Why does Business care more about Margin Than Absolute Profit?
Ahmed Khaled
CEO @ Unleash ?? We Transform C-Suite Executives Into Thought Leaders By Crafting Immortal Personal Brands That Tell Stories To Inspire, Influence, And Impact ?? Top 100 Influential Entrepreneurs ?? Corporate Trainer
A one million dollar question that I used to ask myself "why are business cases worth?Millions?of dollars annually?(Net sales)?could be rejected"?!!!
I kept saying if it's my company, surely I will approve that business case because at the end of the day we are here to make money.
But recently I understood the reasons behind the rejection of such?X millions of dollars?as net sales, are bigger than this.
So let's go through a quick tour to elaborate on the reason.
Profit and loss statement (P&L)
Let me give you an overview of a simple P&L (Profit and losses statement) for most companies based on the below items:
1-Gross sales
2-Trade discount
3-Net sales = Gross sales- Trade discount
4-Supply chain cost = (Production cost+ Material cost+logistcs cost)
5-Profit= Net sales- supply chain cost
Margin % = Profit/Net sales
Difference between Profit and Margin:
Profit:?as we mentioned above is an absolute value based on the currency used.
Margin: is a?percentage?not an absolute value?from the profit over the net sales.
let's pick an example to ease the understanding, ie: Pepsi has the below givens:
1-Pepsi listing price/piece is?5 USD.
2-Monthly sales are?1,000,000 Pieces.
3-Trade discount is?20%?off from total sales.
4-Supply chain cost=?1.5 USD/piece.
let's calculate the profit and the margin for this case.
Firstly we will calculate the?Net sales= Gross sales-trade discount?= (5 USD X 1,000,000 pieces )- (5 USD X1,000,000 pieces) X 20%
Net sales= 5,000,000 - 1,000,000 =4,000,000 USD.
Supply chain cost?= (1.5 USD * 1,000,000 peices )=?1,500,000 USD
Profit= Net sales - Supply chain cost?= 4,000,000 - 1,500,000 = 2,500,000 USD
Margin %?=profit/net sales = 2,500,000/ 4,000,000 =?62.5%.
You can see that Pepsi is selling by?5 M USD?a month, with a monthly profit of?3 M USD?and a Margin of?62.5%
Till this point everything is clear, let's return back to the main subject:
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Why does business care about Margin than Profit?!!!
Each company defines a specific window of Gross margin percentage % for any new product to be approved, and this percentage differs from country to country depending on many variables.
For instance, a company agreed that any business case for any new product should have a Gross margin % of not less than?50%.
There are two main reasons for that as per the below:
1-Downstream uncertainty:
Downstream here is everything related to the market uncertainty.
For simplicity let's use the same above example for Pepsi, but this time we will have a look from another perspective in terms of competition (Coca-cola):
Imagine that Pepsi and Coca-cola have the same listing price of 5 USD on the shelf, but Coca-cola decided to execute a promotion of?50% off?continuously to gain market share.
Pepsi realized that Coca-cola executed 50% off and they begin to lose market share, so Pepsi decided to perform the same promotion at 50% off.
Let's calculate the profit and margin again on that case based on the same givens before:
Net sales= Gross sales- Tarde discount = 5,000,000- (5,000,000X50%)=?2,5000,000 USD.
Profit= Net sales- supply chain cost= 2,500,000 - 1,500,000 =?1,000,000 USD.
Margin%= Profit/Net sales= 1/2.5=?40%.
Conclusion:
If you can see Pepsi still doing a?Profit?of 1 M USD?a month (the same concept that I used to think about initially), which is very good as the absolute value of money, but the?Margin % has dropped drastically by 22.5%?from 62.5% to 40%.
2-Upstream uncertainty:
The second reason is everything related to the supply chain cost as we mentioned before:
let's have the same example before for the 50% off promotion of Pepsi.
Imagine that Pepsi received a message from the procurement team that raw material contributed massively to the BOM has been increased by 1 USD/piece so that Supply chain cost will be?2.5 USD/piece?instead of?1.5 USD/piece
let's calculate the profit and margin for that case:
Net sales= Gross sales- Tarde discount = 5,000,000- (5,000,000X50%)=?2,5000,000 USD.
Profit= Net sales- supply chain cost= 2,500,000 - 2,500,000 =?0 USD.
Margin%=?0%
Conclusion:
Due to an Adhoc happened in the Material cost, it ended up with zero profit and zero margin.
Imagine the company is selling with 5 M USD a month and has zero profit and zero margins.
That's why all business cases are been assessed based on margins with an agreed percentage and not an absolute profit.
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2 年Great Post
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2 年Insightful indeed.
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2 年I want don't want money don't bisnees important for me silent not for me anymore spiking ????????????????
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2 年Very inspiring post
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