What's Your Margin?

Whether the difference between the price you sell something for and what it costs to make is a large figure or a small one, it is a vital component of any business model. How do you get it right?

by Alexander Garrett
Last Updated: 09 Oct 2013

According to research by Manchester University's Centre for Research on Socio-Cultural Change, the Apple 4G iPhone costs $178 to make in Taiwan and sells for $630, generating for the Cupertino company a gross margin of $452 or 71.7% - a figure almost unheard of for a mainstream electronic consumer product. Apple sold 37 million iPhones in the last three months of 2011 and this is just one of the highly coveted shiny objects in its toolbox, so it's not hard to see why it is the world's most valuable company.

For now at least, Apple has reached that rare position of being a company with high volumes and high margins. More often, high margins are associated with low-volume businesses like luxury brands, while mass-market and commoditised businesses have to make do with thin margins. Or at least that's how conventional wisdom would have it.

What's true is that anyone starting a company or investing in businesses has to decide what margins they are looking for, and how they fit in to the overall business model. Yet this business of margins is more complex than it might first appear: finding the right business model is seldom as simple as choosing between premium and value-driven, and, since the advent of the digital economy, some of the old certainties are no more.

Operating margins give a measure of a company's overall efficiency, but when we talk about high and low-margin businesses, it's usually the gross margin we have in mind. John Mullins, associate professor of London Business School and author with Randy Komisar of Getting to Plan B: Breaking through to a better business model, identifies it as one of the five key elements in any successful business model. 'Gross margin is the fuel that drives the rest of the business,' says Mullins. 'Whenever you sell something, whether a good or a service, there is normally some cost of goods attached to that. The gross margin left over is all the money there is - other than investor capital - that can fund all the other costs in the business. So it's crucially important and often overlooked by entrepreneurs, who tend to price things too low.'

As an example of a high-margin, low-volume business, he cites Nokia's Vertu phones, marketed in conjunction with high-end properties, fast cars and concierge services, with prices starting at a cool £3,500. At the other end of the spectrum, there's Costco, the wholesale warehouse club, which charges a membership fee but won't sell anything with a margin greater than 14%. 'Who on earth would imagine we should pay to shop in a store?' asks Mullins rhetorically. 'Yet we do because it consciously has a very low gross margin strategy that offers extraordinarily low prices on large quantities of things we buy every day.' Much the same is true of Walmart with its low prices - and margins to match.

In practice, though, you can't design a business model around the margin, according to Mark Jenkins, professor of business strategy at Cranfield School of Management. 'From a strategy point of view, we would normally focus on the value you can add and the price you want to charge for that, and then you set up your business model and manage your margins according to that position,' he explains. 'Therefore, margin is a variable you have to manage rather than a strategic choice.'

Businesses that start on a price-driven, low-cost route need to be sure they will in time be able to leverage economies of scale or economies of scope to drive up their margins, he argues. Low margins, in other words, are usually an opening gambit rather than an aspiration. The contrasting strategy is to add significant value and charge for it, and so garner a high margin. Jenkins cites an automotive glue maker that positions itself as offering a production enhancement service (which just happens to involve dispensing glue). 'The challenge in that case is to understand what customers regard as value, and whether they are prepared to pay for it.'

To the entrepreneur looking for a strategy - and a business model - there are pros and cons wherever you make your call on margins. 'A low-margin strategy makes it harder for people to compete with you, enables you to achieve economies of scale, like Amazon has, and attracts customers who are price-oriented,' says Mullins. On the other hand, low-margin businesses may be vulnerable to cost inflation, such as budget holiday operators that fail to plan for rising fuel costs or exchange rate fluctuations. And then there's the risk that you never achieve the volumes you need to cover your operating costs.

Many business people believe that, all things being equal, higher margins are superior. In a way, that's obvious: high margins provide you with a greater cushion against cost variations, with more profits to re-invest in growth, and, if you're making something in low volume, it may be less capital intensive. On the minus side, you invite competition by creating a margin space, says Mullins. And Jacqueline Windsor, a director and retail specialist at PWC, says: 'If you're selling luxury goods, you usually need to spend a lot more on marketing. And you may have a lot of cash tied up in working capital - margins are not everything and cash flow is particularly important in retail to ride the peaks and troughs of the economic cycle.'

High-margin businesses need some form of protection to keep the competition out; that could be powerful brand marketing, a patent or some kind of process or technology that can't be easily replicated.

Windsor says that, in retail, she sees winners and losers in every segment of the market. 'It's less about where you play and more about how you win,' she says, arguing that differentiation is the key to succeeding in an increasingly price-transparent landscape.

You'd expect that the internet would lower profits all round. Collective deal-making websites like Groupon can be seen as forcing down margins by enticing businesses to offer discounts.

But while clicks can best bricks on price because the overheads are lower, there's no shortage of internet businesses with gross margins to envy. EBay doesn't own the goods it sells, and in the case of the virtual goods that many gaming companies increasingly make their money from, the cost of goods sold is zilch. Take Zynga, the company behind smash hit online game Farmville. As Mullins puts it: 'How much does it cost it to sell me another tractor or some fancier pumpkin seeds?'

For investors, though, it seems that attracting large numbers of users is key in the digital space. Research carried out by Board of Innovation, an Antwerp-based consultancy specialising in business models, found that those with a high transaction volume received the most generous funding, irrespective of their profit margins. Yash Saxena, who carried out the research, says: 'Venture capitalists are looking for business models that engage consumers. The model may be completely new. Spotify, for example, is a hybrid between a personal music player and a radio - and nobody knows how much value it will generate. But they are looking for companies that could provide multiplication of their capital, so that high volume is essential.'

 

PREMIUM PEDALLING: PASHLEY CYCLES

Pashley Cycles

Stratford-upon-Avon-based Pashley Cycles has been building bicycles and tricycles in the UK since 1926, when it was founded in Birmingham by William 'Rash' Pashley. At first, it made carrier cycles used by errand boys, but, in recent years, Pashley's classic models such as the Princess, the Roadster and the Guv'nor have become, dare one say it, fashionable. And while the country has become flooded by mass-manufactured budget bikes from Asia, Pashley has proved there's still a market for handmade machines produced in much smaller quantities.

Last year, Pashley produced around 10,000 cycles, with prices starting at about £350. Chief executive and majority owner Adrian Williams won't reveal specific margins, but it's safe to say they are higher than most mass-market rivals. But he emphasises his bikes' higher quality. Imported bikes are not necessarily much cheaper but have a lower spec, he points out, adding: 'Cheap and nasty bikes won't last long and won't do the job.'

Pashley's commercial side supplies bicycles and tricycles to businesses ranging from industrial giants Pfizer and Toyota to sandwich-maker Darwin's Deli and estate agent Knight Frank.

But most of its cycles are bought by consumers, and one advantage of being a relatively low-volume manufacturer is that it can offer a huge choice of distinctive models - some 160 in all - and respond quickly to demand. By contrast, says Williams, the mass distribution brands usually have no design and development capability and are simply emulating each other, churning out 'me too' products. This is nevertheless something of a hazard, since Pashley's models can be copied, and often are.

Although he refuses to think of Pashley as a brand - 'brands are often created, but we are a company of real, living, breathing people with an 80-year heritage' - Williams readily concedes that reputation and visibility are key to sales. 'We run a few inexpensive ads and support one or two events, but when people ask: who does your PR?, I say: our product.' When a bike is delivered to a customer, it often leads to several more sales from those who've seen it.

A premium product like Pashley's might well have been considered at risk during the downturn, but it has proved surprisingly resilient. Pashley's slightly cheaper Poppy bicycle in pastel blues and pinks sold strongly 'and our existing market actually grew', says Williams.

 

CLOUD WITH A SILVER LINING: AMAZON WEB SERVICES

Amazon.com

 

Amazon.com is a classic high-volume, low-margin business; it accounts for close to half of all book sales in the US, and its operating margins - thin at best - have been falling.

The company's cloud computing division, Amazon Web Services, operates on similar lines. AWS was launched six years ago to offer third parties the highly responsive 'on demand' IT infrastructure that had been created for amazon.com's own developers. It now has hundreds of thousands of customers around the world, ranging from large corporations such as Shell Oil or gaming companies like Playfish and Zynga to small enterprises and sole traders. The scale of the business is immense. 'We hold some 905 billion objects in our S3 storage system, up from 762 billion at the end of last year, and regularly achieve 650,000 transactions per second,' says business development director Terry Wise.

AWS has a consistent record of bringing down prices. Although Wise won't divulge AWS's profit margins, he is emphatic that they are much lower than other high-tech businesses.

Innovation in how AWS manages everything from power consumption to system availability helps it to operate with low prices and margins. But volume also plays a part. As Kay Kinton, AWS communications manager, puts it: 'With our scale, if you take cents out of the system it really adds up, and it's in our DNA to pass on those savings.'

AWS doesn't have to reduce its prices, but the reason it does is because it's in a rapidly growing market that is all about land-grab. Bringing down costs for customers encourages them to try more services, creating a virtuous circle.

AWS keeps costs to a minimum by offering on-demand self-service; many customers get started with a credit card and the services are easy to use, so there are no lengthy contracts or negotiations. Moreover, spot pricing ensures that AWS's infrastructure is used to the full. And marketing spend is minimal.

The downturn has helped AWS by speeding up the shift towards cloud computing, as organisations look to save money. Whether AWS will be content with low margins forever is a moot point, but, as Wise puts it: 'The train has left the station and, in time, I think we'll see the vast majority of workloads being deployed on the cloud.'

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