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Profit margin compression effect

How does the compression of relative profit margins work exactly? I understand the overall concept, but is there any positive association with it too? That it benefits the company?

How does the compression of relative profit margins work exactly? I understand the overall concept, but is there any positive association with it too? That it benefits the company?

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Hi there,

Compression of relative profit margins is just a fancy way of saying that the percent margin on a given product goes down over time. This can be driven by many things, including increasing variable costs or decreasing unit price. In general, the only time this might be positive is if the company is decreasing their prices deliberately to increase sales, and that the margin from the increased sales are greater than the lost margin. But most of the time I'd say profit margin compression is negative and externally forced, usually by some form of competition driving down prices, or increasing variable costs.

Hope this helps,

Bryan

Hi there,

Compression of relative profit margins is just a fancy way of saying that the percent margin on a given product goes down over time. This can be driven by many things, including increasing variable costs or decreasing unit price. In general, the only time this might be positive is if the company is decreasing their prices deliberately to increase sales, and that the margin from the increased sales are greater than the lost margin. But most of the time I'd say profit margin compression is negative and externally forced, usually by some form of competition driving down prices, or increasing variable costs.

Hope this helps,

Bryan

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Hi Anonymous,

first of all, you should define profit margin, as it may refer to different things (eg gross or net profit margins).

Assuming you are referring to gross profit margin ((Net sales-COGS)/Net sales), you may have that this decreases but gross profit (that is, Net sales-COGS) instead increases. Thus a company could deliberately follow a practice to decrease its gross profit margin (for example, decreasing price) in order to increase the absolute amount of gross profit (for example, increasing volume thanks to the decrease in price).

Example:

  • P=10
  • V=10
  • Var Cost=8.5
  • Rev=100
  • Cost=85
  • Net profit=15
  • Profit margin=15%

Let’s say now you decrease price to 9 and increase the volume to 40 as a consequence

  • P=9
  • V=40
  • Var Cost=8.5
  • Rev=360
  • Cost=340
  • Net profit=20
  • Profit margin=5.56%

Best,

Francesco

Hi Anonymous,

first of all, you should define profit margin, as it may refer to different things (eg gross or net profit margins).

Assuming you are referring to gross profit margin ((Net sales-COGS)/Net sales), you may have that this decreases but gross profit (that is, Net sales-COGS) instead increases. Thus a company could deliberately follow a practice to decrease its gross profit margin (for example, decreasing price) in order to increase the absolute amount of gross profit (for example, increasing volume thanks to the decrease in price).

Example:

  • P=10
  • V=10
  • Var Cost=8.5
  • Rev=100
  • Cost=85
  • Net profit=15
  • Profit margin=15%

Let’s say now you decrease price to 9 and increase the volume to 40 as a consequence

  • P=9
  • V=40
  • Var Cost=8.5
  • Rev=360
  • Cost=340
  • Net profit=20
  • Profit margin=5.56%

Best,

Francesco