ShmoopTube

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Accounting Allah shmoop relative margins good bad and or ugly

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A big part of a company's financial report card will

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come from an assessment of how they're doing relative to

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competitors in two key categories And these are the primary

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drivers of share price overtime margins and revenue growth Like

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you can imagine a scenario where your the new CEO

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brought into quote Fix unquote a newspaper company The company

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on Lee prints on paper and doesn't have a website

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You could very quickly fire all the non union jobs

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and six months later fire all the union workers and

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for one year your margins would skyrocket from eight percent

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to twenty three percent But your revenue with likely get

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cut in half or worse So just looking at profit

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margins alone in a vacuum means nothing like in this

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case you should have been investing in a Web site

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in an Internet presence and relevance in the local community

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and all that stuff and not so worried about cost

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cutting There has to be revenue growth with a company

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or it just doesn't win much love or a multiple

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on Wall Street Right So if you're in the sunglasses

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business Well they're just a handful of large scale competitors

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The one growing revenues at thirty percent with twenty five

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percent operating margins is going to trade it a big

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multiple premium compared with one growing revenues that only ten

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percent with the fifteen percent margins right like way the

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last prophet on less revenues But for the moment the

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focus here is on margin profit margin Here inventory is

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an expense I eat the cost structure of the ingredients

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that go into a product or service like plastics and

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dark glass lenses and two hinges right That's the stuff

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that comprises inventory that lets the sunglass company make it

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sunglasses Well for cross business perspective let's tack on the

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lemonade stand business and the manner in which it manages

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its inventory against the very different structure of a sun

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glasses The business we're including only the cops and the

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liquid as costs that go against gross margin that is

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we have revenues and we have ah very few basic

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expenses in the form of cups water and sugar and

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well that's about it Subtracting those expenses from revenues gives

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us a very high gross margin product in our lemonade

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at something like eighty five percent What that means is

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that we're choosing to ignore all the other costs that

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go into actually physically serving a customer A cup of

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lemonade Obviously the company needs labored a portal lemonade to

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collect the cash to clean up spills and do other

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you know exciting tasks like that They're also basic fixed

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costs like renting the physical place where the lemonade is

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served paying for the city permits and all other kinds

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of expenses that go into a world class Will lemonade

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stand if there is such a thing But for the

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purposes of this intellectual exercise we're only assuming the basics

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a cup and liquid in it as our only expense

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against revenue We've collected of a buck a cup Okay

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So what are the collective extra elements we need in

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order to actually serve that cup of lemonade Will How

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do people get served ignoring labor How do they pay

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Ignoring Visa and MasterCard Robot C How do they use

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robots Maybe labor should go up there in the gross

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margin line as well And maybe not Well what do

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you think It's up to you anyway in the case

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of the lemonade business If the cost of cups double

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than the cost of sugar and lemons went up fifty

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percent that is instead of ten cents a cup It

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cost twenty and instead of a nickel it was seven

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and a half cents for the sugar and lemons Well

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we'd still have a pretty high margin business Gross unit

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margins would be seventy two and a half cents a

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cup The key idea here is that inventory management and

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price optimization for those kinds of inputs doesn't matter all

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that much When you have an extremely profitable company you

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want to optimize revenues Not so much worried about cutting

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costs right If a can of Coke sells for a

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buck and sugar prices double now that can produce is

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something like seventy cents of profits instead of eighty or

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something like that In very high margin business is you

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don't go bankrupt If input costs go up your just

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less wildly profitable poor you literally But there's another side

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to this coin like that Think about the generally very

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low margin airline industry where fuel is a huge part

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of expenses and its pricing is extremely volatile Well in

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times of falling fuel prices assuming they aren't reflective of

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a failing economy and that air travel in economic times

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air highly correlated well then airlines arm or profitable than

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otherwise When their cost of doing business i e The

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fuel is cheap Things can whips off fast though one

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bomb goes off in the Middle East and fuel prices

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double overnight and airlines hemorrhage on more than just blue

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ice So inventory management is hugely imp important there So

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is capital management in the notion of how much margin

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life insurance companies are willing to pay for a given

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amount of pretty detection Okay what does that mean Margin

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life insurance What is this Well answer It's an investment

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in hedges That company's namely airlines make to protect a

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minimum level of profit margin for their company Usually only

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companies and extremely volatile supply line industries like the airline

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industry by these edges because if they don't in very

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bad whipsaw e supply times the company could go fully

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bankrupt The structure itself of these hedges is really not

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that different than basically term life insurance or a healthy

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twenty five year old pays fifty bucks a month for

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a million dollar life insurance policy such that if he

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dies and his wife wasn't the one who killed him

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his wife and kid and a half get a big

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fat million dollar check and will hopefully miss him if

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he doesn't die that month Well then the fifty dollars

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was given gratis to the kindly loving people had Geico

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So the big question What is it worth to airlines

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to guarantee that they'll never have to pay Mohr than

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say the equivalent of sixty bucks a barrel for oil

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or fuel reserves that they keep essentially quote in inventory

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unquote Think about a scenario where one airline has not

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hedged its beds making a huge bet that peace will

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continue to rain throughout the land Then a bomb hits

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and the absolute minimum in fuel cost airlines can spend

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to break even would charge an average SFO JFK a

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ticket to be six hundred twelve dollars Well that prices

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for the airlines that hedged their bets The one airline

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that didn't hedge Well it now has to pay double

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the price of fuel Post bomb era prices Yeah What

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about that airlines Well they're marginal cost just for fuel

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is over a thousand dollars over a grand for that

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trip A customer So nobody books They're expensive flights because

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they have to charge a lot more or they're losing

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money meaning they'd rather just not fly And basically this

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is how you go bankrupt quickly in the airline industry

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So what does all this mean to the Quays I

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investing community and the people who work at Thes Cos

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Well at the end of the day or month or

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quarter or year the goal of any company is just

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produced profits for shareholders Companies come in many flavors of

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profit High margin high profit companies like Google have their

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own distinctive competitive commercial elements That is when on ly

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small amounts of capital are required to build a website

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which can produce very high margins Well they're typically exists

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Ah highly rivalrous marketplace of lots and lots and lots

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of competitors And there used to be that dynamic Yeah

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that's how things were in the very early high margin

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era of Google's existence when there were something like thirty

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search engine companies all vying to provide Internet search services

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for revenues of some fifty eight cents a click on

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costs of less than a penny Other industries are naturally

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low margin ones like that of the airline and automobile

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manuals fracturing ones where mature marketplaces and deep integration with

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government regulation and unions has turned those industries largely into

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job factories for voters union workers at the expense of

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profit margins There's no particular rule for what the profit

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margin of a given company or in the industry should

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be Other than that while generally speaking higher margins are

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good and lower margins are bad And yeah that's on

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