Profit Margin

Now let's spend a bit of time understanding profit margin.

Quite simply, the profit margin or "margin" for short is the difference between the sale price of a product and the total cost to produce that product. This is equally true for services but I'll use a product in my examples.

So, if it costs you $10 to make a toy and you sell it for $15, then your profit margin is $5 on that product.

One of the challenges any business faces is pricing their products (or services) to maximize the over all profit.

Consider that if the price for your product is high, you will make a lot of money (high margin) selling only a few units. For example, if it costs you $10 to make a toy and you want to sell it for $100, you will have a margin of $90. Sweet deal!

However - if the price is higher than most people will want to pay, then you may only sell very few units of the toy, for example one. If you only ever sell one under this scenario, your total profit is only $90. (1 unit X $90/unit = $90)

The second scenario is that you price your toy at $11 so your margin is $1 per unit. Now the price is so low that you sell 90 of them but again, you only end up with $90 of profit, e.g. 90 units X $1/unit =$90

Ideally (and the most successful businesses are expert at this)- you will find a price point (say $12) that still allows you to sell close to 90, let's say 80 with a higher margin i.e. $2 per unit. Under this situation your profit is 80 X $2/each = $160. This is obviously headed in the right direction!

So whether you are in the business of selling goods or services, you should always know what your margin is and whether your business is a high margin-low volume business or a low margin-high volume business. This helps in setting your price point.

Keep in mind a couple of other key points in working out your margins. First of all, any time you can lower your cost - you have increased your margin. So being able to produce your toy in a more cost effective and efficient way is going to result in higher profit.

Also keep in mind that as other similar toys come to market, you will want to maintain your product's position either by making it better (new and improved) which can cost money and thus incur additional costs, or by offering it at a lower price - thus cutting into your margin. Often you will see last year’s favored toy at greatly discounted prices, sometimes below cost just because they are no longer popular and their production has already been paid for!

You can see how challenging it is for businesses to maximize their profit and why costs of goods and services can vary widely. Also keep in mind that this is a very simple example and that there are costs and margins built into every stage of the product cycle.

For example, the material to build the toy needs to be purchased from someone who also needs to make a profit, the manufacturer of the toy needs to make a profit, the importer of the toy needs to make a profit and so does the retailer that ends up selling the toy to the public.

You can see that there is a lot of different margins to be built in when you consider every step in the production chain and again this is a very simple example.

Just as an aside, I have heard that a good starting point for pricing can be determined by having 20% of your prospects reject your product because of price. At that point, it is neither too low nor too high and hopefully allows you to maximize your margin and your profit!

Now – when your bosses and peers start talking about “margin” you can start asking some really great questions about where the business might cut costs to increase the margin or where you might set the price point to increase the margin.


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