Business owners deal with something known as ‘margin’ on a daily basis. A company’s margin, if reached, ensures profitability. Companies that do not reach their margins may still be profitable, but they could also lose money. Needless to say, margins are essential to every business.
You wouldn’t be expected to understand margin if you don’t run a business. However, every new business owner should understand this fundamental principle right from the start.
Cost vs. Revenue
An understanding of margin starts with the reality that it costs money to do business. It doesn’t matter whether you make a product or provide a service. You must spend money to serve your customers. In return, you hope to recover what you spend by charging your customers.
In addition to covering your costs, you also want to earn a profit. Your profit is determined by subtracting your total costs from your total revenues. Whatever is left constitutes your profit.
Margin As a Percentage
Business owners eventually move beyond baseline profit to consider margin. What is margin? It is the percentage of a company’s total revenue that represents profit. It is important because there is a certain point at which it is not worth doing business.
Let’s say you are an eyewear retailer who specializes in sunglasses. You purchase your inventory from Salt Lake City’s Olympic Eyewear. As a bulk supplier of sunglasses, Olympic offers you pricing low enough to allow you a decent profit.
Let’s say you pay $1.00 for a single pair of wholesale sunglasses. When you account for all of your expenses, selling that pair of sunglasses costs you $2.00. If you sell them for $2.50, your profit is $.50. Margin is calculated by dividing profit by sales revenue. In this case it is 20%.
Why It Matters
By now you might be wondering why this matters. After all, profit is profit, right? Wrong. You need a high enough margin to make it worth your while. Let us use some different numbers to make this more understandable.
Perhaps you sell that same pair of sunglasses for $2.10. Even without figuring out your margin, you are still making a profit. But at $.10 per pair, can you make a living selling sunglasses? Absolutely not. Even though all of your expenses are paid and you are making a profit, you’re not making enough profit. At $.10 per pair, you might as well close up shop and do something else.
Not the Be-All and End-All
The last point to make here is this: even though a good margin is essential to every business, it is not the be-all and end-all. This is easily demonstrated by comparing the differences between small, privately owned businesses and their corporate counterparts.
Corporations are driven by stock prices. Likewise, stock prices are driven by stockholders who want to see specific margins achieved every quarter. Some corporations obsess over margins so much that they are paralyzed by them. Keeping stockholders happy requires they continually increase margin. What ultimately happens? Quality suffers because the company has to keep cutting to improve their margin.
On the other hand, privately run businesses don’t have to continually increase margin. If they find a rate that makes them comfortable, they can stay there forever. And if they don’t make margin every now and again, it’s not the end of the world. They can ride out tough times without drastic cuts because they know their margin will rebound in the future.
Now you know why margins are so important to business. Maybe it’s more than you wanted to know. Either way, businesses live and die on their margins.