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“I made my first investment at age eleven.

I was wasting my life up until then.”

–Warren Buffett[1]

Content created by Darin Gerdes. Copyright Great Business Networking.

At a recent business networking meeting, one member demonstrated his service and the entire room was impressed. When someone asked how much he charged, he responded that he normally charges $250. After an audible gasp, he told the group that he would do it for half of that for anyone in the group ($125), but he could not really go lower than that. After all, his costs were roughly $80 in materials plus travel expenses.
You might think that at that price, he was still making a hefty profit, but he was essentially giving his service away to members of the networking group. He wanted them to become products of the product so that they could refer him to others with confidence. He was right to not even attempt to go lower. This is a temptation that many entrepreneurs face and one that can destroy the business.
There is an old joke that, “We lose money on every sale, but we make it up on volume.” Unless you are laundering money for organized crime or you have a government subsidy, you cannot become profitable by losing money on each sale.
The point is that you must know your numbers if you hope to be successful. In accounting for the number phobic, Fotopulos explained:
The rule of thumb is to sell a product at COGS plus 45 percent, to make it worth the risk to offer that product. This will also help guarantee enough gross margin from each sale to pay for the operating expenses of the business.[2]
COGS plus 45 percent is a minimum. Beyond his variable costs, he will have to pay his operating costs and taxes. In our example, he knows that he has to cover $80 in materials plus 45 percent or another $36, so he know that he should not conduct his business for anything less than $116. Fotopulos continued:
The goal is to build a profitable business, not maintain an expensive hobby that will leave you in the poorhouse. Make sure the premium charged above costs is adequate to keep the business viable. So what management decisions can be made if the price being charged for products does not adequately cover the cost to produce them? Here are three possibilities to restore profitability:

  1. Raise the unit price, but only if customers are willing to pay for it.
  2. Lower the COGS by re-engineering the product.
  3. Drop that product from the lineup if it won’t sell at a price high enough to cover the COGS plus a 45 percent premium.

If it’s possible to raise unit price and lower COGS while maintaining sales, you’ve hit the jackpot![3]
You can’t always raise the price, but his price was right for his market. At $250, he earns a great return on investment, and he should do all of the business he can. Especially early on, these margins will be necessary to keep him going during the lean times.
 
Return on Investment
Return on Investment (ROI) is a general term for a measure of the efficient use of resources. There are a number of measures of return—return on assets (ROA), return on equity (ROE), return on capital employed (ROCE). Each have slightly different formulas but they are all trying measure the efficiency of use of assets, equity, or capital.
All other things being equal, you want to generate a high ROI. To determine ROI, subtract your cost from your gain and then divide that number again by the cost. Managers use ROI to determine whether an activity will be profitable before devoting resources to it and after the activity to see if they should keep doing it. As Richard Lambert explained in Financial Literacy for Managers, “Profits are an important indicator of success, but we also need to consider how much was invested to generate those profits. For example, profits of a million dollars are not so impressive if the firm invest a trillion dollars turn them.”[4]
 
A Trip to The Dollar Store
Let’s look at return on investment from a different perspective. The same day that I heard the pitch described above, I took my son to the dollar store. My kids love the dollar store. When I take them to Wal-Mart, they see lots of merchandise, but they are never sure if they can afford what they see on their meager incomes (birthday plus chore money). However, when they walk into the dollar store, they know that they can own anything in the store. They already know the price.
When I take my son to the dollar store, it takes forever because he likes to wander the aisles looking for the best deal for his dollar. Inevitably, he comes back with a large bag of cookies, candies, or some other item that can be divided between himself and his siblings. This time I didn’t mind, however, because I wandered the aisles curious about how much margin the store made on each product.
The dollar store has a fascinating array of items that all sell for a dollar. Before I go any further, it’s important to again clarify that high-value is not the same as high-margin. Value is in the mind of the consumer; margin is the mathematical difference between the cost to produce[5] and the price for which it is sold.
Since the price for all goods is one dollar, the dollar store had to purchase it for far less than a dollar in order to put it on the shelf and still make a profit. If they followed Fotopulos’s rule, they should acquire each item for less than 69 cents in order to have at least 45% margin to pay operating expenses and taxes.  So how can they afford to sell their wares for a dollar?
Sometimes this was achieved by offering a smaller quantity of the item. Sometimes the items were off-brand or very cheaply made. Sometimes, they purchased items inexpensively because the seller wanted to liquidate inventory. This was the case with the books that were on the shelves.
I spotted two hardback books by famous authors that each cost more than twenty dollars when they were published. The dollar store, however, bought these for pennies on the dollar because the publisher was clearing their inventory. Books that the publishers can’t sell are called remainders. “Most dollar stores acquire remainders, close-outs, or out-of-print books similar to the way T.J. Maxx or Marshall’s ends up with close-out department store clothes.”[6] Purchasing a twenty-dollar book for one dollar is quite a value proposition.
The trick then is to pair high margin with high value. The dollar store makes very little margin on certain items. For example, some of the canned food was brand-name.  They also sold reading glasses and pregnancy tests. I’m no expert, but the at-home marijuana test seems like it would be a low-margin, high value item. In contrast, they make very high margins on other items such as a decorative bow, 50 feet of string, or a single candy bar.
After my son figured out what he wanted, I intentionally got into the manager’s checkout lane. I asked what items are high margin and what items are low-margin. She told me that the high-margin items included stationary and brittle plastic toys from China.
Next I asked what items were low-margin and if there were any loss leaders. She told me that the cleaners (e.g., brand-name chemicals like Mr. Clean and Ajax) and the frozen foods sometimes cost more than the selling price, but that was okay because they brought people into the store.
 
Calculating Margin
When you deduct direct costs from your sales, you are left with gross profit or gross margin. Sometimes this is just called margin.[7]  Margin is usually in a percentage and you determine gross profit margin by dividing gross profit by revenue. Remember, gross is before you remove operating expenses. “Without an adequate gross margin, a company is unable to pay for its operating expenses.”[8]
This is not the same as net profit margin, which is net profit divided by revenue. This number tells you how much of every dollar earned results in net profit. For example, if the net profit is 9 percent, we know that for every dollar the company earns generates 9 cents in net profit.[9]
 
Net Margin
Pop culture teaches us that businessmen are making fortunes on the backs of employees and taking advantage of consumers, but in a free market where buyers can buy what they like and sellers can sell what they like, this is rarely the case. It’s rare because as soon as something becomes very profitable, it attracts new entrants who want a piece of that action.
Rarely do we see businesses make outsized net margins of 50 percent, 40 percent, or even 30 percent. Aswath Damodaran, a finance professor at NYU Stern School of Business has examined business margins by industry. After examining 7,480 firms across various industries, he found that the average net margin (after all expenses and taxes have been paid) across all industries is a measly 6.40 %.[10]
Damodaran found net margins as high as 24.89% for tobacco with banks following close behind. But for most industries without the sales benefits of an addictive product or where capital is not the product, net margin is much lower. When we think of an industry with great margins, we might think of insurance, but property and casualty insurance only generates 9.09%, life insurance generates 7.70% and general insurance only generates 6.20%.
Hospitals and health care facilities only make 4.09%. Farming averages 3.2 %, and grocery stores average 1.97%. Though the margin is very low, grocery stores can still do well through velocity or churn.
Some industries generate a negative net margin. They are only propped up by government subsidies. These include energy (e.g., oil and gas, mining, green and renewable energy, etc.), steel and telecom.[11]
 
 
Why Does Margin Matter?
In a previous lesson, we talked about buyer personas. I made the case that you should focus on those personas that are most likely to buy. In the same way, you should also focus on the activities that will create the highest margins. Both are matters of efficiency. To grow your business, you must efficiently create value for your customer while selling your product with enough margin to grow. Remember, “No margin, no mission.”
Do you know your margins? What activities create the most value for your customers? What activities increase your bottom line? If you know the answers, you can begin to prioritize. Efficiency is a key to profitability.
 
 
Actionable items:
 
List your margin for your most common products or services.
 
What is your highest margin activity? Is this what you do best?
How can you alter what you do in order to be more efficient?
 
 
 
End Notes
 
[1] Buffett, M., & Clark, D. (2006). The Tao of Warren Buffett: Warren Buffett’s words of wisdom : quotations and interpretations to help guide you to billionaire wealth and enlightened business management. New York: Scribner.
[2] Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (p. 25).
[3] Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (p. 25).
[4] Lambert, R. A. (2012). Financial literacy for managers: Finance and accounting for better decision-making. Philadelphia, Pa: Wharton Digital Press. (p.  78).
[5] In the case of the dollar store it would be the cost to purchase and stock on the shelves rather than a cost to produce.
[6] Daley, L. (2011, Oct 8). South Coast Today. Retrieved from http://www.southcoasttoday.com/article/20111008/entertain/110080309
[7] Fotopulos, D. (2015). Accounting for the numberphobic: A survival guide for small business owners. (p. 26).
[8] Gross profit margin. (n.d.). Investopedia. Retrieved from http://www.investopedia.com/terms/g/gross_profit_margin.asp
[9] Net profit margin (n.d.). Investopedia. Retrieved from http://www.investopedia.com/terms/n/net_margin.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186
[10] Damodaran, A. (2016). Margins by sector (US). Stern School of Business. New York University. Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/margin.html
[11] Damodaran, A. (2016). Margins by sector (US). Stern School of Business. New York University. Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/margin.html