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Better Profit Margin or More Profit - What is more important?

Anonymous A asked on Aug 17, 2018 - 1 answer

Dear current and ex-Consultants,

In case studies the profitability cases often focus on profit decrease in absolute terms. Hence, I tend to think that the absolute profit is more important to the clients and consultants than the profit margin. However, profits can increase, while margins go down (higher costs, right?) - if this would continue in that direction, it can become dangerous in my opinion and also lead to lower profits at a certain point.
So, what is more important to look at: the profit in absolute terms or the profit margin? If we just look at the profit and ignore the margin, we could have a wrong impression of the company (e.g. increased profits, everything is fine - but in reality costs are constantly increasing). Can we even state a logical relation between the two (e.g. if revenues increase and profit increase, margins increase as well?) or is it totally dependent on the situation (e.g. all different directions are possible like profit decrease and margin increase etc.)

Additional question: when dealing with profit margin changes over time, is it better to look at it on a unit basis ((p-c)/c), or absolute ((total revenues minus total costs)/total revenues)) ? Does it even matter to distinguish the two ways for profit margins in general (inmho it shouldn't as mathematically they are the same) ?

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replied on Aug 23, 2018

Interesting questions -

1) Q: What is more important to look at: the profit in absolute terms or the profit margin?

I would say that it depends on the scenario, with profit margin being generally more important and revealing.

For example, absolute profit may be the preferred metric when evaluating capital expenditure decisions, managing cashflows, or raising finance.

However, when evaluating business performance, profit margins could be a more important and revealing metric. For example, when a business is appraising acquisition targets (e.g. for a market entry), the acquirer may prioritise the performance of the targets' profit margins, particularly in cases where absolute profitability are similar. In such a case, margins could be indicative of targets' productivity, and therefore yields implications for post-acquisition synergies.

2) Q: Can we even state a logical relation between the two (e.g. if revenues increase and profit increase, margins increase as well?)

Relationships can be generalised if certain variables are assumed fixed. For example, the relationship you stated is true if you assume costs are fixed:

Scenario A: Profit Margin = ( Revenue - Cost) / (Revenue) = (10 - 5) / (10) = 0.50

Then, revenues and profits increase (whilst costs remain fixed):

Scenario B: Profit Margin = ( Revenue - Cost) / (Revenue) = (12 - 5) / (12) = 0.58

However, marings can remain unchanged whilst revenues and profits increase (whilst costs increase):

Scenario C: Profit Margin = ( Revenue - Cost) / (Revenue) = (12 - 6) / (12) = 0.50

3) Q: When dealing with profit margin changes over time, is it better to look at it on a unit basis ((p-c)/c), or asbolute ((total revenues minus total costs)/total revenues))?

If I understand correctly, profit margins should be examined per unit when there are multiple units / products subject to change. However, if there is only one unit / product, then both methods should yield the same result (as the absolute result is simply a uniform transformation of revenue and costs by the volume sold).

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