Don't you believe it ... High profit margins are good

Companies, particularly listed ones, live or die by their profit margin compared to that of rivals.

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Last Updated: 31 Aug 2010

As a measure, profit margin has the virtue of being easy to compare across different companies, but that's about the only positive thing you can say. Here are some of the dangers of focusing too much on your margins ...

It incentivises you to avoid profitable growth. To maximise your profit margin, it makes sense to keep the business small, concentrated on the most profitable parts of the market. There is also a positive disincentive to invest in growth, as most investment reduces profit in the short term.

It ignores the amount of capital a business needs. For example, suppose a drinks company makes a 10% net margin on vodka and 12% on Scotch whisky. Scotch is a better business than vodka, right? Wrong. With vodka, you get paid within a couple of months of production. With scotch, you'll wait at least three years for it to mature before you can even ship it. With capital hard to come by, vodka has a huge advantage.

Gross margins probably don't mean anything anyway. I know a subsidiary of a listed company that spent a lot of time looking at the margins on different types of products and made decisions based on them. It ignored the costs not counted against gross margin but shown as overhead. These included the cost of factory space, cost of factory labour and cost of plant and equipment - hardly trivial. Once these were taken into account, the picture was very different.

The point is, business is about investing capital to produce a return. If you ignore the amount of cash invested, and ignore the future benefits of present 'costs', you risk denying the entire business a future.

- Alastair Dryburgh is head of Akenhurst Consultants - www.akenhurst.com

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