When looking at businesses to get involved in my first question is always “what’s the profit margin of this business model?” Specifically by looking at an online business profit margin we should be able to immediately gauge whether the business is a goer or not. We need a quick rule of thumb : thankfully profit margin gives us this shortcut.
This is the case for when starting up a new venture or being invited to join an existing business.
Why is profit margin so important?
Ultimately it’s the gauge of the effectiveness of any business. More than any other metric the profit margin tells you whether it’s a “good” business or a “bad” business.
Let’s take a few steps back so I can back up this statement.
Profit
First – what exactly is “profit”?
The word profit originally comes from the Latin “proficere” from pro- ‘on behalf of’ + facere ‘do’ and thence to the Old French…
Nah! Just messing with you. I love etymology but we’re here for business!
Instead:
Profit = Revenue – Costs
Simply put it is what is “left over”.
If I sell a product for £100 and it costs me £50 to make, package and service that sale then my profit is £50.
Obviously this gets fiddly when we start asking “what are we treating as revenue? What are we treating as cost?”. We’ll leave these questions to the accountants though as it doesn’t affect the important business lessons here.
So my product sells for £100 and costs me £30. I get a profit of £70. Simple enough.
Profit = Good Business, right?
So does profit give us a good gauge of the success of a business?
Not really. It’s hard to compare companies based on profit alone. That’s because larger companies can have larger absolute profit figures simply because they have much, much higher revenues. So even if their costs are very high what is “left” over can easily dwarf a smaller, more efficient company.
For example, I sell a product at £100. It costs me £30. £70 is left in profit.
If I sell 100 of these products in a year the revenue is £10,000. The cost is £3,000. The Profit is £7,000.
Imagine my competitor. They sell a similar product at £100 but it costs them £90 in total. They make a £10 profit on each sale.
However, they sell 1000 products a year compared to my 100.
1000 sales means a revenue of £100,000. Their costs are high : £90,000. Their profit is £10,000.
My competitor has more profit than me at the end of the year. Their revenues are higher. As are their costs.
If we compare ONLY the absolute profit then my competitor has a better business- they’ve made £10,000 in profit compared to my £7,000. £10,000 is more than £7,000. Nice and easy!
Profit Margin
But when we look at profit margin it’s a different story.
The profit margin of my business is 70%.
Put differently: for every £100 I make we keep £70 in profit.
Put differently differently (differently squared?) : for every £30 we spend we make an additional £70.
My competitor on the other hand has a profit margin of 10%.
For every £100 they make they have costs of £90. Only £10 is left in profit.
So: for every £90 they spend they make an additional £10. It costs them £90 to make £100. Not great.
Which is a “better” business then?
The one that makes more absolute profit (my competitor) or the one that is more relatively efficient (my business)?
It’s a tricky question – and people disagree on the answer!
For my money though the more EFFICIENT business is better.
A business with a bigger profit margin is more efficient. It efficiently converts costs into revenues. It’s a streamlined, finely engineered engine. Quiet, sleek, clean.
A business with a thin profit margin is less efficient. It converts costs into revenues, sure. But by god does it make a meal of it. It’s noisy, grimy, messy.
Think of a Tesla engine vs. a Model T Ford here. Which would you rather invest in?
The counter argument here would be that my competitor actually has higher profit this year (£10,000) than me (£7,000). This allows my competitor to spend more than me going forward – in marketing for example to squeeze me out of the market.
This is shortsighted though for two reasons:
- If I have a better profit margin I can go and raise that additional money. I can get financing based on the efficiency of my business machine. It’s far more attractive to an investor.
- My high profit margin business model has more room to scale. All things equal I have more room to grow than the competitor. If costs increase as my company grows (which is normal) I have a bigger profit margin cushion to deal with those increased costs.
Because of this profit margin is simply the best single metric to compare businesses that we are launching or about to get involved in.
Start with Profit Margin
It’s the most useful rule of thumb and the first question you should be seeking to answer when looking at getting started in a business.
Don’t just think about what the revenues can be generated. Don’t just think about how much the costs are.
Instead you need to combine these to work out the profit margins for the business area.
You might be thinking this is obvious (and it is!). But here’s the big question: what are the profit margins of your current businesses? And what about any new ventures you are looking to start? Got the profit margins handy on those?
Once you know the profit margins you can carry out apples to apples comparisons of ventures easily and rapidly: simply, the higher the profit margin the better the business.
Remember that a business exists to create and sell value. One that does so more efficiently better fulfils the definition and purpose of a business.
Simply chasing revenue as a goal is vanity. Just because the numbers get bigger doesn’t mean the business is better. If the cost numbers are increasing at the same rate or (gulp) higher then the business is not improving – it’s degrading and becoming more inefficient.
Online Business Profit Margin
The good news?
Online businesses as a whole have FAR better profit margins than offline businesses. Online business profit margins, all else equal, always trump offline businesses.
Why’s that? No offices, premises or rent. No electric and gas bills. Lower staff numbers. Lower or zero inventory requirement. The list goes on.
Generally costs come from the physicality of a business. Switching from atoms to bits does away with a huge amount of inefficiency and profit margins soar.
In the physical world of restaurants, hospitality, location-based services (i.e. hairdressers) profit margins of 10-20% would be considered solid. In the digital world we wouldn’t touch a profit margin of 20%.
Simply by building your business online you’ll be operating at a much higher level of profitability than a business that has to deal with rent and keeping the lights on. This has always been the case but 2020 and the global pandemic obviously brought this into extreme relief for physical sector business owners.
If you do have a physical business (with low profit margins) and are feeling annoyed with yourself don’t worry! I’ve been there! Thankfully you can easily add online business elements to an existing offline business. And these online business profit margins will generally be higher! Apple does this – their margins on physical items like the iPhone hover around 35%. Their service arm online business profit margin sits at 60%+
If you do want to get some ideas for moving an offline business online then check our guide that starts here: Guerrilla tactic for offline businesses.
If you want to really nerd out I suggest you check out https://financialrhythm.com/profitability-margins-industry/ which has data breakdowns of different industries and sectors based on profitability margins. The data comes from Aswath Damodaran who teaches corporate finance at NYU Stern and is THE guy for all things valuation related. I was lucky enough to do my MBA at NYU Stern but you can also access all of Professor Damodaran’s content online through his extremely generous website.
If you want a quick snapshot of the various profit margins here is a great graphic:
