## Monday, September 17, 2012

### Sometimes lower margins can lead to higher margins: a thought experiment

Sander Koppelaar recommended that I should read the book "What the CEO wants you to know: How your company really works." by Ram Charan.

It's a great book, I highly recommend it. As does Bob Nardelli former CEO of The Home Depot stores: "Finally, a book that shows how business works."

For me it was interesting to see how he used the word "margin". "Throughout this book, we use the word margin to refer to net profit margin after taxes. That is, the money the company earns after paying all its expenses, interest payments, and taxes." p.39

But in describing a street vendor selling fruit he confuses gross margin with net margin. "Every time he sells a melon, he makes just a little bit of money. His profit, the difference between what he pays for the fruit and what he sells it for, is very low. His profit margin-the cash he gets to keep as a percentage of the total cash he takes in-is around 5%."
The difference between the buying and selling price is a retailer's gross margin. The "profit margin" or "net profit margin" is the gross margin minus the costs of selling the item.

(Even as I am writing this and looking up the definitions on Wikipedia I am getting confused.)

Why is it important to distinguish between the two ? The reason is, that in retail gross margin by itself tells you nothing about profitability. This is because the costs of actually selling the product aren't included the calculation of gross margin. In manufacturing the gross margin is more closing related to net profit margin because the costs of manufacturing are included in the manufacturer's gross margin.

Let's look at a simple thought experiment with the street vendor and see how changing your product mix and lowering your margins can increase your margins.

Say the street vendor only sell 1 article per day and he pays \$5,- per day to rent his fruit stand.

Day 1:

\$ 10,- received for selling 1 apple (= sales, revenue)
-\$ 4,- buying price of the apple (= cost of goods sold)

The gross margin is sales minus cost of goods sold.

\$ 6,- gross margin = 60% profit margin (\$6/\$ 10,-)

-\$ 5,- renting fruit stand (= cost of selling or SGA costs)

Net profit margin is gross margin minus cost of selling (=Sales-COGS-SGA)

\$ 1,- profit (=\$10-\$4-\$5) is a net profit margin of 10% (\$1,- / \$10,-)

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Now what happens when you lower profit margin ("the cash he gets to keep as a percentage of the total cash he takes in."

Day 2 Sell 1 orange for \$20,- with a gross margin of 40% (the apple on day 1 had a gross margin of 60%)

\$ 20,- received for selling 1 orange (= sales, revenue)
\$ 12,- buying price of the orange (= cost of goods sold)

The gross margin is sales minus cost of goods sold.

\$ 8,- gross margin = 40% of sales (\$8/\$ 20,-)

-\$ 5,- renting fruit stand (=selling costs or SGA)

Net profit margin is gross margin minus cost of selling

\$ 3,- profit over \$20,- sales is net profit margin of 15%

By choosing the right product your net margin has gone up by half (from 10% to 15% even though your gross margin has decreased by a third (from 60% to 40%).

Day 3 Sell 2 kiwis for \$10,- each with a gross margin of 40% (the apple on day 1 had a gross margin of 60%)

\$ 10,- received for selling 1 kiwi (= sales, revenue)
-\$ 6,- buying price of the kiwi (= cost of goods sold)

The gross margin is sales minus cost of goods sold.

\$ 4,- gross margin for 1 kiwi = 40% of sales (\$ 10,-)

-\$ 2,50 renting fruit stand (\$5,- / 2 kiwis)(=cost of sales)

Net profit margin is gross margin minus cost of selling

\$ 1,5 profit over \$10,- sales is net profit margin of 15%

Total profit is profit per kiwi x 2 = \$ 1,5 x 2 = \$ 3,- is 3x original profit.

E-mail: ajbrenninkmeijer (a) cs.com