How Margins Reveal Business Health
This is Part II of a three-part series:
– Part I: GAAP Basics
– Part II: Understanding Margins (you are here)
– Part III: Cash vs. Revenue
A Quick Reminder on Why We’re Using GAAP Terms
In these articles, I’m using GAAP terminology on purpose.
GAAP — Generally Accepted Accounting Principles — is the standard financial language used by lenders, buyers, auditors, and regulators.
When small business owners rely on improvised or “street” terms, conversations get messy, numbers get misinterpreted, and decisions become riskier.
Using correct GAAP terms gives you:
- clarity
- consistency
- credibility
- shared language with professionals
It’s not about formality — it’s about financial accuracy.
And accurate financial language leads to accurate financial decisions.
For Advisors: This series uses strict GAAP terminology to give your clients a shared financial vocabulary. Feel free to share these articles before planning meetings to align on foundational concepts.
Opening
Revenue tells you how busy your business is.
Margins tell you whether the work is actually worth doing.
Margins are the fastest way to see:
- which services actually make money
- where labor is inefficient
- whether pricing is realistic
- if overhead is bloated
- whether the business model itself works
For small business owners, margins aren’t accounting trivia — they’re survival signals.
As always, we continue using the example of Craig Gilmore, owner of Craig’s Cleaners in Santa Ana, to illustrate these concepts in clear, GAAP-accurate terms.
1. Gross Profit and Gross Margin
What you earn after direct costs.
From Part I, Craig’s numbers were:
- Revenue: $300,000
- Cost of Goods Sold (COGS): $175,000
- Gross Profit: $125,000
- Gross Margin: 42%
Formula: (Gross Profit ÷ Revenue) × 100
($125,000 ÷ $300,000) × 100 = 42%
What Gross Margin Tells an Owner
Gross margin answers the question:
“After I perform the service, how much money is left to run the business?”
If Craig’s gross margin drops, the cause is usually:
- labor inefficiency
- materials or solvents increasing
- pricing too low for the workload
Many small business owners grow revenue while quietly destroying gross margin — and they don’t notice until cash crunch hits.
2. Operating Margin
What’s left after overhead — the true strength of the business.
Operating expenses include:
- rent
- utilities
- insurance
- software
- admin payroll
- the owner’s salary
- overhead supplies
Continuing Craig’s example:
- Gross Profit: $125,000
- Operating Expenses: $100,000
- Operating Income: $25,000
- Operating Margin: 8%
Formula: (Operating Income ÷ Revenue) × 100
($25,000 ÷ $300,000) × 100 = 8%
Why Operating Margin Matters
Operating margin is the health score of the company.
It reveals whether the business actually works after the cost of running it.
A company can have strong gross margins and still be fragile if overhead is undisciplined.
For service businesses like Craig’s, operating margin exposes the truth revenue often hides.
3. Net Margin
What’s left after everything — including interest and taxes.
Continuing Craig’s numbers:
- Operating Income: $25,000
- Interest + Taxes + Depreciation: $10,000
- Net Income: $15,000
- Net Margin: 5%
Formula: (Net Income ÷ Revenue) × 100
($15,000 ÷ $300,000) × 100 = 5%
Important Clarification for Owners
Craig already paid himself a salary inside operating expenses.
So the $15,000 is profit after the owner is paid.
This prevents a common misunderstanding: small business owners thinking “net income = my paycheck,” which is not true in GAAP.
Why Net Margin Matters
Net margin reflects:
- lender readiness
- valuation potential
- reinvestment capacity
- long-term sustainability
Most distressed operators ignore net margin entirely and instead track “whatever cash is left,” which tells them nothing.
4. Contribution Margin
An advanced but essential concept.
Contribution Margin = Revenue – Variable Costs
For Craig, variable costs include:
- hourly cleaners
- per-unit solvents
- bagging/ticketing materials
Fixed costs include:
- rent
- owner salary
- admin payroll
- insurance
Example:
If cleaning a shirt brings in $12 revenue and has $4 variable cost, contribution margin = $8.
Why It Matters
Contribution margin tells a small business owner:
“How much does each job contribute to covering overhead and generating profit?”
Low contribution margin is a pricing or efficiency problem.
High contribution margin means strong service economics.
5. Margin Mix: The Hidden Driver
The hidden driver small business owners overlook.
Let’s break down Craig’s $300,000 business by service line:
Garment Cleaning (80% of revenue):
- Revenue: $240,000
- COGS: $144,000
- Gross Profit: $96,000
- Gross Margin: 40%
Alterations (20% of revenue):
- Revenue: $60,000
- COGS: $24,000
- Gross Profit: $36,000
- Gross Margin: 60%
Total Business:
- Revenue: $300,000
- COGS: $168,000
- Gross Profit: $132,000
- Blended Gross Margin: 44%
The Critical Insight
If alterations grow from 20% → 30% of revenue, Craig’s entire business becomes healthier — even if total revenue stays the same.
Here’s why:
Current mix (80% cleaning / 20% alterations):
- Cleaning: $240,000 × 40% = $96,000 gross profit
- Alterations: $60,000 × 60% = $36,000 gross profit
- Total gross profit: $132,000
New mix (70% cleaning / 30% alterations):
- Cleaning: $210,000 × 40% = $84,000 gross profit
- Alterations: $90,000 × 60% = $54,000 gross profit
- Total gross profit: $138,000
Same $300,000 revenue.
$6,000 more gross profit.
That’s the power of margin mix.
Understanding margin mix is a core part of financial operations.
6. Markup vs. Margin
Many small business owners confuse markup with margin. They’re not the same.
Markup = percentage added to cost
Margin = percentage of the selling price
Example:
Craig buys cleaning solvent for $10.
50% markup:
Cost: $10
Markup: $10 × 50% = $5
Selling price: $15
Actual margin: 33% ($5 profit ÷ $15 price)
50% margin:
To achieve 50% margin, Craig needs to sell at $20
Cost: $10
Profit: $10
Selling price: $20
Margin: 50% ($10 profit ÷ $20 price)
Why This Matters
Small business owners who price using “50% markup” thinking they’re getting “50% margin” are actually getting 33% margin.
That 17-point gap can be the difference between survival and distress.
Always price backwards from your target margin, not forwards from markup.
What to Do This Week
1. Calculate your gross margin by service line or product category — not just blended. Use the formula: (Gross Profit ÷ Revenue) × 100
2. Compare those margins. Which services are strongest? Which are dragging down the average?
3. Ask yourself: “If I could grow only one service line, which margin tells me it should be?”
Margin mix explains why two businesses with identical revenue perform completely differently. Once you see your margins separated, you’ll know where to focus.
Conclusion
Margins translate activity into clarity.
They help small business owners understand not just how much they’re earning, but where the money actually comes from and why it sticks — or slips away.
To recap:
- Gross Margin shows how you earn money.
- Operating Margin shows whether your business is structurally sound.
- Net Margin shows what’s left after everything — beyond the owner’s salary.
- Contribution Margin reveals the economics of each service.
- Margin Mix explains why revenue alone never tells the full story.
- Markup vs. Margin — understand the difference or misprice everything.
Once you can read margins, you begin to see your business the way a lender, buyer, or CFO does — and the way the market already sees you.
Part III will reveal why cash and profit operate on different timelines — and why understanding deposits and receivables is critical for managing working capital.