Tuesday, April 22, 2008

A Brief Thought on Profit

One of the important things a business student has to learn early on in his career is that profit margins are NOT of extreme importance...at least not all the time.

I was reminded of that this morning when reviewing a presentation my friend was preparing for some executives from a major corporation (no need to say which one). He said that the company's stores should switch from selling a low-margin product to a high-margin product, simply because of the margin.

But, intuitively, we all see something wrong with that. Namely, that low-margin products might sell faster, giving us more money in the long-run.

That's why we shouldn't look just at profit margins when we're determining how valuable a firm is. Otherwise, restaurants and supermarkets would be considered bad investments.

A much better measure is return on equity or return on assets, which shows how much money a company makes for every dollar of investment it has.

That's my thought on "profit" for today


Anonymous said...

I figured this was fairly obvious.

Its the same thing that prevents a "monopoly price".

All it is, is analyzing the demand curve.

Can I sell 3 widgets and make 70$ profit on each widget in one day (210$ in profit total), or can I sell 5 progs at 45$ profit each (225$ in profit total).

What year is your friend in? I would think this was very basic.

Robert said...

He's a third year student. In his defense, he didn't write that section of his group project.

Groups not working properly: probably why people don't like working in groups to make stuff!

But it isn't always intuitive. College-educated people make the same mistake all the time in their analysis of companies.