# Volume effect on profit margin

Espresso Whatelse?
New answer on May 30, 2020
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Hello guys,

I have solved this case from Preplounge library and I found it really interesting and clear. I have just one doubt regarding the following paragraph:

"A top performer would immediately state also that, if our concern is profit margin, the problem is probably related to price or cost section rather than in volume. The only exception could be the incidence of some fixed costs but considering that revenues are increasing, that should not be the case."

Why? I would like to clarify this part since I could have the same situation during case interviews.

Best,
Alessandro

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Hello Alessandro,

Thanks for solving my case, I am happy to give you additional details.
Let's consider a product that we sell at 100 and that cost 60 to be produced and sold (Profit margin = (100 - 60) / 100=40%). The only effect that volume can have on our profit margin per unit is regarding the fixed costs incidence.

Let's say that we pay 1000 for our warehouse: if we sell 1000 units the incidence of the cost for each unit is 1, if we sell 100 units it becomes 10. However, our company has increased its revenues. Bearing in mind that revenues are equal to price x volume, we have 2 options:

• Increasing volumes (that would have a positive effect on our profit margin, implying a minor incidence of fixed costs and potential economy of scale)
• Increasing price (and potentially lower volume)

The latter case is the only one that includes a volume reduction (and potentially an higher incidence of fixed costs). Btw increasing revenues with lower volumes means that price will be significantly higher. In order to have lower profit margin per unit, the costs have to increase more than price (e.g. Price=110, costs=80, Profit margin=30/110=27%). Hence, our problem is likely to be in the cost side and not in the volume.
There is still the odd situation where a lower volume would increase the incidence of the same fixed costs and this effect is more relevant than higher price, but it is very unikely to happen. If we have to bet on something in our initial structure, better to go for price or cost section :)

Is it clear?

Best,
Luca

(edited)

Total profit = total revenue - total cost

= price* #unit sold - (Total Fixed+Total Variable cost)

= price*# - total fixed - var*#

prof margin = price - var cost - (fixed cost/total#)

To the latter part "considering that revenues are increasing, that should not be the case."

If the change in revenue was driven by increase in price, then # dont change, fixed cost dont change, low prof margin = high var cost

IF change in revenue was driven by increase in units sold, then we need to consider if fixed cost raised to support this increase in # (such as investment in PPE to support capacity). So i guess your quoted paragraph is based on the assumption of either:

1. Increase in revenue is due to purely increase in price;

or 2. even # increases fixed cost wouldnt change (no capacity issue)

(edited)

Hi Alessandro,

This is a great lesson in being objective-focused.

Always, always, always, keep the objective in mind.

Margin is a per unit metric. Therefore, increase in # of units (volume) in of itself is irrelevant (unless, of course, you're achieving economics of scale)