Adequate profit margins are critical to the survival of your managed service provider (MSP). While startups generally expect to run at a loss for the first few months, you can't sustain a business over the long term by writing checks for your employees from your personal bank account.

The first step to improving your profit margins is to learn how to calculate the two fundamental kinds of profit margins:

1. Gross profit margin
2. Net profit margin

You can then compare your current profit margins to industry benchmarks and consider strategies for getting your MSP's profit margins to where they should be for business continuity and future growth.

What Is Profit Margin?

Profit margin is the percentage of revenue that exceeds your costs. Your profit (or net income) is the money you have left over after paying for materials, labor, office space, and so on, and which you can freely reinvest in your business or distribute to your MSP’s members, partners, or shareholders with no impact on core business functions.

How to Calculate MSP Profit Margins

There are different formulas for calculating your MSP’s gross profit margin and net profit margin.

Gross Profit Margin

The formula for calculating your gross MSP profit margin is:

gross profit margin (%) = (revenue-COGS)/revenue x 100

"COGS" or "cost of goods sold" refers to the direct costs required to offer a product or service. This includes the cost of software licenses and subscriptions that you cover in order to resell products to your clients, as well as the total labor costs of your service technicians.

Your gross profit margin tells you how much profit you make on products and services without considering your overheads. You should calculate the gross profit margin on your product sales and service offerings separately to help you understand your MSP's financial performance across the different areas and identify specific ways to improve.

What Is a Good Gross Profit Margin for an MSP?

A good gross profit margin for an MSP is a minimum of 25% on products and 50% on service offerings. However, an overall gross profit margin of 65-75% is preferable because it allows for unexpected fluctuations in sales and operating expenses.

Net Profit Margin

The formula for calculating your net MSP profit margin is:

net profit margin (%) = (revenue-all expenses)/revenue x 100

The "all expenses" category must include:

• Cost of goods sold
• Operating expenses (rent or mortgage interest, utilities, administrative staff, sales and marketing, insurance, legal and accounting services, business licenses, coffee, etc.)

Some MSPs may also choose to include:

• Interest
• Deductions and allowances
• Taxes

The acronym EBITDA (earnings before interest, taxes, deductions, and allowances) is helpful for specifying which costs you are considering in your net profit margin calculation so that your final figure can be compared more accurately with the net profit margins of other MSPs. The most common way for MSPs to calculate their net profit margins is to subtract the first two expense types from revenue and ignore interest, D&A, and taxes (resulting in the calculation of "net profit before taxes").

Tip: Include your own salary in the correct expense category (service labor costs, operating expenses, or distributed accurately between the two if you dedicate a percentage of your work time to each). Some people fail to consider their own salaries as MSP owners in the calculations, inflating the final figure. However, this is a mistake. You would need to pay someone else to replace you if you didn't work in the company, so your labor is a genuine cost of doing business.

What Is a Good Net Profit Margin for an MSP?

A healthy net profit margin for an MSP is 20-30%. This typically means a gross profit margin of 50-60% and a standard 30% spent on operating expenses.

When and How Often to Calculate Your Profit Margins

MSPs should calculate their profit margins monthly for the first few months, then semi-annually or annually once their finances have stabilized. Regular calculations help you track your progress and identify how specific business decisions affect your profit margins.

It's essential to use the same formula each time (including the same kinds of costs, for example) so that the results can be compared. You also need to determine whether to use a cost accounting or accrual accounting approach so that the revenue and expenses are lined up correctly in the relevant periods.

What Your Profit Margins Tell You

A few factors must be taken into account when interpreting your profit margins. This applies both to positive and negative profit margins.

Interpreting a Positive Profit Margin

A healthy, positive profit margin could mean:

• Your MSP has several high-value customers and your team is operating efficiently with the resources they have. A large profit margin indicates that you are in a strong position to invest in growth.

A small but positive profit margin could mean:

• Your MSP is bringing in great money and operating efficiently but you have been reinvesting a portion of your profits in the business.

• Your MSP's revenue is lower and your costs are higher than they ideally should be.

Interpreting a Negative Profit Margin (a Loss)

A negative profit margin (i.e. a loss) could mean:

• Your MSP has a healthy revenue and is operating efficiently but you have been reinvesting heavily in growth or recently launched a new service offering. You must have sufficient funds available and be confident of increased profits in the future from your investments if you choose to reinvest so heavily that you operate at a loss for a given period.

• Your revenue is far lower and your costs far higher than is sustainable for business continuity. You must make changes immediately to avoid going out of business.

How to Improve Your MSP's Profit Margins

There are many tried-and-tested strategies for improving an MSP's profit margins. Unless your current net profit margin is 20% or above, improving your margins will be a top priority for ensuring the sustainability of your business.

Reduce Your Costs

Reducing costs strategically is generally the first place to start because it allows you to boost your profit margins without increasing your revenue. The word "strategic" is key here because maintaining the quality of service delivery is critical for customer retention (i.e. don't sacrifice quality for the sake of cutting costs because you could lose customers).

Increase Technician Efficiency with Automation Tools

Your human technicians are the lifeblood of your MSP and are essential for quality service delivery. Strategically chosen automation tools optimize your technicians' time by taking care of tasks like time entries, workflow management, and bookkeeping behind the scenes.

• Thread takes care of task categorization, task prioritization, and time entries automatically with Magic AI as well as streamlining communication with clients. Integrating Thread can improve gross profit margins by an astounding 21%.
• Bookkeeping tools like QuickBooks can be used to minimize time spent managing the MSP's finances so you can focus on providing quality service to your customer base.

Streamline Your Software Subscriptions

MSPs subscribe to up to 20 categories of SaaS solutions (or more) at any given point in time. The cost of these subscriptions quickly adds up. Analyze the value each subscription adds to your operation and pinpoint where the capabilities of your subscriptions overlap. You may be able to perform all the functions you need with fewer total subscriptions if you use all of the tools in a more streamlined stack to their full potential.

Leverage Partner Programs

Vendors like AWS and Microsoft offer partner programs with financial perks for resellers. Microsoft, for example, offers up to 25 users across 20 software products plus technical presales and technical support hours with their partner success core benefits package. AWS partners receive a listing on the AWS Partner webpage and a priority listing in the AWS Partner Solutions Finder. Cut costs by taking advantage of the benefits included in your partner package.

Prevent Unexpected Losses 

The fourth place to cut costs is in the area of preventable losses due to disasters. This is an often overlooked aspect of protecting your business's profit margins.

MSPs can lose money on payouts for customer downtime due to a security breach or technical issue. Require your clients to take out a cyber insurance policy and also take out a cyber insurance policy of your own to protect your bottom line in the case of an unforeseen disaster.

Increase Your Revenue

Increasing your revenue (with a slower growth in costs) is the other main way to improve your profit margins. You must have clear and accurate information about how much new customers will cost you to serve to make sure that the increased revenue indeed helps your profit margins.

Optimize Your Pricing Model

MSP pricing is generally fixed contract, usage-based, tiered (scalable), or hybrid. Analyze your pricing model to make sure you aren't losing money on the products and services you offer. A hybrid or scalable model is generally the most profitable (and predictable) for MSPs.

Raise Your Prices

Raising your prices will immediately increase your revenue without a corresponding rise in costs. This is generally done in stages with forward notice and a transition period. Ensure an excellent customer service experience and perception of value to maintain customer satisfaction after the price rise.

Transition to More Profitable Offerings

Some products and services have much higher profit margins than others. Identify which of your offerings have the highest margins and the lowest service requirements and focus your efforts on those.

Tip: Security services, compliance solutions, and cloud backups are in-demand services right now that could help you generate more revenue.

Transition to More Profitable Customers

You will enjoy the most optimal profit margins when you have (almost) 100% customers who:

• Are your target company size
• Use your standard tech stack
• Opt for your full package
• Aren't problematic

Determine your "ideal" profitable customer profile and gradually replace suboptimal customers with new clients who match your ideal profile.

MSP Profit Margins Matter

An MSP business must be economically sustainable to continue to operate and ideally grow. Calculating your gross and net profit margins regularly provides the information you need to monitor and improve these margins.

MSPs can improve their profit margins by optimizing their costs, managed services offerings, pricing models, and customer base. Take care of these four areas and you should soon see improvements in your bottom line.