The Percentage Margin Trap

One of the income statement metrics that stock analysts obsessively focus on is operating margin expressed as a percentage.  Stocks get punished when the operating margin drops or did not meet the goals. So businesses align their marketing and operations to focus on this improving operating margin. To an extent operating margin expressed as a percentage shows the profitability of the operations but the obsessive focus on percentage leads to two errors:

  1. Information loss – specifically the absolute profit earned. ( I am going to ignore here  a more rigorous number, operating cash flow and treat earnings as all cash.) Given two stocks of identical companies in the same market, one with an operating margin of 10% and the other 12%, both with a stated 5 year goal of 4% improvement, can we tell which stock is a better prospect? What about their absolute income level and growth prospects?
  2. Causation Confusion – percentage margin is incorrectly treated as the driver of overall profit. Higher the operating margin, higher the profit. Margins do not drive your profits it is the other way.

Operating margin percentage is a computed number not an intrinsic metric that needs to be actively managed and definitely not a driver for your marketing decisions like pricing the products. Let us take the case of Mattel just because it was in the news recently.

Recently Mattel anounced blow out earnings, with 86% increase in profits with only a single digit increase in sales.  This is extraordinary but there is a concern on what they are focusing on. The WSJ news story’s title reads “Earnings Up 86% As Margins, Barbie Sales Jump“. Margins did not drive the profits up. Profits went up because of price improvement on their Barbie line. In its earnings call Mattel CEO, Mr. Robert Eckert, made the following statement

“We will price our products consistent with our goals of long-term operating margin of 15% to 20%,”

Determining the price to sell based on the stated operating margin goals is cost based pricing.  Pricing the products to  meet a derived metric is like putting the cart before the horse. Price is not driven by a businesses need for meeting its operating margin targets  set by stock analysts but by the customer’s willingness to pay. Based that price the business must either try to make the products at costs that are profitable (price driven costing) or choose not to compete in the market. I want to believe that Mr. Eckert meant here choosing only those products that can help Mattel meet its margin goals and not set prices regardless of the customers.

What drives shareholder value is absolute profits. Not percentages. As Ford said about costs, operating margin is always a computed number.

What drives products prices is value to customers and their willingness to pay, not stock analysts.

What sets prices and drives profitability is effective price management not meeting operating margins.

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