CHAPTER 11: PROFIT MARGINS – PROFITABILITY OF THE BUSINESS

Previous Chapter
The Relationship between Margin and Volume
Next Chapter

The Relationship between Margin and Volume

In very rare cases do both volume and margins go hand in hand. Under common conditions, high volume business generates low profit margins, and high margins business is of low volume. It is the work of fundamental economics behind the scenes.

Take the example of the semiconductor industry. The manufacturer of semiconductor components, also known as the downstream players, will have a larger revenue base than the upper stream players, which are the equipment suppliers. However, the equipment suppliers have better margins than the downstream. 

Table 4 shows the financial data of Malaysian Pacific Industries Bhd (“MPI”) and Vitrox Corporation Bhd (“Vitrox”) extracted from respective companies’ annual reports. MPI is involved in the downstream manufacturing of semiconductor components while Vitrox is involved in the manufacturing of upstream semiconductor testing equipment.

Although both are in the same industry, one is involved in the higher volume business, i.e. manufacturing, whereas the other is involved in the lower volume business, i.e. equipment, as can be seen from the revenue. The margin earned shows the inverse relationship with volume which we have described. 

Once I was looking to get a retractable water hose for a school. Firstly, it was not easy to find. Secondly, it is not cheap. Then I was complaining, “Why don’t they sell these things cheaper?” A simple logic then strikes me. A retractable water hose is not something that everyone is looking for. Only those who want to buy it will look for it. It’s not a mass demand item. So, even if they decided to drop the price, this won’t create demand for it. No one is going to be like, “Hey, retractable water hoses are on sale. Let’s get one.” Thus, products with a low sales volume would need higher margins to justify its continuance.

The opposite is true. For mass market items, since there is a lot of demand, there too will be a lot of supply. With a lot of supply, market competition will ensure all players earn what economists term as “normal margins”, which is the level of margin that allows existing players to continue doing business yet is not attractive enough for new players to join in the game.

Of course, there are exceptions. High volume and margin is possible if there are barriers to entry. One clear example is the telecommunication business. Despite all the competition, the players are still enjoying good margins, averaging 20% at net profit level (and higher at earnings before interest, tax, depreciation & amortisation level). What is allowing the players to earn these margins is the barrier to entry in terms of licensing.

Back to the Apex and Pharmaniaga example, in both cases, the manufacturing division generates higher margin than the trading & distribution division. This is due to the nature of the trading & distribution business which is more of a volume game, whereas the demand for pharmaceutical products is dependent on needs, and not the pricing (i.e. paracetamol sales do not shoot up just because it is on sales). Thus, it follows the relationship between volume and margin.

Next week, we will look at the effect of Associate & Joint Venture Accounting on calculation of profit margins and the leverage of businesses with low margins.