody checks anymore. With clients I often start from an initial business audit, to understand where the financial reading breaks down and which decisions are being made on the wrong number. If you are in Rome we can work in person through my business consulting, otherwise remotely: write to me and we will start from your numbers.
FAQ
What is the difference between gross margin and contribution margin?
Gross margin subtracts only the direct cost of the product or service from revenue. Contribution margin subtracts all variable costs, such as sales commissions, shipping, fees and discounts, and so tells you much better how much a sale really earns.
Should profitability be analyzed by customer, product or channel?
It depends on how the company creates value. A services business usually starts from the customer or the job, a product business from the product family and the channel. It is better to start with one dimension and do it well.
How often should profitability be analyzed?
A monthly review of the main margins is enough for most SMEs. More in-depth analyses by customer or channel can be done every quarter.
Should a product with a negative margin be discontinued?
Not right away. First you need to understand whether it is the contribution margin that is negative or only the result after overhead allocation. In the second case, discontinuing it could worsen the overall result.