Love Your Margins
Margins are your best friend.
They pay for your office, your superannuation, your Christmas party and your holidays.
When things go wrong or sales slow down, your margins keep you afloat.
Yet when times are good, we seem to ignore them.
What is a Margin?
A margin is the gap between what you pay for a product/service, and what you sell it for.
Let's say you run a vending machine, and you pay 80c per bag of chips.
You then sell the bag for $2.
You earn $1.20 per bag.
This is called the “Gross Margin”, and it’s the sale price minus the cost of the product itself.
There’s also the cost of running and restocking the machine, which you calculate averages out to 50c per bag, to pay for a person’s time and a bit of electricity.
So now you have $2, minus 80c for the chips, minus 50c for operating costs.
That leaves you with 70c profit per bag – the “Net Margin”.
We can also describe this as a percentage; 70c / $2 = 35% net margin.
That 70c per bag is your life.
As an entrepreneur, this profit enables you to say “Yes” to good things.
It allows you to grow the business, to take risks, to take a break, to pay bonuses, to trial new offerings.
Margins aren’t accidents
This won’t happen on its own – it requires a great deal of thought, planning and design.
Costs don’t accidentally fall, and prices don’t accidentally rise – only through a combination of talent, diligence and ingenuity.
When Tomer and I ran our business, we picked products based on two criteria – popularity and profit margin.
Either one by itself is useless.
Popular but no margin?
You’ll hopefully break even.
Unpopular and good margin?
You’ll make an occasional dollar but remain frustrated.
That meant our offerings varied week to week, and we refused to sell “traditional items” that made hardly any margin.
Instead we chose a collection of products that had good margins and that made people happy.
Your business is no exception: it’s up to you to deliberately design something popular and profitable.
Margins enable impact
Your profit enables you to do good things – like hire and train people from under-supported communities, purchase environmentally friendly supplies, or funnel money towards good causes.
Ask yourself: If our margins fall, what happens to our social impact?
The more spare cash in your business, the more freedom and power you have to improve the world.
Monitoring and defending
The forces of business will see customers look for discounts, and suppliers push for cost increases.
These aren’t always easy to spot, and your margins can be subtly eroded by a few innocuous changes.
Here’s an example:
You sell a widget for $1, and it costs you 90c to produce.
What happens to your margins if the cost goes up to 95c?
Your profit margin halves.
At first you'd think this is simply a 5-6% increase in costs, not something that destroys your business.
It cuts both ways.
If you raised prices to $1.10, your profit would double – even though to the customer it’s a 10% increase.
That’s why it’s so important to measure and defend your margins.
Small changes have unusually large impacts.
High Margin Offerings
It’s probably worth focusing on high margin goods and services.
Low margin businesses require high volumes of sales, so they are sensitive to small changes and competitors.
The secret of high margin businesses is identifying a large gap between cost and value.
Cost is what your business pays to make something.
Value is what it’s worth to your customer.
Let's look a product like eye fillet steak.
The piece of meat costs a few dollars from a butcher, and is cooked in butter, salt and maybe some herbs.
But a good eye fillet steak in a restaurant is one of the best foods in the world, easily worth $30+.
Customers aren’t thinking “I could have made this at home for $8 per serve including sides”.
Instead they’re overwhelmed by the meal, and generously offer a taste to their friends, and everyone feels cultured and sophisticated.
Beer is similar.
You can buy a bottle of imported beer for under $2, then sell it in a dimly lit, noisy bar for $9.50, and customers will happily drink six of them in one night.
Or think of a hairdresser.
The cost of the dye, scissors and shampoo is minimal, but a great new hairstyle is worth $180+ to their customers.
These margins are important, because they have to do the heavy lifting for literally every other cost.
That steak pays for the chef, the tablecloth and the waiter.
That beer pays for the bar staff, the inevitable broken glasses and the cleaners the next morning.
Those hair foils pay for the advertising, superannuation and holidays of your hairdresser.
If these products didn’t have high margins, then these businesses wouldn’t exist.
We’d all cook at home, drink in our lounge rooms and colour our own hair.
You might like the idea of selling cups of tea or baked potatoes.
But if your customer can’t see enough value to pay top dollar for them, there’s not enough margin for the rest of the business to function.
To further complicate things, remember Jeff Bezos’ famous insight:
“Your margin is my opportunity”
If your margins are lucrative, someone else will come in an undercut you.
Think of what Uber did to taxis, or what Aldi did to Coles, or what Book Depository did to Borders.
That means we need to design, measure and defend the right level of margin for our industry.
If we’re greedy, someone will swoop in.
If we’re careless, we’ll go broke at the first speedbump.
What are our margins today?
What should they be in the future?
How can we protect our margins?
(and the fun one) What’s the best use of our profits?
You might enjoy this four-part series on useful financial metrics.
You can jump straight to:
Part One Introduction, Margins and Breakevens
Part Two Market Sizing and Forecasting Sales
Part Three Customer Value, Acquisition and Retention
Part Four Churn Rate and Customer Behaviour