Beware The Curse of the Low Margin Business

low margin business

Don’t get sucked into a vicious circle chasing sales for tiny profits. Avoid the low margin business.

The number 1 priority for every business should be to make money for its owners.

You must figure out how to make a profit first before you embark on grander goals. Making an impact, creating jobs, and giving back to your local community, can be important incentives, but these will be of no use if you cant make money.

If you are not interested in profits, then you should start a non-profit organization.

Unfortunately, many business owners focus so much on getting sales and ‘growth’ that they forget to look at profitability. They get sucked into low-margin businesses, thinking that their profits will show up magically once they are big enough.

I have always been averse to selling products that leave a tiny margin for profit. In business, things go wrong all the time, and you need to have that extra margin to absorb your losses.

Just Because There is a Market does not mean that you can Make Profits

I have a friend who wanted to start a business in food distribution. He assumed that because there will always be a market for food, this business will succeed. Many people starting in business don’t understand that just because there is a demand for something does not mean you can actually make any money selling it.

A few years later, he sold the business. He told me that there was no point in running the business. Despite the high revenues, profit margins were tiny, buyers were late in paying, and he needed just a massive revolving loan to have inventory available.

All it took was one faulty batch for his profit margins to be wiped out.

The food sector is highly competitive. At the top of the buying chain, you’ve got these huge retailers and distributors with lots of power. These guys keep on pressing for ever-lower prices. As a result, the whole industry gets sucked into price wars and never-ending pressure to lower prices.

But what makes this low-margin industry even less attractive is that the big powerful guys get to set the payment terms. This means not only are you making little profit, but you need to finance your negative cash flow by borrowing money (which inevitably increases your costs).

The Large Volume Fallacy

I meet many small business owners who enter low-margin industries believing that they can somehow crack the industry. They reason that even if margins are only 5% if I sell $2 million of this stuff, I can still make $100.000 in profits.

I wish it were that easy. First of all, a $2 million business that produces anything requires overheads. You need staff to answer the phone and deal with customer support. You need staff to sell the goods. You need someone to process and distribute the goods. You need a large enough place to house your 2 million business. Those costs will eat into your margins.

You need to cover your inventory which can sometimes be 25–50% of your annual sales. For example, I run a construction goods business where the margins are significantly higher. However, I have 20% of my annual turnover tied up in inventory at any given time.

In first-year economics, we are taught about economies of scale. The theory says that as a business grows, it can better use its resources and therefore achieve higher profits per unit sold.

Unfortunately, economies of scale only work well in theory. In the real world, getting bigger also means increasing your marketing costs. Unless you have a method of acquiring new customers quickly without spending additional money, scaling a business tends to lower profits and not increase them. Your profit per unit sold may seem higher, but the sales and marketing costs will eat into those profits.

E-commerce and Dropshipping is not that Profitable

I see many people who start e-commerce and dropshipping businesses. They somehow think that they can sell the same stuff as Amazon (or other big local retailers) and make a bigger profit.

People assume that they can grab one percent of Amazon’s market share, and that will make them rich. People do not understand that even getting one percent of the market (or 0.1% for that matter) requires that you settle for razor-thin margins.

Also, there are many hidden costs when running an e-commerce business. The cost of shipping is usually much higher than what Amazon charges for shipping. That’s because part of the shipping cost is baked into the price of the product. Amazon figured out early that no customer would pay 30% for shipping, so instead, they charged less for shipping and made the product slightly more expensive.

So where are the High Margin Businesses?

There are lots of high-margin businesses out there. You need to look hard enough since most entrepreneurs making good margins don’t exactly shout it from the rooftops. And beware of gurus who brag about the money they make. They tend to talk about sales but never profits.

Some places where you could look for high-margin opportunities could be:

  • Offer customized solutions that the customer can’t find anywhere else. This will allow you to charge a premium on the price of your products.
  • Digital products tend to have very high-profit margins since apart from the initial production cost, the product can be replicated without additional cost. However digital products have high marketing costs in building awareness and convincing the customer to buy your product. Avoid the fancy niches like how to make money online; these are saturated with charlatans.
  • Offer services instead of just products. Services enjoy much higher profit margins, especially in sectors where the supply is scarce. For example, I don’t just sell my construction goods in my business, but I also have in-house staff that can do the installation. My margins from services are usually three times as high. The downside of offering a service is that you are exchanging your time for money, and services are harder to scale.

Finding the right high-margin opportunity can take time. I am personally on a never-ending quest to discover new high-margin opportunities. But you are much better off spending a year exploring options than jumping headfirst into a low-margin business and getting trapped in a vicious circle.

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