Why Does Business Care About Margin Than Profit?

Business-Profit-Margin-CPOI

A one million dollar question that I used to ask myself “why 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, so let’s go through a quick tour to elaborate the reason.

Profit and Loss Statement (P&L)

Let me give you an overview of a simple P&L (Profit and losses statement) for any company based on 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, it is an absolute value based on the currency used.

Margin: It 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 below givens:

Pepsi Can

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 pieces ) = 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 Margin of 62.5%

Till this point everything is clear, let’s return back to the main subject.

Why does business care about Margin than Profit?

Each company defines a specific Gross margin percentage % for any new product to be approved, and this percent differs from country to country depends on many variables.

For instance, a company agreed that any business case for any new product should have a Gross margin percent 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).

Pepsi-coke

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 been 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.

supply chain

  • Material cost
  • Production cost
  • Logistics cost

Let’s have the same example before for 50% off the promotion of Pepsi.

Imagine that Pepsi received a message from the procurement team that raw material contributed massively in 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.