With the sudden stop on economic activities and subsequently financial transactions, it has become apparent that most businesses operate on thin margins. This leaves them in perpetual absence of cash reserves to sustain shocks. Today most airlines are on the lookout for cash in either loans or bailout; and recently a century old car rental service filed for bankruptcy protection in US. And small businesses like restaurants and retailers are set to incur operating losses in proportions that necessitate measures equivalent to capital recovery plan.
In contrast we also have companies that have opened up their coffers to serve social cause! Although intent lies at the core, as we also have institutions technically classified as NGOs, contemplating to dilute their investments to pay salary dues, ability to serve the cause through monetary means is the more important concern. One may argue that the coffers have been accumulated over decades but such old companies lie on both sides of the contrast.
So how did this happen!
It boils down to the fundamental concept of gross margins. There are two concerns while addressing margins, first is the fundamental understanding and second is the context of business.
The method most of us have learnt at school is incorrect in financial terms. But due to lack of awareness many entrepreneurs end up using the same method.
When you purchase something for $80 and sell it for $100 you make a margin of $20.
By using the method taught at school you will arrive at a profit of 25% – ($20 / $80) * 100%.
But this is actually the mark-up – the percentage by which you are bumping up the selling price of the product in reference to the purchase price. A product purchased at $80 sold at $100 has a mark-up of 25% on its purchase price.
Although margin is the difference between the selling price and purchase price, which equals to $20 in our case, the manner used to calculate the percentage is different. This method follows the structure of a financial statement called – profit and loss or income statement.
Revenue – minus cost of goods – gross margin – minus operating expenses – operating profit (loss)
Unlike mark-up, where the purchase price is considered as denominator to calculate the percentage, here the selling price / revenue is considered as denominator to calculate the percentage. The profit and loss statement follows a top-down concept where everything is in reference to the revenue.
Hence, the gross margin equates to 20% = $20 / $100 * 100%.
Gross margins are utilized to finance the rest of the business expenses such as overheads, salaries and interests. Since business is game of percentages, a false perception of margin can cause the business to wrongly plan its expenditures.
Moving on to the second factor which is the context or essentially the dynamics of market competition. This consists of to two factors, first is the consecutive price cuts and second is the establishment of status quo in generalized market.
All businesses have entry barriers in form of either capital or intellect. The lower the enter barrier, the easier it is for new players to enter and compete. Examples of low entry barriers include retail and trading where the capital outlay is low and hardly any intellect is required to conceive and operate the business. Hence as new players emerge, they lure customers with lower prices, which reduce margins, or better credit terms, which increases borrowing cost.
The repetition of this phenomena continues till the elasticity point, which is the minimum amount of margins required for businesses to stay afloat. And once businesses are trapped in such market, they have no choice but to continue operations with thin margins and extend capital breakeven horizon.
Next is the case of lower price status quo. Consider the example of airlines and health clubs, services of each can be generalized across the industry. Air line ticket prices and subscription fees of health clubs started coming down during the previous decade. Although increased market volume meant adoption of strategies to capture market share by serving greater number of customers at lower margins rather than serving fewer customers at higher margins.
As the services were generalized, any innovative model which could reduce the capital outlay or operational expenses with marginal service compromise enabled new entrants to deliver at lower prices. New airlines, such as Easyjet or Southwest, with point-to-point models had lower operational costs compared to traditional airlines, such as United or Delta, with hub and spoke model. Similarly health clubs with fewer equipment and no recreational features resulted in lower capital outlay.
Hence these players were able to slash the prices, while maintaining breakeven, and subsequently establish a new price status quo in the market. As a consequence the old players are compelled to slash prices in order to stay relevant to the customers. Although cost cutting is undertaken, they lose money in the short term along with a perpetual reduction in margins.
And this explains the stark differences we see across companies in today’s uncertain era.
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Photo by Joshua Hoehne on Unsplash
Savvy Munshi 