Dave, My question is this: If you arbitrarily raise your profit margin will you increase costs? I say yes in terms of the loss in market share for your product based on the what the market will pay for the item or service. Another individual says no. What do you think?
Hmmm… I think you might be comparing the proverbial apples and oranges or putting the cart before the horse or some other wacky proverb. 🙂
Seriously, your costs are a combination of fixed and variable costs, and your profit margin is added to your costs to calculate your retail or asking price. So changing your profit margin cannot change your cost of goods.
Let’s step through an example. Imagine you’re the head of production for Sony Corporation and you’re in charge of the slick Playstation Portable (PSP) device. To build a PSP you need to source (buy from third parties) an LCD screen, a variety of chips and circuits, buttons, metal switches, wires, and you’ll also need to do some injection molded plastic and lots of assembly, of course. You print your own boxes (but you source the boxes from another firm) and have your own industrial facilities for producing CDs and similar.
Your fixed costs are the equipment you use and, according to some business analysts, the cost of labor. The individual materials that you buy from third parties are typically known as variable cost items because, well, you don’t have complete control over how much they’ll cost. This week the gorgeous LCD screen might be 450 ¥en, but next week it may jump up to 900 ¥en or drop down to 318 ¥en.
Add up your fixed costs and your variable costs and you have your COG, your Cost Of Goods.
Let’s just take some numbers out of thin air. Fixed cost for producing a single Sony PSP we’ll say is $26, and variable costs are $74. Add that up and the cost of goods is $100. Sony wants to work with a 20% profit margin, so that adds $20 to the wholesale price, for a total of $120.
There are some additional distribution and packaging costs depending on retailer (some might co-brand or require different packaging) but let’s just assume that in large shipments each PSP costs about $5 to ship from the factory in Japan to a retail loading dock elsewhere in the world.
Now it turns out that the retailer uses a simple doubling of wholesale to arrive at the sale price, in this case ( $120 + $5 ) * 2 = $250. Now drop that down just one little penny for marketing purposes and we’ve got our suggested retail price: $249.99.
Can you see how costs and profit margins are related? Sony, in our fictitious example, could triple its desired profit margin from 20% to 60% and you can see how the price increase would reverberate through the supply chain (with an end price of $330).
In terms of loss of market share, that’s quite possible: certainly people who would be willing to spring for a $249 portable game unit might skip it at $330, but even then, market share is affected by the sale price, which is a combination of factors including cost and profit margin, but it’s certainly not the case that an increase in costs will cause a loss in market share. For example, if the raw materials for plasma TV screens triples in price overnight, all companies selling plasma TVs will be affected equally, so while the cost of goods might increase across the board, and while the retail price might jump up, the market share for each vendor might well stay the same since they are the entire market.
Hope that clears things up!