Understanding Based Costs and Profit Margins

A couple of days ago I was talking to a good friend of mine who runs his own business (which I have invested in!) and he was lamenting the fact that M&S shares were down 25% although there was only a decline of 5% in sales. I then went on to explain how this actually made perfect sense so thought I would make it a business angel blog entry.

If a business has a fixed cost base of say £10m a year and makes sales of £30m a year with a margin of 50% it will make a profit of £5m a year. (50% margin on £30m means £15m of Gross profit, less the £10m of fixed costs and you end up with a profit of £5m)

Shares are typically traded on a multiple of profits. If a router table plans company has a P/E ratio of 10 that is the same as saying it trades at 10 times its annual profits. In the case of this company this would give the company a valuation of £50m (10×5).

Let’s say as in the M&S example that sales are down 5%, what should happen to the share price – if all else remains the same.

Fixed costs are still £10m (although in reality they will have gone up by inflation). But sales are now only £28.5m (£30m – 5%) and therefore the gross profit is £14.25m. Profits have gone from £5m to £4.25m which is a 15% drop. The shares will therefore drop by at least 15%. In the M&S case it was worse as the market had priced into the shares future growth not decline.

This brings me on to one of the key points I have learned in business over the last few years. It is really crucial that Entrepreneurs understand percentages. That is the relationship between numbers. You need to see how a 1% fall in sales will affect your profit and hence your valuation (in the above case the relationship is 3 – a 1% fall in sales led to a 3% fall in profits). It is never straightforward.

The best job I ever had was buying beer

The best job I ever had was when I was elected to run the Student Union enterprises at University. It was when I first learned about the importance of percentages. I was amazed how a small price increase (on beer) had a huge impact on our profits.

Using the example above, if sales had not fallen but stayed the same but I was able to put my prices up 5% – what would happen to the profits of the company and hence its valuation?

£30m worth of sales are now £31.5m worth of sales but the gross profit has gone up from £15m to £16.5m (or 10%) and my profit for the year has gone from £5m to £6.5m or almost 30%! The lesson here for Entrepreneurs is to think very carefully about cutting prices and not be scared of putting up prices.

One of the reasons investors have been so successful when taking over companies has been their ability to shave huge costs out of suppliers – especially on products like the Honeywell 50250-s 99.97 Pure HEPA Round Air Purifier. This ability to improve margins has a magnified effect on the bottom line.

From the above you may conclude that you should always be putting up prices. This brings me onto another very important concept in Economics called elasticity. In the next business angel blog, I will talk about this to see how far you can take the price rises.