The Sizing of Profit Margins

September 2018

Howdy Pricers!

Did you realize it's already September? Many of us are sending our children off to school.

Did you know what's even more fun than schooling your kids? Schooling your competitors!

Now is a great time to revise your pricing strategy and increase your profitability.

Pricing Question from a Reader

I started working for a new business and noticed that some of our products have much higher margins than others. I've argued that we should get rid of the low margin items and focus on the high margin ones. My bosses disagree. Which of us is right?

Without more information, I can't say for certain, but, all things being equal, you're right: companies are better off selling high margin items.

Unfortunately, all things are never equal in the real world. There are many reasons why your company may benefit from its decision to continue offering products with low margins.

For instance:

  • Some low margin items act as tripwires. An offering made available with a low price can serve as a catalyst for creating a trusted relationship. New buyers who are satisfied with their initial purchases will be more likely to buy higher margin items in the future. Consulting firms, for instance, frequently offer small and relatively low cost roadmapping sessions with the intent of charging substantial sums for follow-on work.
  • Some low margin items are offered in limited quantities to attract the attention of shoppers. Once in the store, customers may decide to purchase higher margin items instead of, or in addition to, an advertised item. Many vendors will deliberately maintain low margins on some products (like milk and gasoline), because customers pay great attention to these products' prices and use them as signals of vendors' overall pricing levels.
  • Some low margin items allow for upsells of high margin complementary goods. The margins enjoyed on cell phones are often minuscule, but the margins on accessories like phone cases and cables often border upon the obscene.

Of course, there are other factors to consider too, not the least of which are manufacturer payment terms and minimum advertised price requirements. One of the most important is often forgotten due to a misunderstanding of pricing terminology.

Most people mistakenly believe that the words profit and margin mean the same thing.

They don't.

  • Margin is the measure of return on investment for each sale.
  • Profit is the measure of how much money is earned in total.

We intuitively expect a correlation between the two. It seems reasonable to assume that a product with a higher margin would yield a higher profit.

Unfortunately, this is not always the case. Some firms with very low margins earn an awful lot in profit. Likewise, some firms with very high margins barely make any profit at all. One can look to the restaurant industry for a prime example. McDonald's rakes in billions of dollars each year for relatively low margin items, while gourmet restaurants that charge an arm and a leg are lucky to scrape by.

It all comes down to turnover (the speed at which items are sold). The faster a business can sell a given product, the more often it can re-invest its income into additional inventory. Even if a vendor earns pennies on each sale, over enough sales it can earn a tidy profit.

At the end of the day, business owners, stockholders, and analysts only care about one thing: economic profit. The margins on each sale and the pricing of each item are merely the means to an end.

Questions come from readers like you. If you'd like your questions answered, send them my way.

♫This Q&A and many others are now available on the Pricing After Dark podcast.

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