LVM’s Impact on Net Profit and Contribution Margin
Small service businesses need to prioritize profitability.
Research shows that typical small service companies struggle to be profitable. Ninety percent of all service and manufacturing businesses (gross sales >$700,000) operate with profit margins in the single digits. It’s not an easy thing to fix, particularly when companies aren’t familiar with the calculations that give them the best view of financial performance.
LVM’s Role in Profitability
Generally, your company’s Labor Value Multiple (LVM) metric is a key indicator of profitability. LVM measures the balance of a service organization’s revenue against its largest costs. It’s simple enough to understand on a macro level, though things get a bit more complex as you dig into the details.
At its most basic, understanding LVM means understanding where profits are coming from and what operating expenses are being detracted. Generally, small service businesses can lump these determinations into the following categories:
- Contribution Margin
- Cost of Goods Sold
- Cost of Services
- General and Administrative Expense
- Gross Profit
- Net Profit
- Sales Expense
LVM is calculated by dividing your company’s gross profits by its service wages. Let’s examine 2 aspects of this in particular as they pertain to LVM: net profit and contribution margin.
1. Net Profit
Increasing LVM means increasing productivity. If Company A operates with an LVM of 3.0x and Company B operates with 1.5x, Company B is spending twice as much as Company A to generate each dollar of revenue.
Looking at net profit (gross profits – cost of goods sold), it’s clear that increasing net profit while keeping service wages low is a path to a higher LVM.
Example: If your service wages increase without a commensurate increase in profit (adding a new employee to the staff without adding any new clients), LVM will decrease. In this way, LVM acts a barometer for how effectively your company can balance staffing against service delivery.
2. Contribution Margin
This also applies to contribution margin (revenue – cost of goods sold – cost of service delivery). Using the net profit example, adding a new employee to the staff (without increasing profit) means increasing cost of service delivery in the contribution margin equation. You’re paying more wages for the same level of profit.
In this way, the connection between LVM and contribution margin is clear. If LVM is decreasing, it means you’re either:
- Losing revenue
- Paying more for goods/production
- Paying more for service delivery
It’s easy for small service firms to take a granular view of their own finances and learn which factors are making them less profitable than they should be.
Get an In-Depth Look at Profitability Calculation
Our new whitepaper, A Practical Guide to Driving Profitability for Your Service Business goes into the fine details of profitability calculations for LVM, net profit, or contribution margin. It digs deeper into detailed profitability calculations for small service firms:
- Breakdown of service firm operating expenses and how they affect profitability
- How to calculate LVM, Net Profit, Contribution Margin, and more (with examples)
- How to set up your accounting platforms and payroll services to generate these reports
- Key drivers of LVM and how to apply these levers for growth
Interested in learning more?