Course 204: Different Types of Profit Margins
How Margins Interact
In this course
1 Introduction
2 Types of Margin
3 How Margins Interact

Looking at how these various margins relate to each other for a given company can be instructive. For example, consider Coca-Cola KO and PepsiCo PEP. In 1997, Coke's net margin was 21.9%, while Pepsi's was less than half that--10.2%. Most of that difference arose from Coke's higher gross margin of 68%, as opposed to Pepsi's 59%. Those are both good figures for the beverage industry, but Coke's legendary brand name allows it more pricing flexibility, while its exclusive focus on producing syrup--not bottling or making potato chips--keeps down the cost of goods sold. That translates into a significantly higher gross margin, and that 9% advantage in gross margin is magnified when operating expenses and taxes (similar for both companies) are taken out. On the other end of the scale, consider Cott COTTF, the Canadian company that makes discount private-label soft drinks for grocery stores. Cott's gross margin in 1997 was only 16%, a small fraction of Coke's and Pepsi's. But Cott's operating expenses were also much less, since it doesn't have a well-known brand to maintain and spends far less on sales and marketing than the two giants do. As a result, Cott posted a net margin of 2.5% in 1997. But profits are more precarious for a company with low gross margins, and Cott lost money in both 1996 and 1998. Operating expenses are particularly important for retailers, whose gross margins are generally much lower than those of companies in other industries. Consider a couple of discount retailers, Wal-Mart WMT and Kmart KM. Wal-Mart's gross margin in 1997 was lower than Kmart's (20.4% versus 21.8%), because of its policy of keeping prices as low as possible. But Wal-Mart's net margin was more than three times higher (2.9% versus 0.8%), because its operating expenses were significantly lower than Kmart's. Next, consider the leading Web retailer, Amazon.com AMZN. Amazon's gross margins have been about 20% every year; that's significantly lower than those of its main competitors, Borders BGP and Barnes & Noble BKS, which both have gross margins of about 30%. On top of that, Amazon's operating expenses (mostly marketing and sales) have been about 40% of revenues, giving the company a negative operating margin of 20% (that is, its operating losses are 20% of its revenues). Assuming that Amazon won't be able to boost its gross margin very much in the competitive environment of the Web, it would have to cut its operating expenses in half just to post a net profit. In comparison, Yahoo's YHOO operating expenses ate up 60% of its revenues in the second half of 1998, but it still managed to post a net profit during that time because it had a gross margin near 90%. That doesn't necessarily mean that Yahoo is the better company; it just has a different business model that inherently makes higher gross margins possible. By themselves, profit margins are only a first step in evaluating a company's profitability. But as one of the building blocks of returns on capital, profit margin is a very important number, and understanding the different kinds of margins and how they interact can give you deeper insight into how a company operates.

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