Like living creatures, organizations have a strong instinct for survival. Despite this, many companies run the risk to go extinct. What does your company need to survive? Three essential elements are:
· Products that meet market demands;
· Customers willing to buy your products;
· A healthy profit margin on your products.
In this article I would like to zoom in on the profit margin, as applicable to manufacturing companies. What is a healthy margin? Evidently, a negative margin isn’t healthy. A negative margin can only be carried for so long, because a sustained negative margin will inevitably lead to a collapse (unless it concerns products that are subsidized for commercial reasons, for example to support the sales of other – profitable – products).
A profit margin can be qualified as healthy if it’s on par, for a longer period of time, with that of the competitor with the best margin in the market. It’s hyper healthy if it’s even better than that of the competition. If the margin is structurally on a lower level than that of the competitor, you might still make a profit, but it makes survival in the long run highly uncertain.
Traditionally there are two different strategies for (mass) manufacturing companies: cost leadership and product differentiation. Both strategies are aimed at creating a sustainable competitive edge. In the past that worked out quite well. Nowadays that’s no longer the case for most products. The life cycle for the average product has decreased dramatically, forcing companies to develop and launch new (versions of) products in ever faster cycles. The consequence of this is that it has become virtually impossible to establish a lasting competitive edge. Even companies that have nestled into comfortable niches in the market can’t consider themselves safe for a long time. Neither the competition nor the technological developments ever stand still. Today’s margin can suddenly start to erode tomorrow, when a competitor launches a renewed product into the market.
A pattern typical for the development of selling prices of consumer products is that newer versions (improved versions, containing new features), are as expensive or even cheaper than the previous version. Hence, the customer gets more for the same or a lower price. This selling price consists of the costs incurred to deliver the product plus the margin. If a company doesn’t want its margin to erode, it is inevitable that the costs be decreased.
The selling price of a specific product with a distinct set of features is more or less a given. It’s determined by what a customer is willing to pay, based on the perceived value. This implies that competitors can ask a similar price for a similar product (with similar features and quality). The margin that they are able to realize is a function of cost efficiency. Lower costs lead to a higher margin (naturally a higher margin can also be the result of a higher selling price, but this is usually offset against additional marketing efforts, resulting in higher costs. It could also concern an underserved market niche, allowing the provider to charge a premium price. But in general this will only be a temporary situation).
How does a margin that exceeds the margin of competitors help a company to survive? Firstly because it enables an organization to build a financial buffer to weather potential meager years. Secondly because it offers more flexibility in applying commercial strategies. You could decide to lower your margin to that of your direct competitor. Since your costs to produce the product are lower than those of that competitor, your selling price will be lower too. In situations where price elasticity is playing to your advantage, this will lead to additional revenue and – eventually – more market share and profit than the competition. Another possibility is to use the additional margin to add features to the product while maintaining the selling price at the same level. This would also make your product more valuable in the eyes of the customer. A third option would be to invest the additional margin in innovation and product development, and thereby increasing the odds that the next generation of your product is again superior to that of the competition.
In summary: it’s difficult to overstate the importance of a lasting superior margin. It’s an essential prerequisite for survival of your company in the long run. That’s exactly why so many companies are looking for handles to manage their product margins. Essentially, there are two places to find these handles. In the top-line; are their opportunities to raise the selling price by improving the perceived value of your product in the eyes of your customers? Or in the bottom-line: are their opportunities to lower the costs of a product? It’s our mission to guide organizations in this this quest. For this we use techniques like lean product development, value engineering and target costing. And a full toolbox with methodologies, techniques and templates. Are you curious how we can help you to improve and sustain your margin? Please contact us:
+31 6 1232 2189