Maintain Your Margins to Maintain Your Viability
In business vocabulary, the term ‘margin’ is a fairly important word to know, as it is connected with several concepts that speak to profitability. Understanding your margins and maintaining them in inflationary times is key to remaining in business. Understanding what ‘at the margin’ means is useful for informing your actions, while getting a handle on the ‘contribution margin’ each sale, item, or service provides you is important for positioning your company appropriately. Failing to appreciate, calculate or keep an eye on any of these margins can cause hardship over time.
Of course, as we are talking about accounting, if you do not reconcile your books monthly and review your financials to monitor your margins, you are not ready to understand why your profits are slipping and where you need to make changes to correct the situation. In other words, you are failing and will never know why.
So, the general term ‘margin’ measures profitability, is expressed as a percentage (of sales) and is calculated as net income / net sales. High margins are good while low margins can be catastrophic. Once calculated, margins for a company can be compared to peer companies in an industry to get a feel for how well the company is doing maximizing revenues and controlling costs as compared to like competitors. These calculations can also paint a picture of success or impending failure, depending on what they reveal about margin maintenance over time.
Frequently in inflationary times, margins are eroded (lowered) when the cost of goods rises, along with supply chain issues that cause increased costs to be experienced. It can be difficult to raise prices to customers in concert with the increases in costs, which can cause margin shrinkage.
If you are doing a good job of reviewing your financial statements and know your fixed and variable costs, then you realize that once your fixed costs have been covered in an accounting period, additional sales result in outsized gains as only the variable costs need to then be covered. In other words, the increased sales have an outsized positive effect on profitability. The increased revenues are earned ‘on the margin’ and are desirable as a way to accelerate profitability. These transactions inform your actions as it is rational to expect that you, as manager, would tend to try and increase sales once your basic costs have been covered in order to increase your overall profit margin.
Each item or service you sell contributes to your overall revenue figure. Each item or service sold generates money to add to the gross revenues generated by your company, thus adding to your company’s net revenue. To fully understand what the contribution margin is of each service or item you produce or sell, it is necessary to fully understand what the total cost of each item is. This is calculated from your financial statements and from directly auditing the individual costs of each input, and if performed well, can give you the information you need in order to position your company to the markets you are in, with an eye towards how you plan to position the company in the future.
Once again, the key to forming strategies for the future, for determining where you make money and sustain your company, and knowing what your profit margins are and from where they are made is critical to your success. This may sound like a lot to take in, so don’t try to recreate everything accounting at once. Start with understanding your basic financial statements, audit them to prove they are totaling accurately and represent your operations correctly, and then do some cost accounting projects to determine the true costs of different products and services you produce. Now you are ready to put this information together and build a successful resilient business!
Marshall Doak is the Director of the Southern Oregon University Small Business Development Center and a huge supporter of innovation and the community that forms around innovation in the economy. In private practice, he works with businesses that plan to transition to new ownership within the next five years, assisting them to build value that can be converted to retirement income when the business sells. He can be reached through: firstname.lastname@example.org or 541-646-4126.
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