I recently had the opportunity to attend an event hosted by the Idea Collective Small Business Community (The Idea Collective Small Business Community | The Hub) where Marcus Lemonis was a keynote speaker. (If you don’t know Marcus, check out the CNBC TV show The Profit or Google him to see his amazing pedigree.) Marcus was providing advice to small business owners and warned us to avoid focusing too much on margins. He said, “Margins don’t pay the bills”. What does pay the bills? Cash. So, if you can make $100,000 a year with a 13% margin or $105,000 a year with a 12% margin, the second option is preferable. Makes sense, right?
Another, perhaps more esoteric, reason not to focus on margins is because they may be causing you to make bad decisions. While the previous example was based on overall business net margin, the following example is related to product margins. First, let me say that the whole idea of product margin is based on cost accounting. Cost accounting is not a natural law! It is just a system that was devised to help make financial decisions. The problem is that it was created making some assumptions that are no longer valid because of significant changes in the way businesses operate today, especially related to what are fixed vs variable costs and their resultant ratio. The classic example to prove this point is the “Product P and Product Q” story told by Dr. Eliyahu Goldratt in his book The Haystack Syndrome. Briefly put, his story demonstrated that choosing to focus on the product that provided the highest margin, calculated using standard cost accounting methods, can lead to lower profit. How can this be? Dr. Goldratt explains that total time to produce an item is less important than the time it spends on your most constrained resource. Cost accounting uses total production time when calculating sunk costs and margins. It does not distinguish one resource from another. But you should! The amount of time a product occupies your most constrained resource is a much better indicator of a product’s contribution to your bottom line. This is because that one key resource controls the throughput of your factory. It is your capacity-limiting factor. So, if you are using that resource you want to maximize how much you get paid per minute/hour/day of usage. Higher margin items don’t necessarily do this. Another way to look at this is that you don’t really want to maximize your profit per item sold, rather you want to maximize your profit per unit time. For example, producing (and selling) 10 items per hour at $10 profit each (=$100) is better than producing (and selling) 5 items per hour at $15 profit each (=$75). In most companies, the second item would be the preferred product because the margin is 50% higher but selling the first item would provide about 33% higher profit because of the higher throughput/unit time. Yes, I understand that this may be counterintuitive at first, but I’m confident that you will see the truth in this if you really think about it.
Don’t focus on margins,
Dave