Lately I have been getting a lot of business ideas from my batchmates at IIM Bangalore, and they seem to be making the same error as many entrepreneurs. Gross margins may be a good indicator of consumer surplus, which is the difference between the price charged by the seller and utility gained but the consumer; however, it is not an accurate indicator of profitability. In practice, the consumer surplus gets shared between the buyer and seller – as the buyer pays less than the value of utility gained, whereas the seller bears the cost of operating business including overheads and nominal profits.
Gross margin is a good indicator for back of envelope calculations, but the inferences are limited. It works well for judgements pertaining to one-time opportunities, but it does not work well when you intend to repeat such transactions consistently. As repeating transactions necessitates an operational set-up incurring overhead and capital costs. And the ability to contain such costs well within the gross margins dictates the success of any business. Hence, neither high gross margins indicate high probabilities of business success nor low gross margins indicate low probabilities of business success.
Today service start-ups backed by so called low cost IT systems (although the operational cost of IT systems is low, the HR cost for maintenance and upgrade exceeds such costs by folds) have huge gross margins, but fail to make profits. Despite attaining economies of scale and victory in a zero-sum game at VC expense, they usually fail to attain profitability. This brings us to the subject of cost structure, in simple words, how are the costs proportionately distributed amongst the various factors including cost of goods, operational expenses, cost of financing, capital depreciation, and taxes. Hence, one should assess disproportionate cost categories before making judgements.
Another challenges is being scared by low gross margins. We all know that Walmart leads discount retailing and is also most known retail-market chain in North America. However, if you’re aware about the fact that FMCG products have razor thin margins and Walmart started its business from smaller markets (towns with ~50,000 population), the idea of success becomes counter intuitive. As prima facia rational strategy to compensate for razor thin margins would be to increase number of transactions by accessing larger markets; a strategy adopted by all Walmart competitors including the leader K-mart. However, Walmart took frugality and optimisation to new highs, making them the most cost efficient retailer across all expense categories; thus generating profits and growth opportunity.
Hence, before making any business judgement, it is better to develop a more detailed back of the envelope calculation with a cost structure that indicates proportional distribution across categories. And it is always a good idea to be frugal like Sam Walton and Warren Buffet. Another business that has thrived on frugality and optimisation in an industry notorious for loss making is South West Airlines. At both companies, expense frugality and cost optimisation were not only management practices but also ingrained in their cultures. Since success cannot be explained by functional strategies and management practices, it is attributed to causal ambiguity.
And this is what we call magic!
Magic happens from gross to net, and we are the magicians.”
Improvised Pitch, Apex Zenith Project Consultants LLP
Earlier in 2017-28, when I started a management consulting practice, this had become our improvised pitch. As financial awareness and strategy sync for micro and small businesses was one of the key challenges. And over the years, the belief has been substantiated.
And if you want to learn more about business from our experiences, check out our Udemy course on Business Management Essentials.
Header Image Photo by Matt Flores on Unsplash
Savvy Munshi 