Margins (continued)

Last week in MBA Mondays we talked about margins, which I defined as:

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.

That led Amish Shah to leave me this comment:

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.

As Amish points out there are other kinds of margins in a business. I like to focus on "gross margin" because I think it tells you a lot about the scalability of a business (as I detailed in last week's post). But operating margin which is gross margin less all the operating costs is another really important metric.

There are relatively low gross margin business (like Apple which has gross margings of 38.5%) which have relatively high operating margins (Apple has operating margins of 29.2%). And as Amish points out, you can have a relatively high gross margin business like Salesforce have relatively low operating margins.

It is important to pay attention to these metrics. You might have two businesses with identical operating margins but one has high gross margins and high operating costs (like Salesforce) and the other has low gross margins and low operating costs (like Apple). The businesses will be very different to manage and will require different teams, strategies, and financing requirements.

#MBA Mondays

Comments (Archived):

  1. christopolis

    From a management perspective I do not believe managing operating margins is beneficial and it can be very harmful. You should always be trying for efficiency by reducing operating expenses but the cost of running a business is the cost of running a business. Managing operating margins can lead to some very bad decisions and a downward spiral of cutting employees or outsourcing core services leading to shrinking capacity and then shrinking revenue which then causes you to cut more employees and outsource more and so on. All the while operating margins can be improving.

    1. Dave Pinsen

      Not to mention the effects of that downward spiral on the broader economy. I went into more detail on this elsewhere recently, but a pair of FT articles a couple of weeks ago contrasted the manufacturing employment situation in the U.S. and in Germany in the wake of the global financial crisis. The article on the U.S. situation noted a vicious circle: U.S. factories that had laid off a lot of workers in 2008-2009 were wary of hiring more employees now, despite an uptick in orders — because unemployment was so high.

    2. Alex Murphy

      I would have to take an opposite point of view on this. The biggest gains in operating margin come from improved economics of the business. When your company does $2M in revenue and grows to $3M you will likely see a doubling of your operating margin. That is because most of your operating costs (payroll) for the key positions will not need to expand.Of course, many companies choose this point in time to take on a significant round of investment, but that is done consciously about what the increase in expense will do to operating margin. Operating margin drives cash flow which is the key to continuing to grow and expand the business.While a lot of companies have to go through the pain of layoffs, this rarely is done to drive up operating margin, it is done to preserve cash due to a downturn in the business. It almost always is followed by stagnant growth or worse. This is very different than managing the margin.

      1. christopolis

        I maintain that for managing it is a useless number. The inputs arerevenue and operating expense. You have to manage around those twonumbers. You cannot directly affect operating margin without impactingone of those numbers. For decision making purposes it doesn’t help tosay let’s address operating margin. It does help to say let’s work toincrease revenue and/or reduce operating expense.You should check with the US auto industry to see if they have madedecisions around operating margins that have led to exact effects Imention, especially at the product level.

        1. Alex Murphy

          You are right that Operating Margin is an outcome of how well you do at driving revenue and managing expenses.The piece here to manage to is that as your revenue grows, you should naturally see the operating margin increase. If you don’t then there is a profit leak in the business which is often caused by naturally allowing the underlying operational expenses to creep up as revenue creeps up. As the person that controls the P&L, this is one of the most critical things to try and control. The obvious exception to this is the case where you/mgmt/the board have made a strategic decision to increase your operating expenses (ie more / new core talent) with the explicit purpose to scale the business.As for the car companies, they are the car companies. They made a ton of mistakes over the last 50 years. We all hope to have such large companies one day to have to deal with what they have had to deal with over the years.

  2. Mark

    “You might have two businesses with identical operating margins but one has high gross margins and high operating costs (like Salesforce) and the other has low gross margins and low operating costs (like Apple).”All things being equal, would the second (like Apple) imply more stability? It seems they could have more burn time to adjust to changing conditions.

    1. Alex Murphy

      Double edge sword for Apple. They are likely to see a reduction in their COGS over time improving margins as the components get cheaper. They also have the benefit of less “weight” on the org if sales slip a little bit.But, they are more susceptible to swings in the supply chain that can reduce units and increase their COGS. To date, they have done a great job of owning and managing their supply chain. But that doesn’t mean it will always be that way.

    2. fredwilson

      Well if gross margins collapse on you for any reason the latter might beless stable

  3. Sidhartha Bhimania

    Increasing operating margins with increasing revenues is a very strong indicator of scalable business model. Businesses with low COGS are the ones where this kind of growth plays out.But entrepreneurs should not plan for this. As Drucker said: ‘The purpose of the business is to create and satisfy a customer’ and mostly the profit that comes from this objective is far superior that from objective of ‘profit maximization’.

    1. fredwilson

      I like that Drucker quote

  4. Dan Cornish

    I am wondering about SaaS businesses margins like Salesforce. They have a low operating margin because they spend over 50% on sales and marketing. Their cost to acquire a customer is approx. $0.80 per dollar of 1st year revenue. If they got rid of their expensive sales force then they would be very profitable, BUT they could never do that. So is it possible to transition from a high cost to low cost model? My personal opinion is no. It is baked in so they would have to tear down the company to become profitable which would destroy their stock price.

    1. ShanaC

      Shouldn’t this be a matter of getting ad spending under control and into the right channels- or is this a classic wanamaker problem

      1. Dave W Baldwin

        You’re on fire Shana 😉

    2. PhilipSugar

      I think its really hard to milk cash cows if you are a Wall Street CEO. Double taxation of dividends figures into that.I have said for years I think Microsoft should have been milking Windows and Office and returning the money to shareholders.So most companies end up growing to fit the size of the aquarium.

      1. Dave W Baldwin

        Love the aquarium analogy since it becomes a useful metaphor showing finite walls.

        1. PhilipSugar

          Salesforce will run into the same problem as Siebel.Eventually, somebody will steal their heat and convince companies to go with them instead of the higher cost alternative.Their expenses have grown to their revenue. Seems this always happens.

          1. fredwilson

            There must be a better way. Can you say open source?

          2. Dave W Baldwin

            Shared this with Phil with that User/AI/Other(s)AI/Other User(s) thing.Lots of opportunity, doing so with low OH delivering higher net.

          3. PhilipSugar

            I think the challenge there is when you sell to business, they need to be sold. Therefore that costs money.Its classic. They are so afraid of wasting money, that it ends up costing more to try to not waste money than the money that might be wasted.Dan (forgot last name) from Philadelphia had a good post about that.

  5. Blorch Headblownov

    In my Managerial Accounting classes, we were taught to say Gross Profit, not Margin. Anyone putting that line on a calc-sheet, for say a break-even or NPV would get that line marked off.I think the instructor’s point was to emphasize that Gross Profit is the brass ring, but that seems to be what others in the FMA meetings I attend say as well. Is that a generational custom?

  6. PhilipSugar

    Look at a high margin business that has terrible operating margins: AirlinesOnce you’ve made the decision to fly the plane each seat carries 100% gross margin…actually more than that because you make a profit from selling everything else. Same actually for sports teams, not only do you get the ticket price, but you get 50% on every dollar from the concession vendor.In a high margin business you are always going to have high fixed costs because if you don’t margins will go to zero instantly (you’ll get a million competitors each trying to undercut you, because the cost to get into the business is low)

    1. Dave Pinsen

      Your last paragraph assumes the business in question is a moat-less one. It’s possible to keep competitors at bay and maintain high margins for a while if you’ve got a moat.

      1. ShanaC

        next question- how do you build a moat

        1. Alex Murphy

          Fremium services like Google AnalyticsPay as you go based upon performanceBigger faster product that is constantly evolvingAdd a clear measure of value to the customer so that they have a very fast ROI and aren’t asking your competitors to out innovate

        2. Aaron Klein

          Ensure that your users get so much value out of the network of services or network of other users that it would be painful for them to leave.For example, there’s no great value that stops me from switching from one Twitter photo sharing service to another. (Except for being able to scroll back through history on one site for ALL photos, and I just don’t care that much.)However, leaving Twitter for the open source competitor is painful, because my other friends aren’t there. And a bunch of the other services on the web work with Twitter but not with something else.

          1. PhilipSugar

            A good moat definitely is lots of users.Metcalfe’s Law applies. The value of the network is the square of its users.So being four times bigger equals sixteen times better.Again…..getting all of those users is a BIG fixed cost.

          2. Aaron Klein

            I agree completely with you re: high fixed costs for those businesses. It’s a rule everywhere I’ve looked.

          3. Alex Murphy

            what is 600 million squared?

      2. PhilipSugar

        I think your fixed costs will still be high.I can’t think of a single business that has huge gross margins with low fixed costs. Unless we’re talking small dislocations where information flow is poor…i.e. classically called a broker.I wrote about “moats” in the last post. I think Google gives away Android, Gdocs, gmail, gvoice, etc. as a moat to protect search.To operate search is a high fixed cost business. Their size of their datacenters are legendary.

        1. probjoe

          I think gross margin is protected by “gross moat,” which includes fixed cost moat and others such as network effects, brand etc.Microsoft, a high gross margin company, has low operating costs (relative to revenues) compared to Amazon, a low gross margin company, or compared to an airline.

    2. Dave W Baldwin

      The Law of Accelerating Return cuts both ways… sorry, but if operating margins are terrible and nothing is accomplished changing it, you end up with something perpetuated into gov funded. There are many ways this comes about, starting with lobbyists over to laws/regs creating a good ole’ boy scenario where the competition is kept at bay.

    3. fredwilson

      Airlines are complex businesses to operate. Flying a half empty plane is alow margin affair

      1. JamesHRH

        Fred – here in Western Canada we have one of the great modern airlines (WestJet), at least from an operations PoV.They looked at the business in a thematic way, with a Drucker-like focus on customers (‘the airline exists to let people visit their families more often’ was the theme for the first 10 years of ops).WestJet is, in essence, a Southwest variant, with less zanyness and more of an understated Canadian way of doing things. But they don’t fly half full planes (does anyone now that the Southwest model has proven itself out?) and they never did. They don’t fly 12 models of plane from 4 manufacturers, because they understand that the airline is a service business, where cost management and motivated staff count as much as flying to the right place on time.They were always transparent about pricing (if the plane is full, it costs more) which everyone seemed to appreciate.And they have ended up flying places they never thought they would (Caribbean, Mexico, Florida, Palm Springs & the rest of SoCal), because their original theme led them there (Cdn grandparents like to see their kids in February, but not in their snowsuits!).They seem to be at a crossroads now, as the company is large (over $1B revenue). They seem to be dealing with functional politics – the pricing model is nowhere near as transparent, with seat sales and the like. They seem to be losing their sense of the nature of the business.I really think that most Founder / CEOs who struggle with the Monster inside their Head are struggling with that issue: they are, for whatever reason, losing (if they ever did have a full one) their understand of the nature of their company.It is rare to watch a CEO struggle with a rapid paradigm shift, which is happening to another great CDN company (RIM). That a great B2B offering would get run over by a B2C phenom is historically close to unprecedented. But, the CEO job is to understand the company and how it connects to the market opportunity, and right now Mike & Jim look like they have lost their understanding of the nature of the market opportunity.

  7. Dave W Baldwin

    Since I live in the upper Mid South, probably not suprising my belief in the end run net vs. gross. That way, the gross can be a useful metric looking at a bigger picture, yet you still have to look at wise use of additional capital (marketing) that strengthens the net. In this scenario, you have more profit to keep devoting to customer service, communication and R&D.Of course, the way to do this is to enable many employees (real AI) serving multitudes of the common folk (customers)….

  8. paramendra

    Important addition of detail.

  9. amishshah

    Thank you for mentioning me in your post!This is a fascinating discussion, and as you mention, managing these metrics will require different teams, strategies and financing requirements. I think your last sentence is the biggest takeaway here. Gross Margin can tell you a lot about the scalability of a business, but Operating Margin can tell you a lot about the business activities needed to drive that scale. To continue the Salesforce example, the Saas business has high gross margins and is highly scalable, but the nature of their business (high ticket B2B) requires extensive sales/marketing efforts.Early stage startups in the consumer web/mobile space will be product-focused and not necessarily focused on margin (especially if they have no revenue!), but as they mature and define their business model, they will need to think about the activities that will drive it. (Will I need more engineers, or more salespeople? Do I spend more on R&D or facilities? What help do I need?)Asking questions like that, and linking them to both gross margins and operating margins, will – as you said – be helpful in making the decisions they need to make about teams, strategies and financing.

  10. SVB_Financial

    Thanks Paul. We’re getting great feedback on Benchmarking. Here’s the link for more information if folks would like to check it out: