Understanding How Profit Margins Affect Business Decisions
When you graduate from college with a tangible, in demand skill and no formal business training you are starting off in the middle. In my case, I started a business at 24 with the understanding that I could make websites and people would pay me for them. Not only that, but they would pay me more than I could make at my job as a government employee. I knew very little else about running a business at the time and by starting in the middle it took several years to learn the lessons that may sound obvious to you already.
One of these lessons I learned was the importance of margins for running a business. Several seemingly unconnected experiences helped me realize just how important margins are for the health of a business. When these experiences are looked at upon the same plane, it's easy to see why strong margins are so important for business success.
Business Example #1: Nucor Steel
It all started with the book Good to Great by Jim Collins. As I was reading through the examples of companies that outperformed the stock market by 3x over a period of 15 years, I noticed that one of the companies mentioned was Nucor steel. This particular company piqued my interest because the steel industry happens to be where my father in law worked throughout his career.
Hoping to win over my future father in law while dating his daughter, I started talking to him about Nucor steel to see if he could corroborate the story found in Good to Great. While his opinion as a former competitor to Nucor was not as glowing as that of Jim Collins, he told me something that was just as valuable: They were a highly profitable company because they had great margins.
That was it. A two word explanation for a how company became tremendously successful, and a business lesson that affects every decision I make moving forward. Well, not every decision, as we will soon learn.
Business Example #2: The Online Pool Supplies Business
If only I had taken the words of my father in law to heart sooner, I never would have gotten into selling Pool supplies online. It all seemed like such a good idea: I could take over an online e-commerce store selling salt chlorine generators online and literally print money through all of the online sales generated. At least that's what I thought would happen when I bought the e-commerce store from a family member with connections into the pool and patio industry for $1.
On the surface everything looked tremendous: $400,000 in revenue the previous year with a 1,000% ROAS (return on ad spend) for all of the money spent with Google AdWords. All of the metrics pointed to this being my most successful business idea of all time and my ticket to champagne and caviar.
But when it came time to balance the checkbook I realized that I needed to put in more money out of pocket in order to keep running the business. That shouldn't happen with all of that revenue, right? Well, it turns out that we lost money every single time we sold a salt water chlorinator!
How on earth can that happen with a 1,000% ROAS through AdWords and similar results with Comparison Shopping Engines?
Margins! We had terrible margins.
In order to offer the best prices online (and generate sales), we could only mark up the product by 20-30% and we would need to offer free shipping to all customers. Even though we had a favorable drop-ship relationship with the distributor, the shipping cost represented 5-10% of the wholesale price of the product. I also needed to pay a customer service person to help with fulfilling the orders, and this also accounted for around 5% of the purchase price. Add in the AdWords spend of 10% of the product sale price and any revenue from the sale was quickly washed away. And we haven't even mentioned fixed expenses to this point.
Add it all up and it looks something like this (scaled down so I don't look like a complete idiot):
Cost of Goods Sold: –$75
Shipping Expense: –$8
AdWords Expense: -$10
Customer Service Expense: -$5
Credit Card Fees: -$3
Fixed Costs: -$5
Profit (Loss): (-$6)
For the most competitive products in our catalog, we ended up paying money out of pocket for the privilege of selling them to consumers.
Talk about a failing business idea.
Needless to say, I got out of the Pool business for good after 6 months of losing my shirt and ended up dipping into my savings to pay for a degree from the school of hard knocks.
For those of you thinking about getting into the e-commerce business, please understand one thing first:
If you don’t have margins, you’ll eventually become a commodity
Competing on price is nearly impossible in a world where Amazon.com exists, because they can survive for a long time losing money on individual purchases and having loss leaders. Your bootstrapped e-commerce business can't do the same.
Do you know what merchandise has the best margins? Products that are truly unique to the marketplace. If you can create something that is not easily reproduced or simply better than others, you will be able to sell it for a large margin. This is the strategy that works so well for Apple.
If you ever watch the show Shark Tank you know that investors cringe when they see a margin of less than 50% on the sales of a product. Aim for a minimum margin of 50% before quitting your day job.
Business Example #3: Running a People Based Business
Another direct example of how margins affect business decisions comes from my years as a principal owner in an advertising agency. An agency is a people based business and salaries are the single largest expense in an agency (more than everything else combined).
For an agency margins can be calculated as the difference between what you pay your human capital (employees) and how much revenue you bring in the door. In most cases salaries represent well over 50% of the revenue coming in, which makes it nearly impossible to reach the 50% margin I mentioned above.
People based businesses are easy to get started because you can forecast employee headcount needs based on the revenue projections for your business. It’s straight-forward to project booked revenue vs. headcount expenses for the year and you can add or reduce employees in order to achieve your desired margins. This is why we see people based businesses hiring and laying off employees so often.
Like any business model, there are benefits and drawbacks to running a people based business. There is usually a low cost of getting started and the businesses carry very little debt. The revenue can also be very stable and the work can be fulfilling for many.
One of the main drawbacks with people based businesses is the perceived value of the service being provided and the amount of time required to get work done. Clients want all of your time at below market rates. Your margins are determined by the seniority of the staff your hire, so there is a temptation to hire less senior staff to maintain profit margins. You try to achieve scale with people, which is nearly impossible to accomplish.
While I loved my years in the agency business, I eventually found myself chasing the dream of moving on to businesses with larger margins.
Business Example #4: Google
Software based businesses that achieve scale of users and revenues are about as profitable as they come. Google is an outrageously profitable company by any stretch of the imagination and this allows them to invest in ensuring their margins are protected well into the future. If you look at their financial statements, you can see that Google made just south of $60 Billion in 2013. It cost them less than $26 Billion to do so, which means that they had a 57% margin for the year.
What did they do with that margin? Well, they spent nearly $8 Billion in research and development. They spent over $12 Billion in administrative expenses as well (it is not clear what makes up this amount of money, but it likely includes things like employee bonuses and all of the free food). That means they spent nearly $20 Billion dollars above and beyond the amount of money it costs to actually run Google to stay ahead of the game. Even after these investments into the future they had a net income of nearly $13 Billion, which is more money than they likely know what to do with.
That is what great margins do for companies; it allows them to invest for the future while still meeting shareholder expectations.
This is why Rand Fishkin was brilliant to transform Moz from an agency to a technology startup when he did. He started with a business very similar to example #3 above and then pivoted to change his business to be more like the example of Google. Check out their sick revenue growth as a result!
What Can Great Margins Do For You and Your Business?
Summarizing what we have learned above, here are some of the things that get funded as a result of great margins within a company.
- Margins are used to fund research and development of new products
- Margins are used to fund employee bonuses and variable compensation plans
- Margins are used to fund dividend payments back to shareholders
- Margins are used to fund test and learn budgets
- Margins are used to fund marketing initiatives
- Margins are used to fund acquisitions of other companies
To me there's no way around it: Margins are everything in business. The sooner you recognize this simple fact, the more quickly you can advance your career.
Using Margins to Positively Affect Your Career
Understanding the profit margins of the company you work for is a key aspect of career advancement. Businesses with high margins are often the most fun places to work, have awesome perks and often come with stock options. If you are looking for a new position, you should absolutely consider the margin structure of the new company before joining. If you are looking to break off as an entrepreneur, pursue an area that allows you to bring a unique product to the marketplace and cannot be easily replicated. This is how you will command strong margins.
For those of you comfortable with your current company, work toward advancement. The higher you rise through the food chain at your organization, the more your compensation will be tied to these very same margins! When you help the people above you reach their bonuses, you are more likely to end up on top in the future.
Do you know how CEOs at public companies get paid tens of millions of dollars a year? This is all variable compensation based on hitting their profitability targets. For example, if Larry Page were to get paid 1% of gross profit at Google, he'd make $340 Million a year! That's a lot of money for one person, but it still leaves 99% of the profits to distribute amongst everyone else.
When I look at where I should focus my time and efforts in the future, margins are going to play a huge factor in the choices I make. For now I'm dreaming of the day that my father in law explains how I am a billionaire because my company has great margins.