Margin Matters
Profit Margins. For a business, profit margins are the difference between incredible success and incredible failure.
Maintaining big profit margins is no easy task — only a few companies can maintain large profit margins over long periods of time. In it’s heyday Microsoft (MSFT) sported net profit margins of nearly 40%. These days 20% is a more typical number for the software giant.
On the opposite end of the spectrum, sellers of commodities often experience very low profit margins. Kroger is a good example here. The big grocery store operator sees very small profit margins of 1%-2%.
Both Microsoft and Kroger have revenues that exceed $90billion annually, but the difference in the cash they generate is startling — Kroger recently brought home $1.5 billion in profits, and Microsoft’s exceeded $20 billion.
This reminds me of the old saying, “It’s not what you make, it’s what you keep.”
Reinvesting Matters
I know what you’re thinking, “So what! Higher profit margins just means Microsoft’s stock price is expensive. Kroger is actually growing faster!”
While it is true that Kroger is growing faster, there’s more to this wealth building game than revenue growth. After that cash gets earned, any number of interesting things can happen — Cash can be used to reinvest in the existing business, buy back shares, pay dividends, or even expand into new lines of business.
Over time those reinvesting activities will either add considerable value to the business, or subtract from it.
In Microsoft’s case, it took over a decade before the business value was realize in the form of a higher stock price. Partly, this was Microsoft’s own fault — they wasted A TON of cash on overpriced business purchases which eventually failed (anyone remember Aquantive or Nokia?).
Today, both companies are well run, and they both pay steady growing dividends. Over the long term, reinvesting made the biggest difference in the overall wealth result (100% higher!). More cash reinvested at high rates of return can really move the needle.
This is exactly what Buffett means when he says, “In the short-term the stock market is a voting machine, but in the long term it’s a weighing machine.”
The “weight” of reinvested earnings makes a real difference in company value. Given enough time, that difference should be reflected in the stock price.
What’s Your Profit Margin?
There’s several important lessons about life and investing we can learn from this real-life wealth building.
For example, you might have a co-worker that’s on the corporate ‘fast track’. As a result, every year this co-worker gets a bigger raise than you, and he (or she) can increase spending.
But these big raises come at a cost — That co-worker works 80 hours a week and doesn’t have a family.
When you drive home at night, do you envy that success? Is working those longer hours and kissing-ass for that bigger raise the best way to build wealth?
Not necessarily! If we think back to our Kroger and Microsoft example, there’s more than one path to building wealth.
Just like Microsoft, you don’t need incredible growth rates to build wealth… as long as you’re saving enough. If you keep a high saving rate for long enough, your net worth will grow quickly.
This is exactly what happened in my own career — I didn’t reach financial independence because of large raises every year! I reached financial independence because my profit margins were higher. I saved more, and reinvested all of my excess cash into good businesses.
That’s right, I rarely saw an annual salary raise over 3% during my 15 year working career… despite working 50 hour work weeks, and often working on the weekend.
Why?
A high-level of productivity was considered perfectly normal in my industry. It’s a very competitive world, and standing-out from the crowd isn’t easy.
Unsustainable Job Earnings
Don’t get me wrong, if you can grow your salary faster than inflation, that’s great! Keep doing it! But for the love of money, don’t spend it all!
On a typical human timeline, your job income simply can’t grow forever. Eventually something is going to happen that upsets the income applecart — Maybe you’ll get pushed out by a youngster on the fast track to “success”, a big layoff happens, or those long hours simply deteriorate your health.
There’s a million reasons why it can happen, but it’s most important to know the result — job income growth eventually stops. Live long enough and you’ll experience it.
If you’ve kept your spending low, when that income drop happens it won’t be a major hit to your lifestyle. You’ll be able to live off the earnings from all that invested cash.
Simply put, saved money can work longer and harder than you ever could at a job.
Start With The Big Stuff
So how does a person go from being a 2% saver to a 50% saver?
You start with the “big stuff”, cutting out waste from the biggest expenditures in your annual budget. For most Americans, these expenses will be Housing, Transportation, and Food. Those three expenses alone consumed 60% of the average American family’s spending.
How do you trim those expenses? You sell that 3 thousand square foot home and buy a smaller one closer to work. You get rid of that giant luxury SUV, and drive a smaller/older vehicle instead. You move closer to work so you can walk, ride a bike, or take the city bus. You cut food expenses by cooking your food at home.
Boom! Just by making those four changes you’ll have made huge progress toward growing your own profit margins. Maybe your savings rate will reach 50% on those changes alone… but why stop there? Keep going!
There’s no reason why you can’t go on to save 60% or even 70% of your income. This is where all the “small stuff” really comes into play — like clipping coupons, saving electricity, or giving up Netflix.
There’s a million little things one can do to save money, but get the “big stuff” right first, so there’s room for the small things to matter.
Final Thoughts
The best money advice I was ever given, was to run my life like a successful business. There are many possible paths that lead to success, but commonalities exist between them.
Good profit margins (aka savings rates) are one of those commonalities. The best businesses continually find a way to keep costs low so that profit margins remain high. It’s both investing advice and personal finance advice.
Year after year, the best businesses seek to widen that gap between income and expenses. It takes continual effort — This isn’t something you do once and then you’re done.
It reminds me of a quote attributed to Carlos Sicupira, “Costs are like fingernails, they always have to be cut.”
Have you trimmed your costs lately?
[Image Credit: Flickr]
Saving does matter as much as trying to increase our income. Mr. FAF and I are big savers. We always try to cut costs. Our spending remains almost the same after Mr. FAF started working full-time. Our biggest weakness is the grocery budget. We spent $1,100 in Sep but were able to keep it under $500 in Oct. 😀
Nice job on the grocery budget in October!
Keeping your spending the same while your salary rises is another great way to improve your ‘margins’.
I wonder if that earning chart will change in the future. It seems like older workers are having a harder time keeping good jobs now. The earning decline will probably happens earlier in the future.
Keeping the overhead low pays off at every stage of life, but it will make a huge difference when the earning drops.
Have a terrific Thanksgiving!
I’m with you on the idea that it might be happening earlier. Technology changes fast and traditional industries are getting disrupted faster than ever. Companies want young blood to inject new ideas and keep costs low (young employees typically work for less)… so it’s almost inevitable.
Just like Microsoft, you don’t need incredible growth rates to build wealth… as long as you’re saving enough.
Yep, that sums it up nicely. Most folks just can’t seem to get to that point. Like you said, saving on the big stuff is FAR more important. The constant chatter about cutting back on latte’s is helpful, but it’s less important than the house, car, and food. If you optimize those, you can have your lattes and you’re probably still winning!
The latte factor often gets blamed for overspending, but you rarely hear people say “You’ve got too much house” or “You have too much car”.
Housing is a huge expense. I just accepted a job and will be moving back home to the Chicago area after the New Year. Housing prices in Illinois school districts that are comparable to the Olympia School District in Washington are approximately 10% more expensive. Additionally, property taxes are almost twice as much as they are here. Ugh… Good thing I’m getting a pay raise but I’ll find out next year exactly how cost of living compares.
My in-laws are telling me to buy a big house with big yard. I neither want the insane mortgage payment nor the tax payment. Additionally, I don’t plan on wasting my time doing yard work. My wife and I are thinking two bedroom, two bathroom apartment with all amenities…
Right now, time is what I value the most.
Wow, I had no idea housing was so expensive in Chicago. I thought we had it bad here in Washington!
Yes, reducing the cost is very important. That’s what we can do. The income, in some way, is beyond our control. House is definitely at the top list of expenses. Once the house is bought, it’s hard to control its cost sometimes, like property tax, repair, etc. Very good post. Have a great Thanksgiving!
Thanks Helen! You’re absolutely right! While it is possible to move the income needle at your job, it requires a HUGE amount of effort — you’ll need to outperform every other employee in the office and that isn’t easy.
Time is more important than money. I know as an engineer my husband’s salary growth has a limit. If you don’t stay current in tech, it’s a pretty big hit salary wise. My husband said people who are much older than him, at his level, get paid a lot less than he does. They’re the “stuck ones.” We’re saving a lot because I don’t ever everrrr want to be a “stuck one.”
This is a perfect example of what happens once you get older in nearly any industry. I wouldn’t use the word “stuck”, but at some point income momentum definitely slows… especially once you have a family and can’t work those long hours and weekends like the young kids.
“Maybe you’ll get pushed out by a youngster on the fast track to “success”, a big layoff happens, or those long hours simply deteriorate your health.”
Check, check and check. My old job had all those downsides. These days it’s laughable to think you could have a stable, easy job until you’re 65 and continuously get raises every year. HA! Gotta take care of ourselves because we can no longer rely on pensions and governments.
Absolutely FIRECracker! I doubt there’s ever been a time period when there has been less job stability. Technology disruption and rapid change has many traditional industries less stable than ever.
While many might argue “just find a new job” if you lose a job, it isn’t that easy. Especially once you’ve reached a high salary level.
Gotta look out for #1.
I like that quote- costs are like fingernails haha!
I think reducing housing cost is very important, that’s why we are living in my 450 square foot apartment for the time being with baby 🙂 So far it’s working ok and we are in a 600 square feet right now in Hawaii and it feels like SO MUCH MORE space. Hopefully this won’t tempt us to ‘lifestyle inflate’ when we get back to Vancouver lol.
I agree with Millennial Revolution- we have to rely on ourselves and not pensions and governments.
I am on mat leave so I took the plunge recently to reduce my cell phone costs from $64 a month to $54 a month. Lol, every little bit counts! (I think US data/cell service is much cheaper than Canada).
GYM recently posted…The Best Combination: Self-Employed and the Employed
I think you’re right — I think Canada does have higher cell costs (mainly due to less competition and lower population). That said, I know many people pay more than $54/month here in the states.
It’s all a matter of perspective of course. I’m happy with a $10 per year cell phone plan, but many people might call me ‘cheap’ or crazy because we won’t pay for a data plan.
Absolutely agree Mr. Tako. Our modest success has very little to do with my investment prowess and everything to do with our commitment to controlling expenses/saving while at the same time increasing income.
10 years ago our savings rate was an abysmal 8% and our networth was negative. 10 years later it is 75% and our networth is fast approaching the point of financial independence. A big part of our story is that my salary has increased at about 10% annually over this same time period, but the most important factor is that we did not succumb to the temptation of inflating our lifestyle at the same rate.
Thanks for all the great content. Keep up the good work!
Thanks Mr. Zero! Congrats on that fabulous savings rate. It really does make a difference!
Also in an industry where the 50+ hour weeks are expected. Too often I hear bloggers who act like it is easy to stand out and increase salary. It always makes me feel bad about myself.
Early in my career I choose good benefits and what was a stable company over high salary. I don’t regret that decision but once the company changed and was less stable I went for higher salary. We saved the increase instead of increasing expenses, it really helped saving rate.
I completely understand Bunnyfreak — when you’re already working 50+ hours a week it’s hard to increase your hours or stand out from the crowd. Everybody works really hard already.
While some bloggers say “get a side hustle” to increase income, they probably haven’t worked a job that requires that level of productivity.
Back when I was working, the only thing I had time for after work was sleeping.
I keep on wondering how to cut our expenses and then I keep on wondering if that would even be worthwhile.
I keep trying to understand the geography of a city in the US, because where I live the closer you are to the city center (where the jobs are) the more expensive the homes are. My home would cost about 3-4 times as much if it were within walking distance to my work (mostly because the cost of the land is 10 to 20 times as much). It would not be downsizing to live close to my job, it would actually add about 10 years to our working life – we know, we actually done the math.
We could downsize from a house to an apartment, but that would mean no yard and no dogs (because our large breed is not addapted to living in a flat), which would hurt us a lot more than the money saved. It would also mean living with worse air quality and little to no green spaces, but no commute. It would be miserable living for us.
I currently have a car and a commute, but it comes with the perks of walking my dogs near the forest in the mornings. Some things are well worth the money.