expert
Expert with best answer

Sidi

99% Recommendation Rate

350 Meetings

1,982 Q&A Upvotes

USD 349 / Coaching

3

Profit Margin vs. Profitability

Hi

I am confronted with the following case: If we decide to enhance our product quality and use better input materials, this will actually increase variable costs and, hence, decrease profit margin. On the other hand side, we know that people will buy much more products at the current price which will boost revenues. Is it fair to say that in this case, the company is boosting absolute profits while willing to forgo profit margin?

So generally speaking, if a company can drastically increase volume sold by accepting higher costs, profit margin is not really relevant? Thx!

Hi

I am confronted with the following case: If we decide to enhance our product quality and use better input materials, this will actually increase variable costs and, hence, decrease profit margin. On the other hand side, we know that people will buy much more products at the current price which will boost revenues. Is it fair to say that in this case, the company is boosting absolute profits while willing to forgo profit margin?

So generally speaking, if a company can drastically increase volume sold by accepting higher costs, profit margin is not really relevant? Thx!

3 answers

  • Upvotes
  • Date ascending
  • Date descending
Best Answer
Book a coaching with Sidi

99% Recommendation Rate

350 Meetings

1,982 Q&A Upvotes

USD 349 / Coaching

Hi!

First of all you should be clear on what is meant by "profit margin".

  • Absolute profit margin, i.e., the difference between the unit price and the unit cost
  • Relative profit margin, i.e., profit per unit divided by the unit price

In both cases, your described measure will only boost total profits if the volume effect (selling more) outweighs the margin compression effect (selling at a lower profit per unit). This in turn depends on the steepness of the quality-related demand curve (i.e., the quality-elasticity of demand).

Cheers, Sidi

Hi!

First of all you should be clear on what is meant by "profit margin".

  • Absolute profit margin, i.e., the difference between the unit price and the unit cost
  • Relative profit margin, i.e., profit per unit divided by the unit price

In both cases, your described measure will only boost total profits if the volume effect (selling more) outweighs the margin compression effect (selling at a lower profit per unit). This in turn depends on the steepness of the quality-related demand curve (i.e., the quality-elasticity of demand).

Cheers, Sidi

(edited)

Hi Sidi, thanks a lot for the answer. That makes totally sense.... Is there any short-cut for comparing the volume & margin compression effect? Or is it just a calculation of profits before and profits after? — Anonymous A on Feb 13, 2020

Well, since this is just a multiplication, a good shortcut is to compare the percentage change in margin and in volume. If the Volume increases by a larger percentage than the margin decrease percentage, then the overall effect is positive. — Sidi on Feb 13, 2020

Book a coaching with Clara

100% Recommendation Rate

15 Meetings

544 Q&A Upvotes

USD 159 / Coaching

Hello!

Instead of getting confused with terminology, think it this way: this is the classical case that gets solved easily by translating words into a math equation (PROFIT = revenues - costs; PROFIT= P x Q - Vc x Q - Fc) - , in which you intput:

  • Increase of Vc (variable costs)
  • Increase of P (price at which goods are sold)

Then, it´s Q (quantity of sold goods) what determines if we gained or not with the change.

Hope it helps!

Cheers,

Clara

Hello!

Instead of getting confused with terminology, think it this way: this is the classical case that gets solved easily by translating words into a math equation (PROFIT = revenues - costs; PROFIT= P x Q - Vc x Q - Fc) - , in which you intput:

  • Increase of Vc (variable costs)
  • Increase of P (price at which goods are sold)

Then, it´s Q (quantity of sold goods) what determines if we gained or not with the change.

Hope it helps!

Cheers,

Clara

Book a coaching with Francesco

100% Recommendation Rate

2,691 Meetings

3,029 Q&A Upvotes

USD 349 / Coaching

Hi Anonymous,

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

Referring to your question:

  • Is it fair to say that in this case, the company is boosting absolute profits while willing to forgo profit margin?

It depends on the effective increase in volume. According to the level of increase, the company may be either better off or worst off in terms of absolute profits.

  • So generally speaking, if a company can drastically increase volume sold by accepting higher costs, profit margin is not really relevant?

It depends on the objective of the case. If the objective of the client is to keep a certain profit margin, of course profit margin is relevant. If the goal is simply to focus on absolute profits, the strategy you described could make sense to increase profits as profit margin is not part of the goals.

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).

Referring to your question:

  • Is it fair to say that in this case, the company is boosting absolute profits while willing to forgo profit margin?

It depends on the effective increase in volume. According to the level of increase, the company may be either better off or worst off in terms of absolute profits.

  • So generally speaking, if a company can drastically increase volume sold by accepting higher costs, profit margin is not really relevant?

It depends on the objective of the case. If the objective of the client is to keep a certain profit margin, of course profit margin is relevant. If the goal is simply to focus on absolute profits, the strategy you described could make sense to increase profits as profit margin is not part of the goals.

Best,

Francesco