Money is Nice but Business Margins are Better
Nonprofits are nice, but few of us run them.
No; many of us are members of the for-profit business society, and for good reason. For-profit companies can increase shareholder value, build personal wealth, supply the economy with jobs, and grow a community.
However, there appears to be an epidemic occurring where for-profit business owners aren’t familiar with the very financial metrics that drive the success of their companies. If you run a business with the goal of earning a profit, among other things, wouldn’t it make sense to understand the business levers that result in more cash?
Your financial data tells a story. It’s the tale of your company’s efficiency and effectiveness. Within each fact and figure is a nugget of information that can help you build a better business.
Perhaps most important of all? The insights gleaned from business margins.
Important Business Margins to Know
Revenue and profit numbers are important, but they don’t show the full picture of company success. In actuality, these numbers show you the absolute terms of business performance. However, an entrepreneur should never think in absolutes.
Margin ratios, on the other hand, tell you how your business is performing relative to itself and even to its competitors. These ratios are not expressed in absolute terms, meaning that they’re comparable across time and organizations.
With this in mind, ratio analysis is the best way to look at your company and make decisions based on the data. So, how do you go about it?
Gross Margin — When you begin your ratio analysis, it’s always important to start at the top. Revenue is important, yes, but only as a percentage of another business number.
When you’re trying to create a more profitable business, rather than looking at hard revenue numbers, look first at your gross margin. This margin number is expressed as: (Gross Profit) / (Revenue).
Gross margin is the portion of the money you earn when you sell a unit of your product or service, prior to paying for operating costs. It measures the producer surplus, which is the price of a good minus its cost of goods sold (COGS), or the cost of the material inputs needed to produce the good.
So, when you want to grow your revenue so you increase your profit, look at your gross margin. If you sell your product for $5.00 and the COGS are $2.50, your margin is 50 percent. Can you increase your margin by producing your product for less or selling it for a higher price point?
Answering yes to either will increase your revenue.
Operating Margin — Your company’s operating margin takes your operating profit and divides it by your revenue. Your operating profit, of course, is the total amount of money your business makes pre-tax, taking into account all COGS and operating costs.
Rent, employee wages, and company snakes are all operating costs.
Operating margin therefore shows you the percentage of pre-tax profit you make on each unit you sell. So, if your gross margin is 30 percent and your operating margin is 10 percent, your operating costs account for 20 percent of your total business cost per dollar of revenue.
This is a great ratio to measure the efficiency of your company. A well-run and well-oiled business has a high operating margin because it’s able to generate a lot of revenue on a small operation. Increasing your operating margin is the practice of trimming fat and ensuring your current operations are the best way to run your business.
Increasing your price point or reducing your COGS naturally increases operating margin, sure, but make sure your operating costs are in check, too. Be a lean startup, not a bloated multinational.
Profit Margin — Profit margin is the ultimate efficiency ratio, because it takes into account every cost your business incurs — including taxes. Sometimes there’s a give and take where you want to realize an operating cost or an increase in COGS so it reduces your tax burden. But sometimes you don’t.
Understanding your profit margin can help you make that decision.
Profit is the ultimate goal of your business. Understanding your profit margin, which is your profit divided by your revenue, allows you to get the full picture of your business. Changing any business number will affect profit margin, and checking your margin each time you tinker will tell you right away whether it’s an effective change or not.
The whole point of all of this is to increase profits. Therefore, above all else, seek to increase your profit margin.
The Importance of Margin Analysis
The number one benefit of margin analysis is the measurement of company performance.
Let’s say, for example, that you earned $100k of profit in January 2016 and $105k of profit in February 2016. So what? That doesn’t really tell us anything.
But let’s say instead that your margin remained the same but your operating margin increased by 5 percent month-over-month. You now know that your increase in profit had something to do with a reduction in operating costs.
Or, how about if your revenue increased but your profit stayed the same? Looking at your gross margin might tell you that each additional unit of sales resulted in a higher unit cost, causing the rise in revenue to have no impact on bottom-line company performance.
Understanding your margins is the best way to understand your company performance from one period to the next.
Margin analysis also lets you compare your performance to the performance of your competitors.
What if you’re a small startup with $100k in annual revenue, and a major player in your industry has annual revenues of $100 million? How could you possibly compare?
Well, remember that these are absolute numbers. If you use ratios, you can quickly check the performance of your company against the performance of a comparable.
So, if your startup has a better gross margin than that of a large multinational, you know that you’re already producing your product at a lower cost. Conversely, if your gross margin is lower, you might find that the bigger company is experiencing economies of scale and that you’ll need to achieve the same scale in order to successful.
The same goes for the other two margins. You can check the efficiency of the rest of your business by comparing margin percentages.
I think you get all of this by now. However, the fact remains: many business owners don’t know — or don’t trust — their margins. Further, company margins can be wrong altogether, making the whole exercise useless.
It’s important that, as business owners, we ensure that the proper data is inputted so the margins are correct. Then, once they are, we need to mind them and constantly check for performance.
Only when this is done will we know how our businesses are performing, and, more importantly, know how to make them better.