In How to Get Past the 3-Year Hump on BNET, John Warrillow, author of Built to Sell, boils it down to gross margin:

Whether you’re starting a lemonade stand or the next Groupon, arguably the single most important predictor of your future success is what you pay for the stuff you need to make your final product.

And that simple math is sales less cost of sales, or sales less direct costs, which we call gross margin. In a store, it’s what you sell it for less what you paid for it. In a service business, it’s what you charge less the service costs you incur in delivering the service. It gets trickier with services because there are people costs involved. Do you include yourself as part of your costs?

From that gross margin, subtract your expenses, like the salaries that aren’t part of direct costs (most aren’t),  rent, and of course all those sales and marketing expenses, and you get profit before interest and taxes. Next step, take out interest and taxes, and that’s profits.

It’s  a good reminder of fundamentals. He says you get three obvious advantages from minding the underlying profitability of the gross margin:

1. Cash preservation

2. More money for sales and marketing

3. More profits.

So then he gets to the real message, how to increase your gross margin:

The secret to fattening your gross margin is differentiating your product so it doesn’t become a commodity. There is an expensive way and a cheap way to differentiate your brand.

The expensive way is to slug it out through advertising in a Coke vs. Pepsi-like battle for the mind of the consumer. If you win, you can charge obscene margins. Tiffany’s pays about the same for its diamonds as your local jeweller does but charges you three times as much for the privilege of presenting your gift in the little blue box.

The cheap way of raising your gross margin is to differentiate your business by redefining your company as the only player in a specific niche instead of a small fish in an ocean of larger competitors.

Good stuff. Nice post. I haven’t read the book yet (it’s in the active stack, waiting) but the post makes me believe in the book.

Tim BerryTim Berry

Tim Berry is the founder and chairman of Palo Alto Software and Follow him on Twitter @Timberry.