Margins are one of a business's most important metrics. After all, the more you can charge over your costs, the more money you can make. But does this mean that you should always focus on increasing your margins, or can you ever trade a lower margin for a higher net profit?
Margin vs. Net Profit: What's the Difference?
Margin is a measure of the relationship between revenues and expenses, while net profit is simply a bottom line number.
For example, if you sell a $10 hat that costs you $3 to make, you have a 70% margin on that item. If you sell 1,000 of those hats, your profit is $7,000 ($10,000 - $3,000). No matter how many hats you sell, your margin remains 70% unless you can find economies of scale to bring your $3 cost down.
Margin becomes more useful when you have multiple products. For example, add a nicer hat that costs $4 to make but can sell for $12. That gives you a margin of 66.7%. If you sell 1,000 of those hats, your profit is $8,000. With both types of hats combined, you have a $15,000 profit and 68% margin.
In the above example, going for the lower margin percentage looks like the right move. If you sell both hats, the overall margin goes down but
profit goes up. If you can only sell one hat, the lower margin hat by percentage results in a larger total dollar profit.
The catch here is making sure that sales will actually increase. This means doing your market research to make sure that there is adequate separate demand for both hats if you plan to sell both. If you plan to switch to the more expensive hat, you need to make sure the cost increase won't decrease your volume.
One important reason to accept higher costs and potentially lower margin ratios is to increase or guard your quality. Increasing margins often means making cuts to materials, customer service, or some other part of the customer experience.
Often, becoming known for quality will increase your sales by either volume, net dollar amount, or both. This could, in turn, increase your net profit.
If you choose to decrease quality, your market will be made up of highly price-sensitive customers who will readily jump to a competitor if you can't sustain low enough margins to allow you to offer the lowest price.
Maximizing your margins on individual items may not be your best overall strategy. For example, Costco's famous rotisserie chickens have been priced at $4.99 so long that they're sold at a loss. Costco's strategy is to draw in customers looking for an easy meal and hope they either pick up more items or build loyalty for future shopping trips.
You don't need to adopt a pure loss-leader strategy, but you should be aware that lower margin products and services could help increase your sales on higher margin items.
Increasing Variable Costs
A strong indicator that it's time to consider a lower margin strategy is when you'd be reducing your margins by increasing variable costs while maintaining the same fixed costs. This might include staying open longer, making lower margin items with excess production capacity, or increasing marketing spending.
Since you haven't increased your fixed costs, you've taken on almost no additional risk since the extra costs are directly related to additional sales. If demand falls, you can simply cut these costs and return to your previous margins.
How to Choose the Right Strategy
The strategy you should choose comes down to your numbers. What are
your fixed versus variable costs? How are your sales broken down? Where are you positioned versus your competitors? Once you have this data, the decision will almost make itself.