A Disadvantage of a Low Profit Margin

Profit margin, or net profit margin, is a ratio analysis tool that helps you improve your company's ability to generate a profit, but you won't benefit from using this tool unless you know how to interpret it. Having a low profit margin is similar to entering a danger zone. Knowing the disadvantages that this type of margin can brings makes you aware of the financial pitfalls you must avoid when steering your business.

Profit margin refers to the percentage of sales converted into net profit. Dividing net profit by sales for a given accounting period and multiplying the product by 100 will yield the profit margin expressed in percentage. For example, a company that earned a net profit of $10,000 from total sales of $100,000 will yield a net profit margin of 10 percent: 10,000 divided by 100,000 multiplied by 100. Low profit margin is one that falls below the average profit margin of businesses within a specific industry.

A low profit margin can leave you very little room to lower your selling prices. Lowering the selling price is sometimes necessary to have an edge over competition or to implement pricing strategies. A low margin means there is little funds available for profits and expenses. Lowering your selling price without a corresponding and proportional reduction in cost of goods sold will further reduce the funds available for expenses and profits. A business manager should avoid reducing selling prices when the profit margin is low to avoid cash flow problems and low profitability.

Low profitability prevents business managers from increasing expenditures. Expenses that are intended to provide future benefits, such as marketing expenditures allocated to boost sales, are necessary to maximize profitability. With all things being equal, an increase in expenses decreases profitability. In the case of a low profit margin, increasing expenses will further push the margin down to a lower level.

The biggest disadvantage of a low profit margin is poor operational efficiency. Profit margins that are lower than industry average margins are indicative of the need to improve performance. It shows that most businesses within the industry are managing their operations better than you are. The lack of improvement results to a profit level lower than what is attainable.