Classifying your business as volume- or margin-driven can help you set your strategy wisely.
Businesses come in all shapes and sizes and sell all kinds of different things in different markets. Sometimes they can be so different that any comparison between them feels like apples and oranges. But regardless of what type of business you run, trying to classify it as either a high-volume, low-margin business or a low-volume, high-margin business can lead to valuable insights that can help you develop your strategy, operating procedures, and marketing initiatives.
Before we get to those insights, we have to suffer through just a little accounting and a little math. (Not much, promise!)
You can calculate your business’s return on capital by taking your net profit and dividing it by your total capital--all the money you invested into your business as equity plus all the money that you’ve borrowed from the bank. In simple terms, for every dollar that you invest into your business, this is what you’re getting back.
Return on capital can actually be thought of as the product of two different ratios, your profit margin and your asset turnover, multiplied together. Your profit margin is just your net income divided by your total revenue. Your asset turnover is just your total revenue divided by your capital.
Okay, no more math. What does that mean in the real world? It means that some businesses make their money by charging a lot for whatever it is that they’re selling. Others make their money by selling a whole lot of whatever it is that they’re selling.
There’s actually something of a spectrum here because there’s an inherent trade-off between these two strategies. Generally, if you start to raise your prices, then at some point, it’s going to start getting harder to do the same volume of business because some customers will start balking at the price increase. On the other hand, if you cut your prices to move more inventory, then your profit margins are going to go down. Depending how your business strikes that trade-off, your business may actually fall anywhere along that spectrum, but even so, it helps to simplify things by thinking in terms of these two buckets.
We tend to illustrate this concept using businesses that sell physical products. The comparison between a manufacturer and a retailer is a classic example. The manufacturer has a lot of capital tied up in factories, machines, and assembly lines, so the manufacturer is going to have lower asset turnover and will need to make that up with a healthy profit margin. In contrast, a retailer doesn’t have as much capital tied up in those factors, and there may be a lot of retailers selling similar products, making it difficult to charge a high margin, so the retailer will try to make it up by doing a lot of volume.
But don’t make the mistake of thinking that these principles apply only to sellers of physical goods. The insights are useful for all businesses. Even if your business is a personal services business, you could still calculate these ratios off of your financial statements and put yourself in one of these buckets.
Whatever type of business you run, the general lessons are the same: If you can’t do a high volume of business, then you need to make that up in your profit margins, and the only way that you’ll be able to do that is by offering a well-differentiated product or service that the market highly values. Your every obsession needs to be about figuring out what the market values, how you can align your internal processes to deliver that value, and how you can make sure through your advertising that the market knows what you’re offering.
But suppose that you’re selling something that you just can’t charge a high margin on. It’s easy to make, lots of other people sell the same thing, and you just can’t seem to do anything to differentiate your product from what others are selling. In this situation, you’re basically selling a commodity. You’re going to want to focus on getting as many customers to buy from you as often as you can get them to do so.