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How to Know When Better Profit Margins Are Not Really Better

If you were to ask CEOs and business owners if the ability to increase profit margins year after year would help their companies compete more successfully against their competitors, you would be likely to hear a resounding yes. After all, if making a profit is an important company goal, cutting costs or increasing prices to improve profit margins are good things, right?

Not necessarily. At some point, cost cutting can be counterproductive, starving a company of new sources of growth and undermining performance over the long term.

For example, a mid-market manufacturing company increased its profits at extremely aggressive growth rates for numerous years by emphasizing margin growth — even though revenues grew at only a few percent per year over that period. Eventually, the company ran out of business healthy opportunities to cut costs. They began slicing into areas of their business that benefited its customers and brands.

Performance targets were missed by margins that were so large, the CEO was compelled to acknowledge publicly that they had underinvested in product development and marketing. The company had to spend considerably more on those functions, as well as invest in a profit margin analysis​ and improvement plan to get the business back on track and to a state of positive, sustainable growth.

Indiscriminate margin-boosting price increases can also hurt a company’s competitive advantage. For another example, one large company’s top executives asked few questions of a business unit that regularly hit its earnings targets — until its performance faltered. Later on, they learned that the unit’s managers had produced years of strong profit growth largely by increasing prices. That allowed competitors to step in with similar but less-expensive products, cutting into the unit’s market share.

It turns out there are limits to how much — or how long — companies can improve their profit margins. A recent study that showed the margin performance of 615 of the largest nonfinancial companies from 2001 to 2013, found that around two-thirds were able to sustain their margin improvements over three consecutive years at least once during the 13-year period.

About half were able to sustain a margin increase for four or more years. Since there are thousands of potential four-year sequences across 615 companies and 13 years, the fact that half the companies could sustain such a margin increase just once suggests a low success rate for the total number of potential four-year or longer time periods.

More importantly, the longer companies increased their profit margins, the more likely they were to fall behind their peers in terms of total returns to shareholders (TRS) once their margin growth stalled. Only about half of the companies that sustained margin improvements for three years were able beat their peers’ TRS in the years that followed — about the same odds as flipping a coin. Improving margins for four years made subsequent performance even worse, not better.

How long a company can increase its margins without undermining its performance depends on the starting point. Underperforming companies with low initial margins or companies in certain phases of the industry cycle, for example, probably have more leeway for increases. But the longer companies increase their profit margins, the more vigilant managers must be to avoid cutting corners.

Fortunately, a few straightforward rules of thumb can help business owners and CEOs avoid taking margin improvements too far. Among them:

Expediting the closing of the books at the end of each month, streamlining production processes, or introducing sophisticated fulfillment tools can cut administrative, manufacturing, and distribution costs without hurting the quality of your product or the experience of its customer down the road.

Cost cuts or price increases might boost earnings in the short term. But those that affect a company’s ability to market and sell its products or to meet changing customer needs will generally hurt business performance in the medium to long term — which can be just a year or two. The same can be said of cuts that affect a company’s ability to get its marketing and sales message out to customers.

If you are a small business owner or CEO within the San Francisco Bay Area or Silicon Valley, in need of an experienced part-time CFO to help your company maintain a business-healthy profit margin, improve financial and operational reporting, cash flow or accounting and billing process management, our highly skilled outsourced CFO services provide direct access to high-quality expertise in a cost-effective manner.

CFO Growth Advisors (CGA) specializes in unique and highly effective growth strategies that are tailored to help companies grow more quickly and efficiently while improving sales and profit growth. Contact us to learn more.

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