A consultancy's gross margin: what sits above the line
What gross margin means for a consultancy, why fee-earners' salaries belong in direct costs, and how to set up the books so the figure is easy to read.
By Achekam · · 5 min read · For Consulting businesses in South Africa, Nigeria, Kenya
Ask the owner of a manufacturing business for their gross margin and they will know the number, because the cost of raw materials sits right there on the income statement. Ask the founder of a ten-person advisory firm and the answer is often a shrug. There is no stock, no factory, no materials. Everything looks like overhead.
That shrug hides a problem. A consultancy whose income statement lumps every salary into one line cannot tell whether it is pricing its work properly, whether a new hire is paying for themselves, or whether growth is making it more or less profitable. Gross margin answers those questions, as long as the books are arranged so the right costs sit above the line.
Gross margin when what you sell is time
Investopedia defines gross margin, also called gross profit margin, as the percentage of a company's revenue retained after direct expenses such as labour and materials have been subtracted. Its formula is:
(net sales minus cost of goods sold) divided by net sales, multiplied by 100
Investopedia's article on gross margin walks through the formula and how the figure is read, including how it differs from net margin.
The phrase "cost of goods sold" sounds as if it belongs to businesses that sell goods. It does not. Investopedia explains that the direct costs in cost of goods sold include direct labour as well as materials. For a consultancy, the "goods" are the hours its people deliver, so the cost of delivering them is the cost of sales.
Which costs belong above the line
The test is whether a cost rises and falls with the work you deliver to clients. A practical split for a consultancy:
| Cost | Where it usually belongs | Why |
|---|---|---|
| Salaries of consultants who deliver client work | Direct cost | They are the service being sold |
| Associates and subcontracted specialists on client projects | Direct cost | They replace or add to your own delivery hours |
| Travel and accommodation for client assignments | Direct cost | Incurred only because of the engagement |
| Licences or data bought for a specific project | Direct cost | Tied to one piece of client work |
| Reception, finance and administration salaries | Overhead | Needed whether or not projects run |
| Office rent, marketing, general software | Overhead | Support the firm as a whole |
The awkward case is a partner who both delivers work and runs the firm. Pick a consistent approach, such as treating the share of their time spent on client delivery as direct, and apply it every month. A gross margin that changes because the method changed tells you nothing.
Why service margins look higher, and why that is not the end of it
Investopedia notes that gross margins vary by industry, with service businesses tending to have higher gross margins than manufacturers because they have less cost of goods sold. That is worth knowing before comparing your figure with a client in manufacturing or with a published industry average.
It also means a high gross margin in a consultancy is not automatically good news. If fee-earners' salaries are sitting in overheads, cost of sales is understated and the margin looks healthier than it is. The first check on any surprisingly strong gross margin is whether the direct costs are all where they should be.
Arranging the books so direct costs sit together
In Achekam, each business has its own double-entry ledger with a standard chart of accounts created when the books first open, and accounts can be added, renamed or switched off. Use that to give the direct costs their own group:
- Add separate accounts for consultants' salaries, associates and subcontractors, and project travel, placed with the cost-of-sales accounts rather than among the overheads.
- Rename any general "salaries" account so it is clear it holds only support staff.
- Switch off accounts you will not use, so nobody posts to them by mistake.
Payroll reports show cost, headcount and staff movements by month and by department. Put fee-earners and support staff in different departments, and each month's payroll report then tells you how much of the salary bill belongs above the line. Where the payroll posting lands in a single salaries account, move the fee-earners' share to the direct salaries account with a manual journal. An unbalanced journal, or one dated in a closed month, is refused, and a posted journal is corrected only by reversing it.
Management accounts then show an income statement for a chosen period beside the period before, added up from the business's own journals and exportable as PDF or CSV. With the direct costs grouped together, you or your accountant can read gross margin straight from it: fee income less the direct cost accounts, divided by fee income. To split that further by type of work, see fee income by service line.
Gross margin and net margin answer different questions
Investopedia explains that gross margin considers only revenue and cost of goods sold, whereas net margin takes all of a business's expenses into account. In a consultancy, the two point to different decisions:
- Gross margin falling usually points at delivery: fees too low for the hours spent, too much senior time on routine work, or write-offs of time the client would not pay for.
- Net margin falling with a steady gross margin points at the firm itself: overheads growing faster than fees.
A worked example in words: a firm wins a large new client and fee income rises, but gross margin drops because the work was priced keenly and needed more senior time than planned. Net margin barely moves because overheads were spread over more revenue. Looking only at net margin, the partners would think the new client was fine. Gross margin tells them the pricing needs attention before the contract renews.
Partners reviewing these figures each month can pair them with management accounts for partners. Start by moving fee-earners' salaries above the line this month, and compare next quarter's gross margin with the same method throughout.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
