Why margin isn't a good metric

A product's profit margin doesn't always tell you how a company is performing -- at least, not without a lot more context

Dear Bob ...

I have to disagree with you on your example from Keep the Joint Running this week ("Higher hierarchies," 6/22/2009), where you recommend marketshare over margin as one desirable characteristic of entrepreneurs.

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In my experience, it is not one over the other; both are critical to long-term success. Perhaps the lessons are still open to be learned, but incredible market share with little margin is ... Facebook? Or as my German friends say, "In America it is not 'I believe,' it is 'make believe'." For the one Microsoft, Google, and Amazon, there are thousands of tombstones for the dead companies that bet everything on market share with no care for profit margin.

- Skeptical

Dear Skeptical ...

I get that a lot. And looking at what I said in the article, I didn't clarify whether I was talking about overall corporate profit margin or average product profit margin. The two are vastly different subjects. For the record, I was referring to product profit margin, and for that I stand by my statement.

Product margin doesn't equal profit or even profitability. Some companies are well-known for having paper-thin margins and huge profits. ExxonMobil comes to mind (at least in their corporate propaganda -- I'm not sure if I believe 'em and I can't find an authoritative source of information).

The way it works is simple: The more volume you sell, the less margin you need, so long as you achieve the volume by turning over inventory instead of accumulating it. The key to more volume is market share, which has the additional benefits of taking market share away from competitors. In many cases it's also an indicator of increased customer loyalty, which makes it a predictor of success, where margin merely reports past success.

There are times when taking the risk of reduced corporate profits in exchange for increased market share makes sense as well. You mentioned Amazon.com, and it's an excellent example of a company that realized critical mass was, for its business model, everything, and succeeded in achieving it.

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Even without a business model that depends on critical mass, the combination of declining market share and increasing profit margin is a warning sign of trouble to come. General Motors is an example: Its management focused on profitability instead of focusing on building cars people want to buy.

An entrepreneur would never make a mistake like that.

- Bob