Margins (continued)

Last week in MBA Mondays we talked about margins, which I defined as:

Margin is the amount of money you make on each incremental sale or unit of revenue before factoring in the “fixed costs” of your business.

That led Amish Shah to leave me this comment:

While you focused this post on margin from “incremental sale” (gross margin), I think it’s important to acknowledge that there are other margins in the business. And they shouldn’t be ignored.

Operating Margin, for example, is another one I like to look at (and you have previously mentioned it is the most interesting line in a P&L). There’s a lot of info in there… Salesforce’s gross margin looks great at 80% but operating margin is a lot less glamorous at 0-10%, depending on which quarter you look at.

As Amish points out there are other kinds of margins in a business. I like to focus on “gross margin” because I think it tells you a lot about the scalability of a business (as I detailed in last week’s post). But operating margin which is gross margin less all the operating costs is another really important metric.

There are relatively low gross margin business (like Apple which has gross margings of 38.5%) which have relatively high operating margins (Apple has operating margins of 29.2%). And as Amish points out, you can have a relatively high gross margin business like Salesforce have relatively low operating margins.

It is important to pay attention to these metrics. You might have two businesses with identical operating margins but one has high gross margins and high operating costs (like Salesforce) and the other has low gross margins and low operating costs (like Apple). The businesses will be very different to manage and will require different teams, strategies, and financing requirements.

 

From the comments

amishshah added:

Thank you for mentioning me in your post!

This is a fascinating discussion, and as you mention, managing these metrics will require different teams, strategies and financing requirements. I think your last sentence is the biggest takeaway here. Gross Margin can tell you a lot about the scalability of a business, but Operating Margin can tell you a lot about the business activities needed to drive that scale. To continue the Salesforce example, the Saas business has high gross margins and is highly scalable, but the nature of their business (high ticket B2B) requires extensive sales/marketing efforts.

Early stage startups in the consumer web/mobile space will be product-focused and not necessarily focused on margin (especially if they have no revenue!), but as they mature and define their business model, they will need to think about the activities that will drive it. (Will I need more engineers, or more salespeople? Do I spend more on R&D or facilities? What help do I need?)

Asking questions like that, and linking them to both gross margins and operating margins, will – as you said – be helpful in making the decisions they need to make about teams, strategies and financing.

 

This article was originally written by Fred Wilson on April 18, 2011 here.