Margins – how they can make or break your business
Posted On July 8, 2020
Gross Margins, Net Margins, Profit Margins, Operating Margins are few of the terms thrown around when we talk about the profitability of a business. What do they mean? Why are they important? In this post, I will try to cover these in very simple terms. If you are a start up founder looking to understand these terms then read on.
The Donut Business Margins
Let’s say you are running a donut business. To build a sustainable business you need to make profits. To make profits you need to know all your expenses and price the product appropriately. So what are the expenses involved in running a donut business?
There is the cost of ingredients needed to make donuts like flour, sugar et. Let’s call these the ‘Cost of Goods Sold’
Then there is the expense of operating a store like rent, employee salary, electricity bill etc. Let’s call these the ‘Operating Expense’
What else? Well, if you had taken a loan out to set up this business, then there is the Interest you have to pay out for that. There is also the tax that you have to pay to the the government. Let’s club these under ‘Interest and Taxes’.
Now let’s say in a month you buy ingredients worth Rs. 1000 to make 100 donuts. This means your Cost of Goods Sold = Rs. 1000.
Your rental, employee salary, electricity bill etc. comes around to Rs. 500 a month. So, Operating Expenses = Rs. 500.
The interest and tax expenses comes out to around Rs. 100 per month. So, Interest and Taxes = Rs. 100.
Adding all these expenses your monthly expense comes out to around Rs. 1600. So, by selling the 1000 donuts you need to make a minimum of Rs. 1600 or Rs. 1.6 per donut. At Rs. 1.6 a donut you are essentially at break even or no profit, no loss.
Now if you want to expand your business you need more money. You can raise this money by getting a bank loan, approaching an investor or by raising the price of your donuts. So, if you were to raise the prices of donut by Rs. 0.4 you would now be selling donuts at Rs. 2.
Rs. 2 / donut * 1000 donuts
Cost of Goods Sold (COGS)
Cost of ingredients
Revenue – COGS
Rent, Salary etc
Gross Profit – Operating Expenses
Interest & Taxes
Operating Profit – Interest & Taxes
Once you have the above values you can calculate the margins with the following formulas
Gross Margin = (Gross Profit/Revenue) x 100%
Operating Margin = (Operating Profit/Revenue) x 100%
Net Profit Margin = (Net Profit/Revenue) x 100%
From the above calculations we can understand that higher gross margins ensure that you have more money left to spend on sales, marketing, rentals and employee salaries after paying for the raw materials cost. But not all industries work on high gross margins. Industries dealing with physical goods usually have low gross margins as it involves a higher Cost of Goods component. Industries dealing with digital goods, financial services etc have higher gross margins as there is 0 or very low Cost of Goods component.
So naturally for low gross margin businesses the key lies in volumes and the size of transactions. Slight variations in any of the two can send these businesses to a tail spin. Low gross margin business that survive for a long period of time usually develops a defensive moat around them. These can be
Network Effect Moats – eg: Any social media network becomes more useful as more and more of your friends join it. This is the moat that Facebook, Twitter etc take advantage of
Cost Moats – eg: Switching Costs – If your company has been using Amazon Web Services there is cost involved in moving to Microsoft Azure or Google Cloud
Cultural Moats – eg: Brands like Patagonia, Starbucks etc have huge brand value which makes it difficult to beat these brands
Resource Moats – eg: Pharmaceutical companies like Pfizer own many IPs, patents etc which makes it difficult for upstarts to compete with them
In über competitive spaces companies are willing to work on negative margins as long as they can raise external funding and drive out the competition in the area. Post that they can raise their prices to become profitable. Most of the heavily funded start ups deploy this strategy as this is the easiest to implement. So in the donut example, if some one was selling donuts for Rs. 1.2 you will obviously have to sell it at 1.2 or lower to compete provided that the donuts are of the same standards. Who will blink first depends on who has the deepest pockets.