What Is Margin Pressure?
Margin pressure is the risk of negative effects from internal or external forces on a company's profitability margins. Most commonly margin pressure analysis will focus on the three main income statement margin calculations: the gross, operating, or net margin. Overall margin pressure can also be analyzed within contribution margins as well.
Margin analysis is primarily used to understand how profitable unit sales are at different points on the income statement in comparison to total revenue. A unit of sales can be adjusted for a multitude of costs including direct costs, operating costs, and net costs. In general, anything that makes a company’s costs or revenues change will usually cause a change in the margin. Margin pressure is perceived as any cost or revenue change that could lower a margin calculation, ultimately resulting in lower profitability.
Understanding Margin Pressure
Margin is calculated to identify the profitability of a unit of sales when adjusting for different costs. Gross, operating, and net margin are the three main margin calculations most analysts focus on but other types of margin calculations can also exist. In all margin calculations, a unit of sales is adjusted for certain costs and divided by total revenue. As such, margin looks at profitability in comparison to revenue.
Margin pressure is the result of negative changes in margin ratios resulting in decreased unit profitability per revenue.
Margin pressure is a type of risk that companies seek to mitigate or avoid.
It can be related to macroeconomic events such as an economy-wide increase in costs or comprehensive changes in regulations. Margin pressure can also be isolated for specific companies resulting from supply chain changes, production issues, labor problems, and more.
For example, when the Japanese tsunami disrupted supply chains throughout Asia in 2011, many manufacturing companies saw their profits temporarily squeezed by the need to substitute higher priced goods in production.
Identifying the Effects of Margin Pressure
Businesses will experience margin pressure whenever the costs of production rise and/or when price competition changes. Both production costs and price competition will be influenced by supply and demand in each respective market. Substantial changes in an economic market cycle can often be a key driver of margin pressure overall. Macroeconomic changes like increased tariffs and e-commerce competition can have big effects on margins with production costs rising and sale prices falling respectively.
Three key areas where companies focus on margin pressure include the analysis of gross, operating, and net profit margins. These are the three most important margins used to intricately analyze the profitability and efficiency of a business as captured on the income statement. These three margins will have their own unique margin pressures while other margin pressure considerations can also exist as well.
Gross profit divided by revenue results in a gross margin that analyzes how much profit a unit of sales generates after accounting for direct costs. Since gross margin focuses on direct costs, any margin pressure on the gross margin would be caused by either an increase in direct costs or a decrease in price per unit.
Oftentimes, changes in commodity prices will be a key factor affecting gross margins. Many companies seek to hedge the effects of rising direct costs by buying goods in the futures market, which provides for cost management.
Operating profit divided by revenue results in an operating profit margin ratio that analyzes how much profit a unit of sales generates after accounting for both direct and indirect costs combined. Margin pressure on the operating margin will come from rising operating costs potentially in the areas of selling, general, and administrative expenses (SG&A), wages, depreciation, or amortization.
Net profit divided by revenue results in a net profit margin that analyzes how much profit a unit of sales generates after accounting for direct and indirect costs along with interest and taxes. As such, rising interest payouts or higher taxes will result in net margin pressure.
There can be several other effects for companies when seeking to manage margin pressure:
- Price decreases can be a substantial risk for margin pressure. If sales prices decrease while costs remain the same or increase then margins will decrease.
- A new competitor entering the industry can affect both direct and indirect costs as well as prices.
- If a company or industry faces increased regulation, it may cause costs to increase or prices to decrease.
- If a company experiences internal production problems or unexpected labor problems then it can pressure margins.
- Competitors who can easily copy, imitate, or steal intellectual property can cause decreases in market pricing.
Overall, companies will seek to manage margin pressure by closely monitoring evolving changes and trends in their marketplace. In general, any change in costs in the numerator of a margin calculation or price in the denominator of a margin calculation will result in a marginal change per unit. The marginal change per unit is primarily the key factor companies seek to analyze and mitigate when seeking to manage any effects of margin pressure.
- Margin pressure is the risk of negative effects from internal or external forces on a company's profitability margins.
- Margin pressure is perceived as any cost or revenue change that could lower a margin calculation, ultimately resulting in lower profitability.
- Gross, operating, and net margin are three of the most important profitability margins companies watch for margin pressure.