Margins
Margin or margins is a word you hear a lot in business. I want to talk about what it means and why it is important today on MBA Mondays. I did talk about margins once before, in the context of the income statement, back when we were walking through the basic financial statements. But I'd like to talk about the concept outside a strict accounting definition.
Margin is the amount of money you make on each incremental sale or unit of revenue before factoring in the "fixed costs" of your business. Fixed costs would be things like the rent on your office, your administrative team, and the people who do your accounting/bookeeping work for you. The key concept to wrap your head around is some costs rise and fall based on how much revenue you have and some costs are fixed and are the "cost of keeping the doors open."
I have a friend who runs a pickles business called Ricks Picks. His pickles are awesome, but I digress. If you buy a jar of Hotties (spicy sriracha-habanero pickles) from Rick, you'll pay $7.99. That jar of pickles costs him between $4 and $5 to make and send to you. That includes buying local cucumbers from farmers, making the spicy brine, and cooking up the pickles in their industrial kitchen. That includes shipping the pickles to Rick's warehouse and then shipping them to you. Let's say all of that costs $4.50 per jar, then Rick's profit on your pickle purchase is $3.49 per jar. Margin is often expressed in percentage terms, so $3.49/$7.99 is a 43.7% margin.
Notice that I didn't include the cost of Rick's time, his office, the team in his office, the marketing efforts, the cost of his website, his accountants, and a bunch of other costs in that calculation. That is because he has to spend all of this kind of money no matter how many pickles he sells every year.
Now let's think about four different businesses that are well known in the tech business; Apple's iPad business, Google's search business, Amazon's retail business, and Salesforce's SAAS business. Each of these businesses has a different margin structure.
Apple has significant costs associated with manufacturing and selling each iPad. This article in the EE Times suggests that the "bill of materials" (often called the BOM) of parts that are used to make the iPad2 are $270. You can buy an iPad2 starting at $499. If you just subtract $270 from $499, you get $222 of margin on every iPad2. I'm not trying to be accurate here. Apple's margins on the iPad2 could be a lot higher or a lot lower than $222/iPad. I'm just trying to point out that when you make a hardware product, your margins will be impacted by the material costs of making a physical product. Apple's reported gross margins in its most recent quarter were 38.5%.
Amazon typically operates as a traditional retailer in their core e-commerce business. This Oxo kitchen tools set costs $99.99 at Amazon. Amazon purchases that item in bulk from Oxo (or a distributor) for something less. Maybe $60 or $70 per unit. So they have a margin of $30 or $40 per unit. Amazon is not a manufacturer. Oxo is. So Amazon's cost is the price at which the manufacturer is willing to sell it the item at wholesale. Amazon's reported gross margins in its most recent quarter were 20%.
Salesforce is a hosted software company. When you become a customer, they don't have to make anything new to service you. They just open up additional resources on one of their servers and you are good to go. They have very high fixed costs associated with building, maintaining, servicing, and selling their software, but the cost of actually delivering an additional unit of revenue is very low. Salesforce's reported gross margins in its most recent quarter were almost 80%.
Google's search business is a media business with aspects of the hosted software model. Providing search queries to consumers is a lot like salesforce's hosted software business. Each additional search query doesn't cost Google very much. They need to add more servers over time to handle more queries. The revenue those queries generate comes from the adwords paid search service. Some, but not all of that revenue comes self service. Some comes from a salesforce that goes out and sells keywords to large customers. But like the hosted software business, paid search is a high margin business. Google's reported gross margins in its most recent quarter were 65%.
Now that we've gone through a bunch of examples of businesses with different kinds of margins, let's talk about why margins matter. In general higher margin businesses are easier businesses to grow and manage. Lower margin businesses are often very difficult to scale, both operationally and financially.
If you think about my friend Rick, he has to go out and spend a lot of money every summer and fall when cucumbers, beans, beets, and okra are less expensive, higher quality, and fresh from the local farm, make and jar the pickles and move them into his warehouse. That is cash out the door. Then over the rest of the year, he sells the product, gradually getting back the money he laid out plus his margin. As his business grows, that summer/fall production runs costs more and more. And the dollar value of inventory in his warehouse grows. He has to come up with some way to pay for that production. This is called working capital and in lower margin businesses, working capital isssues loom large and are an impediment to growth.
Let's look at a hosted software business in the mold of salesforce.com. They spend money upfront to build and host the software but then as their business scales, the cost of "manufacturing their product" is relatively low. They can grow rapidly without having to come up with huge amounts of capital to finance that growth.
When you think about your business; starting it, building it, scaling it, and financing it, pay a lot of attention to your margins. Understand what kind of business you operate and where it fits in the margin universe. Understand how those margins will impact your operations and your financing needs. There is nothing worse than waking up mid-course and realizing you have a lower margin business than you thought that is more capital intensive than you thought and you are caught without a plan to deal with these issues. I've seen that kind of thing kill more than a few companies.
Comments (Archived):
Good stuff Fred, but I think you perhaps missed an opportunity to throw fixed and variable costs into the mix.In reality it’s the low incidence of variable costs that allows a business to scale rapidly without absorbing too much capital.It’s almost the same thing as you’re saying, but not quite.
And contribution margin…
Yep, the degree to which variable costs are lower to total costs result in a better Contribution Margin (which allows a business to cover its fixed expenses) and can create a faster scale (operating leverage). However, if (and when) business starts to slow down then having a cost mix that is slanted more towards the fixed cost and can hurt, in some cases tremendously. This type of ‘old economy’ business had a relatively high degree of operating leverage.Incremental analysis and Contribution Margin analysis is actually the modeling behind the Coupon CPA tool I created for small business owners to analyze their proposed Daily Deal promotions in advance of signing the deal with the promoter. This topic is also a subject in my latest micro-book that is going through its final edits.
Yikes some of my comment disappeared before I hit enter!Should read:However, if (and when) business starts to slow down then having a cost mix that is slanted more towards the fixed cost and can hurt, in some cases tremendously. The family owned a golf course for a number of years. This type of ‘old economy’ business had a relatively high degree of operating leverage.Incremental analysis …
Talking about margins and working capital, there are a couple businesses where the working capital is actually negative, like Groupon (maybe you could have discussed this here), as people pay Groupon before Groupon actually has to pay back their own suppliers.On top of that they probably have a relatively high un-utilization rate (people bought deals) but never actually used them, which brings them very high margins (pure profit on un-used packages/deals).These 2 factors makes their use case very much of an edge case, but also incredibly interesting in terms of self-financing (the faster they grow, the more money they have to grow!)
Do you know the % of unused coupons Julien? I’m not certain whether this is higher than the 5-10% paper contest/coupon unused rate from pre-ecoupon days.Interested in this as I haven’t seen much traction from the aftermarket ecoupon marketplaces that were cropping up last year.
I don’t know for Groupon specifically, but I studied a similar model in France where that reached up to 20%.No matter what, even 5% is is a very high number, when you think that these coupons are 100% pure margin. They could virtually sell ‘at cost’ and just rely on the number of un-used deals to build up their margin!
Good point.
The Coupon CPA tool I developed allows small business owners a chance to change this variable and see the potential financial impact that results. That said, personally I am very leery of business models that tries to count on the end-user NOT using the service they pay for (e.g. a consumer buying a Daily Deal and then not using it). There are some other things that might come into play here as well based on research I have done and continue to do.
In my experience with unused coupons or uncollected certificates, I look at this as gravy. I’ve factored it in in repeatable models but always on the low side.Glad to look at your tool if you’d like.
That might be fine unless a state considers these as Uncalimed Property and subject to Escheat Laws
From what I’ve seen, if they’re issued as a “coupon” and not a “gift certificate”, they can get away with it.
I am not a lawyer (and have never even played one on t.v.). I called one state specialist and they were unsure what a determination might be on an unused Daily Deal certificate escheatable or not based on their characteristics.
Not likely as almost all have an expiration date but what an insightful thought.This “breakage” is typically 15%.
its below 10%
thnx
correct that arnold – these seem to be pretty solid daily deal metricshttp://sebprovencher.com/20…
Dell Computer was another good example of this. You’d order your computer, pay with your credit card and then Dell would start building it. A week or two later, you’d get it and start using it. And another two and a half months after that, Dell would have to stop earning interest on some of your money and actually pay their suppliers for the parts in your now-used computer!Structuring revenue and cash to your advantage is one of the most powerful tools in business.
Customer acquisition cost is a big piece of the margin puzzle. And mostly unknown in early stage companies till they mature.Yes, I know this is bringing in marketing again but most, no all, companies past early adopters need to address not only how but the cost of getting those new unique visitors or customers. And if the time to convert is long after a calculable acquisition cost, this falls into capital needs as well.
Marketing is a luxury for most companies.The cost of sales includes salaries + commission. Rick will need someone to do sales at some point in his growth and that becomes a whole new ball game.
Tom…either don’t understand or don’t agree. Customer acquisition is not a luxury, it is like oxygen, an essential.
My point is that most companies need to focus on sales and their cash flow goes to maintaining and nurturing a sales force. If they are fortunate to have cash at that point they can address the “luxury” of marketing.
Got it, thanks for the clarification Tom.We don’t agree on this one. Stems from a definition of what marketing is. Lots of diverse opinions on this.I won’t muddy up this comment stream. My views on this are here: http://bt.io/GumF
he’s got one person who works on a commission basis. he needs a few more. if you have any great commission based pickle salespeople, send me an email
Fred, tell Rick he owes you a few bucks.”Pickle salesman” might be a quite a few notches below your pay grade but so far you’ve made us all aware of a pickle shop most of us have probably never heard of in our lives and probably never would have known about. I just placed an order. Somehow I know I’m not alone.Surely there is some kind of AVC-related spike in pickle sales happening this month thanks to you! Mmmmmm…. pickles. Delicious margins.
My wife backed rick with an angel investment a few years ago. I just eat thepickles and listen to music with rick. It worked out well
…and the Circle of Life is complete. :-)Nice. Well done, Fred.
+1.When people talk about business ideas with me. I always write down the following: LTV > CPA. LTV is lifetime value of a customer; basically, the marginal value of the customer. (In fact, that’s what it should be, to account for marginal costs, but I deal mostly w/digital media ideas where the marginal cost is so low.)CPA is the cost per acquisition of a customer.LTV has to be higher than your CPA or you’re not going to make it, and I ask people to articulate that stuff 🙂
“LTV > CPA”A core tenet of the natural order of all businesses.Early stage companies have a lot of moving pieces in the equation but I agree completely, it is a key way to talk about the value they they are bringing to the customer and how that value continues…and hopefully builds over time.Many whiteboards get filled flushing this out.
LTV and CPA issues are dependent upon where the business is with its current capacity (can it serve without adding more) and also where the business is relevant to covering its existing fixed costs. At the very margins LTV could equal CPA and no economic ‘harm’ would befall the business. However, if a customer is only worth what it costs to acquire and fixed costs have not been covered and/or capacity is already close to 100% then the analysis might need to be modified.
Dharmesh Shah of Hubspot has a good blog post on why SaaS companies (like Salesforce) do need tremendous capital as they grow – because while the margin per customer on a percentage basis is high, the actual dollar amount per month is low. It’s the LTV of the customer that’s important. Interesting stuff.http://onstartups.com/tabid…
That equation LTV>CPA is lifeblood.In the comments below, I think we are getting too ‘one up’ in word definitions. You have to have some marketing before sales, figuring a way to begin the development of an image.Keep hammering the LTV>CPA equation Dan!
one of many golden rules of businessa guest MBA Mondays post in the makingyou up for that dan?
Sure, just gotta clear it w/my boss 🙂
please ask him/her
For sure, tomorrow. Either way, thanks for the offer!
marketing – you want to open that wound again????
Sorry….can’t help myself ;)Or maybe it’s happening on its own.Let’s ban the term (momentarily) and have Dan talk about “LTV > CPA”. Great idea and he is the perfect person for this.
I think it’s funny that I’m the perfect person for it given how rarely I use it professionally, hah 🙂
You wrote a great headline:LTV > CPAThe rest will follow naturally.
Ha! :-DRestraining myself. ^^
Ha!
…after a successful career as a VC and a brief stint as roadie for the Rolling Stones, Fred Wilson went on to become Professor of Business at Harvard, Stanford & Brooklyn Community College…
of the three i would choose Brooklyn Community College in a nanosecondbecause brooklyn is the coolest city in the world
I have a feeling you’re already educating people at all three institutions through posts like this one…
I’m sure you are right Aaron but more importantly Fred is educating a much wider audience.I think of AVC as continuing professional development
Absolutely. The education here is top notch and the student loans are the best deal around. 😉
Brooklyn is second to Jackson Heights, a close second. http://goo.gl/fb/sndyh
I completely agree with the post. I have been on both sides, in a traditional manufacturing business (margins were around 50-60%) and now in the software side. I had to go through a lot of trouble in my manufacturing business to understand the idea of cashflow, and working capital requirements. That definitely almost killed the business a number of times, and was the reason I shed a lot of hair that year.I am also guessing that Rick sells stuff on some sort of payment terms (Net 30 etc) and if he does not have a way to factor those (either by a bank or otherwise) that could also put a lot of strain on his working cap requirements eg he buys something, pays for his inventory, sells it at a net 30 and is out of cash for that deal for 2-3 months. Of course, he could setup payment terms with the growers as well (and in a mature business people normally do) but as a new business you normally end up getting the worst terms as a buyer and doling out the best terms because you really want to sell and generate revenue.
particularly large corporations. Nordstrom did not pay us for over 2 months and we were out of cash for over four months on that deal. Horrible horrible times! You do things…and so you learn…no other way.
I wish startup folks understood this in a real way. I’d also like to include a magical understanding of this as well:1> The difference between sales, cash flow, and payables.2> That their costs, no matter what they think, are higher than what is in the xls.-XC
Hurray for the SaaS business for having the highest profit margin from these great examples. (I’m biased, but still… the numbers speak)How about examples from consumer-centric businesses like the ones USV invests in? What would Twitter’s or Zynga’s gross margins look like?Another comment is that one must also look at net margins when dealing with gross margins. These measures of financial performance and efficiencies go hand in hand.
zynga’s were a lot better before facebook took their platform tax
Interesting insight.
you want to play on someone else’s platform you gotta pay.It’s a distribution cost really, isn’t it?http://www.startupboyo.com/…
Yes
And it’s interesting to play comparing margins across companies/industries in a fast way with Google Finance’s stock screener: http://www.google.com/finan…®ion=us§or=AllSectors&sort=&sortOrder=&gl=us&hl=en&I am not sure but I think that when you have the scale of Google crawling, the growing Internet can impact your margins drastically in the future? I mean: It’s very different the scale-margin problem in Salesforce vs Google.
I’m creating an ecommerce based healthy personal chef business for the masses. Based on my initial thinking around pricing and expenses I believe we will be operating a high margin 50-60% business with the customer paying upfront. I’m a little concerned about how we can best approach pricing. I think we will probably just test, test, test. I suspect food pricing is probably a very different beast.
Send me an email, this is an interesting idea. I have a couple of products that may work for this. http://www.fitnesscoffeeusa.com and http://fiberpasta.it/p/en/
Thanks! We are going to make all the food ourselves from raw ingredients so I’m not sure either would fit into our focus.
In the food business, your pricing is always a function of competition first and cost of goods sold — food cost — second.It is a highly segmented business in which the Big Mac can co-exist with the $8 hamburger ($20 burger in NYC). The segmentation is clearly an opportunity.There are many healthy eating initiatives out there right now which deliver good nutritious food with excellent portion control and are typically “heat and serve” operations. You buy it, take it home and heat it up and serve it. They are all fairly similar. This is a modestly new wave and not all of them can survive.The personal chef business adds a level of quality and a level of more expensive creative labor. It is an idea which has been around for some time.It is a luxury product and folks who employ private chefs are willing to pay for the incremental cost as their frame of reference is often private clubs and fine dining. This is not the cafeteria crowd.How you get this concept to the masses will be very challenging and interesting.I used to own the largest catering operation — a hands off investment relationship — in central Tx and would be glad to chat you up a bit on what I learned. I do not think this is a very good business and I had other complementary reasons to want to own it.Nonetheless, I bought it 3 weeks before 9-11 and the rest is history.Send me a text at 512-656-1383 w/ e-mail and I will be glad to visit further. I have business interests in CHS so if you are a grad of that boys school down there and live nearby, I would be glad to buy you a cup of coffee.BTW, I went to another trade school myself, VMI.
You should have a text from me. It is a 310 Google Voice number.
Got it. I will send you an e-mail in just a second.
JLM do you get up near KC much in your travels? If so let me know, would like to take you to the family joint and buy you lunch or dinner.
I will eventually. I am pretty much a cheap whore when it comes to a free meal.I used to spend a fair bit of time in KC. I remember the great steaks, BBQ and Country Club Plaza.KC is one of those grown up cities with serious people. I like it.
Well you sound like you have some food industry experience, or personal passion. I have garnered both over the years. My father-in-law has been in the business his entire life & I have learned a ton about this industry via him (my formal training being in finance) and he is lucky to co-own one of KCs most venerable establishments. I might text you so you have a way to get in touch with me if you do come up this way.
Sounds interesting. My wife & I launched (misfire) a meal prep lifestyle business and are in process of relaunch. I agree w/ JLM’s comments getting this to the masses might be challenging & difficult.
Just a quick thought. In the specialized food prep business, you have to get the customers to pay 3-4 days before the event so they are, in effect, financing the food costs and to keep them from stiffing you.This catering company I used to own had a ton of jobs on the night of 9-11, not one of which was held but we had gotten paid for all the food and thus did not get hurt — for six months when the bottom fell out of the business.
Interesting post. Hit a couple of chords with me.1. I am sure when you receive business plans from new ventures, most of them show a very high margin. How often are the margins correct from the plan to implementation?2. Do you look at the plans and try to then calculate out what a true margin could be? I would show a realistic margin that would be easy to accomplish, but do everything possible to make that the floor instead of the ceiling.Entrepreneurs are optimistic in nature, but it would be interesting to know just how optimistic versus realistic they really are versus implementation.
we are not nearly that analyticalwe are gut investors to the core
While you focused this post on margin from “incremental sale” (gross margin), I think it’s important to acknowledge that there are other margins in the business. And they shouldn’t be ignored.Operating Margin, for example, is another one I like to look at (and you have previously mentioned it is the most interesting line in a P&L). There’s a lot of info in there… Salesforce’s gross margin looks great at 80% but operating margin is a lot less glamorous at 0-10%, depending on which quarter you look at. Is that still an easy business to grow and manage? Is it attractive to an investor?
good question and i think you’ve just given me next week’s mba mondays post!thank you
And its important to consider EBITDA margin as well, because it acts as a proxy for the free cash flow generated by the business.
Google’s reported gross margin ratio is lower than I would have expected. The marginal cost of each additional query seems trivially small… this didn’t add up to me.So, I pulled GOOG’s 10-K. Goog doesn’t breakdown marginal cost there, but they do mention that they include payments to AdSense publishers in their “Cost of Revenues” as a traffic acquisition cost, which I suspect accounts for a large portion of their marginal cost.If GOOG were just a search engine with no distributed ad network, I’d think their gross margin would be in the 80s. If they were just an ad network (like AdSense) they’d be lucky to break 40% gross margin. So, the fact that they’re in both businesses and their gross margin is 65% makes sense when you blend the two businesses together
yup. adsense is a way lower margin business because of the publisher rev share. but it is strategic as it creates more liquidity in the market for keywords. i bet paid search is >80% gross margin
Both high and low margin businesses have blessings and curses. I think you definitely described the blessings of the high margin business and the curse of the low margin business.The curse of a high margin business is that unless you have a sustainable “moat” around your business somebody can come in and reduce your margins to zero. Examples: Music Industry, Classified Ads, different software that now gets given away.The blessing of a low margin business is that as you scale you can gain efficiencies and lower cost per unit because of buying power. Its why you don’t see to many new big etailers and why small retailers say they can buy items at Walmart cheaper than they can buy them direct.
This is why intellectual property is so important to drug companies. The IP is the moat.
Yes and I agree with people that say why Google makes and gives away: Android, Chrome, Gmail, and Gdocs is to build a moat and scorch the earth when you try to approach the search business castle.
Fabulous analogy.I also think that companies like Google — maybe Apple and MS also — will ultimately have such an integrated product offering that you cannot consider not taking the entire thing.This is the genius of the MS Office Suite — who thinks of buying just one product? You buy the bundle and yet that was quite innovative thinking just 20 years ago.I am truly amazed at the speed w/ which Android has become an equal competitor to any other system in the phone business and the speed with which it has become a worthy competitor in the tablet business.This is a truly amazing time in the history of technology and business.
Don’t we float back and forth between bundling and debundling? We keep arguing about this involving cable
great comment Phil
I think your last paragraph is an often overlooked point, being the most efficient in a low margin business can be an extremely valuable moat. This is especially true in industries with high CapEx such as airlines. It would take a tremendous amount of capital to compete effectively with someone like Southwest Airlines and if you’re successful your reward is earning single digit margins.While high margin businesses attract investment capital to competitors (ie Groupon), low margin business have the opposite effect.
I should have pointed out that the “moat” for low margin businesses, is that if you are large you can basically “bleed out” your competitor.You can make them lose money on every sale and try to make it up with volume.I think Airlines are tough example because everybody has the fantasy of “flying”. They are a high gross margin filling an empty seat basically is 100% margin, but low operating margin business. That’s why the returns suck.If you are in a low margin business you want to be not glamorous (railroads) or produce a great specialty product like Rick’s Picks. I bought a bunch!!!
Overall, a great topic and indeed critical to understand, but I think this is really misleading “In general higher margin businesses are easier businesses to grow and manage” – particularly as it relates to B2B and ASP businesses. So many people get intoxicated by the potential margins of a salesforce.com kind of product but they fail to go back and look at how much money they spent in Sales and Marketing cost to get to this level. They HAD to raise a tremendous amount of money and spend a tremendous amount of money to get their scale. In 2001, their costs were $35 million to earn $5 million in revenue. $25 million of that was for sales and marketing. The vast majority of the really successfull B2B winners needed to sell enough early on to win investor confidence so that they could get $50 million+ in funding to spend on sales and marketing. The common pattern for success in B2B is GREAT sales and marketing, which is REALLY expensive and NOT easy. It’s really friggin hard and most entrerprenuers don’t understand that. They see how easy it would be to make a better product than sf.com, e.g. and don’t get that is not about just about the product and it’s really hard to get over the fixed cost hump.
Very good point.The worry is always how long you can defend your advantage that you got spending all of that money.Somebody like Zoho can come in and sap your margins.However, the advantage you have in BtoB is customers are less willing to change on price, because of the classic paradigm: If I do something super innovative and get a big win I get a 5% raise. If it fails I get fired.Its one of the most interesting dynamics I see. You worry so much about wasting money that the end result is you waste more money trying not to waste money than you would in the first place.
i think there are better ways to acquire customers than the way salesforce did itbut i will save that for another post
I hope you do that post sooner rather than later
I have thought there were better ways as well – but have not won with other models or identified b2b asp players that did anything other than a direct sales model, including: channels (channels are for commodities, not new stuff), freemium (it’s not normally a price issue, it’s BUSINESS PROCESS issue), selling individuals instead of departments (you end up with a bunch of small deals that don’t always stick and sometimes create animosity with the formal purchasing channel), trials (see freemium). I am sure there are some good success stories out there, I just don’t know what they are. Looking forward to your perspective.
I agree with the comment Dan.
Competitors margins also play an important role in determining strategy and the viability of a business. Unless your product is completely unique, your competition will most likely set your price (roughly). They may have significantly higher or lower margins than you do, which changes the landscape and how you need to react.In the world of uber high end watches, there are lots of players making very mediocre stuff and passing it off as true haute horlogerie (high watchmaking). The sort of stuff I love and work with are incredibly expensive to make, and yet there is only so far pricing can go. Therefore often two competitive products at similar price points can have massively different margins. Unfortunately this means the higher margin, lesser quality company has all that extra money to spend on advertising and marketing. It relegates the best stuff to a niche where only the truly clever and super hard-working survive.Luckily we are not in a winner-take-all market. In that sort of scenario, having significantly lower margins than competitors can be an unsurmountable obstacle.
Since you brought them up, I have to recommend Ricks Picks Mean Beans. They are incredible.
killer product. try them in a bloody mary sometime
I like to think of gross margins as the measure of the productivity of the economic engine that drives any business. If you have good gross margins then the only other thing to worry about in the short term is your overhead.I generally think of gross margin – corp OH = net margin as the shorthand for any business.It is a 3-legged stool.If you have decent gross margins, then growth is your friend as each incremental dollar of revenue creates more gross margin in absolute terms.If you can keep your corp overhead fairly fixed, then each dollar of gross margin is adding to net margins at almost 100%.Corp OH as a percentage of revenue is an important thing to watch as it tells you whether the growing business is becoming more and more efficient from a profit perspective.A healthy company has a good gross margin which is dependent upon the industry. This a measure of the health of the economic engine of the business and is the justification for pursuing growth.A healthy company has a well controlled corp overhead which declines as a percentage of gross revenue (not gross margin) as company grows. This is a measure of the efficiency of the growth dynamic.The net margin — which is simply the resultant of the gross margin and the corporate overhead — is a measure of the bottom line profitability of the company.Once you have done this analysis, you can begin to dive deeper taking a look at cost of goods sold (reduce this and you grow gross margins obviously), the LTV v CTA of a customer, the efficiency of marketing in acquiring customers and the cost of capital within the company.I very much like to analyze the productivity of persons and capital in any enterprise — corp oh as a % of gross revenue, gross revenue per employee/marketing employee.Once you see the impact of margins and how they impact everything else arithmetically, you can thoughtfully tweak things to improve performance. It is a never ending challenge and opportunity.
Glad you and Dan Lewis are adding to this discussion.Keeping it simple where OH matters and its relationship to LTV>CPA matters.Main thing is you have to have the lowest possible Corp OH during/after development to have use of the most in Marketing/Sales.
Great comment. There is no better way to gauge the effectiveness of a business with scaling revenues than to benchmark its gross margin against other similar companies.The interesting thing is that tech companies have very high gross margins because everybody who works on the product gets lumped into R&D (an operating expense).It’s always seemed like the engineers who spend their time just making the existing product run should be under COGS, and the ones building new stuff under R&D.But nobody does it that way (so of course I don’t either or we wouldn’t benchmark against our industry).
<quote>Let’s look at a hosted software business in the mold of salesforce.com. They spend money upfront to build and host the software but then as their business scales, the cost of “manufacturing their product” is relatively low. They can grow rapidly without having to come up with huge amounts of capital to finance that growth.</quote>And yet, SaaS businesses often need a fair amount of financing to scale. That is because, unlike traditional software licensing businesses, hosted software is often paid for on a monthly basis, while customer acquisition costs still have to be paid for upfront….sorry, I know you know this stuff but I just thought it was interesting to continue in that vein!
Agreed, with SAAS you need to build a solid platform before you can benefit from the low unit costs and you’re essentially building out the infrastructure ahead of the demand curve.
That’s really because of the revenue and cash model, not the margins.Salesforce has roughly similar margins to Microsoft but they almost ran out of cash when they had a pure monthly fee model. It was only when they rolled out annual fees (and raised prices if you wanted to stay on your old monthly fee plan) that they really started scaling profitably and customers were financing the expansion of their infrastructure.Even though SaaS companies need more financing to get off the ground, I’d still take a steady stream of revenue over time instead of a “hit product” that I have to repeat every year or two.(But Apple seems to make that work okay for them…)
Totally agree with you that SaaS working capital needs are not a function of margins. Also concur with the rest of your comment.BTW, I wonder how much of Apple is now essentially a subscription model. Buy iPad 1, use for a year, sell/discard, buy iPad 2, rinse repeat. I.e., what part of Apple’s customer base is really consuming hardware on a repeatable basis and how far/long will that scale?
Apple’s model still looks like that but the thing is, a subscription model has inertia. If I could sign up to pay $49/month and get a new iPad every year, that would be a sub.With their current model, I have to really want the new MacBook Air more than the current one, enough to plunk down the money again.That’s a hit-driven product model. It can be powerful but it’s not as stable.
Great, great post – thank you Fred. I think so many businesses fail to separate their direct costs from their fixed costs and just look at their overall profit rather than considering their margin which, as you say, could tell them a lot they didn’t realise about their business.
I wanted to add, as someone who has had many confused customers, that margins and markup are not the same thing. A margin can never be greater than 100% and can only be 100% if you got the product you sold for free. Margin is the price sold less the price bought divided by the price sold. Markup can be greater than 100% and is sales price less original price divided by original price.I know this is small and silly but it makes a difference and, surprisingly, confuses a lot more people than it should.
great explanation
A follow on question is – how does a business deal with pricing – because often, it is not a cost+ approach, but a value / what is the customer willing to pay approach; but the latter creates, eventually a discussion of “why do you make exorbitant rent on each sale” – obviously, all the prior discussion in this thread alludes to the need for covering development, sales/outreach as well as people cost, but does it not create a conundrum of customer with options saying “reduce your markup”.
Hi,I don’t think your example using Rick’s is really accurate. You are saying that the “Hotties” would cost the customer $7.99 shipped to his/her home . But I don’t believe that is true. Yes, the product is $7.99 but Rick adds $9.00 to ship it to you.So he is really getting $16.99 to send you his single jar of pickles…
ah yes, i messed that upthe shipping is zero margin thoughthis is why his internet business is hardand why he sells bundles more than individual jars online
virtual currencies are the high margin business that changes the world. profits from virtual currencies subsidize everything. right now currency issuance is already the highest margin business in town, but legislation protects the industry and obscures it under the cloak of nationalism. that game is falling apart and once the central banking industry becomes a free market we will see google-esque subsidization/moat-building. only it will be even more awesome that what google offers. free web analytics? pfft. try free housing, free education, free healthcare, free energy…..a communist’s dream come true, borne out of a free market capitalist’s dream come true.
It was touched on a little in your post and in the comments but the structure of how you fund working capital can be as important to scalability as the margins. Some businesses, like a subscription service, collect cash before they pay out their variable costs associated with delivering that service – so customers are funding their working capital requirements (in theory). Other businesses, like a retailer, has to purchase inventory up front then carry that cost until the inventory sells. If the retailer can arrange credit terms, then the wholesaler is funding the retailer’s working capital. A high margin business that has to put cash up front and wait for sales on the back end can be very difficult to scale.
Great post on margins.How about this scenario?* A low margin business, say 10% per week* Cash turns around every week* Great potential to scale up * Limited working capitalWhat would be the best way to scale up?
Even with a weekly cash turn, 10% margin isn’t really compatible with limited working capital.Been there, done that…my dad’s company (distribution of security equipment) had gross margin of 22% on its best day. It was a brutal business because you needed so much velocity and scale just to cover your opex before you made your first dollar of profit. A huge education for me.I wish you luck but I predict you’ll have a hard time finding capital to support a 10% margin business. And even if you do, do yourself a favor and move heaven and earth figuring out how to cut production costs and get margins to 15%.Still brutal, but you’ll grow 50% as fast!
Great post Fred, though your text was about margins not including CPA, I’m glad to see a lot of discussion figuring in total OH.FWIW… this link is to Gartner’s predictions, something to think about regarding the probable playing field coming sooner than later. http://v.zite.com/gqb1tEI bring that up due to my insistance of need to hold down Dev cost and by so doing increase your exposure (multiple OS). Do that and you can set a smorgasboard in front of the end run customer appealing to multiple demographics.Not so long ago, mentioning the Dev cost going both iOS and Android bewildered most. Though the Gartner link above is just predictions, it does back what I’ve been telling folks regarding the field will open up again… which means your Dev cost needs to be in check to the point of being able to do true multiple OS’s.Do that and then you’re able to concentrate on the marketing/sales side establishing a reliable measure of margin and its relation to different demographics leading to multiple, yet simple metrics.
How do you look at ‘marketplace businesses’ like Ebay, Etsy, Viagogo or Elance. E.g. Elance charges roughly 10% fee for the services offered on their website. This looks like a low margin business.I think thie 10% fee is still 100% margin to Elance as this fee fully contributes to their gross margin. So is it true that in some cases an apparently low margin business can actually be a high margin business?
etsy doesn’t book the transactions as revenue as they don’t collect therevenueso they have a very high margin business
Hey Fred -Have you ever thought of compiling MBA Monday posts into an e-book or PDF?
kevin from knowitall downloaded all the AVC posts ever written and made ahuge pdf of iti suppose someone could do that with MBA Mondayshere’s what someone did with the MBA Monday postshttp://mba-mondays.pandamia…the content is creative commons licensed so my hope is it will find its wayinto many formatsbut i won’t be doing that worki’ve done everything i want to do which is to put the concepts down intowords in a format that they can be remixed, republished, translated, andsuperdistributed
The pickle example really made the other points clear.
and sold a few pickles too!
Ha ha!
Fred- great post, as always. I think it’s confusing to relate working capital dynamics of a business with margin. To my mind, margin is about the value-added in the production process for people buying your product or service. Working capital is a different dynamic, reflecting the relative strength of the buyer-seller-supplier value chain.Businesses with extensive working capital needs are challenging to scale because they require incrementally more capital. But, for example, a low margin custom bike business that only starts manufacturing bikes after it receives an order is relatively simple to scale, as you can just bring on other people to continue the build if your current capacity is overrun.
Margins are important, especially when trying to understand the nature and the value of the business. The better question is what does the margins on Twitter and Zynga look like. I looked at Linkedin’s S-1 and I wasn’t nearly as impressed. That is, I was hoping for higher net earnings in comparison to what Linkedin is trading on the secondary market. Even with a very favorable P/EG, I can only calculate the fair value to be at 800 Million and not the 2.5 Billion that is trading on the secondary market. Perhaps, I missed the mark somewhere or I am very old fashion in that I stick with the discounted cash flow valuation.
It would also be worth mentioning the impact of different cash flow models. Lower margin products in which you get paid before you have to pay for the goods are MUCH less devastating to cash flow than the pickle example. For example, Groupon hands out 50% to merchants as “cost of goods”, but Groupon gets paid before they have to pay the merchants. This is a great model, in fact they get to use the merchant’s 50% as financing for growth. So, in this case, I’d actually rather have a ticket average of X with 50% margins than a ticket average of X/2 with 100% margins (both lead to the same bottom line contribution), as I get interest free financing money in the former example.
cool
As an ideal, the tighter you can couple building the market and transacting with it, the more natural and better the process is.