Starting a new business is an exciting prospect, but it involves making many strategic decisions. One of the choices entrepreneurs face is whether to start a product-based business or a service-based model.
Understanding the profit margins and implications of each is critical to laying the groundwork for a successful startup. Should you develop a tangible product with the potential for high prices or offer a service that can lead to more gradual but steady profit growth?
What are profit margins?
In the business sphere, profit margin is the percentage of revenue a company earns after covering all costs associated with producing and selling goods or services. This is an important metric that directly affects the viability and growth potential of a business. High profit margins indicate efficiency and a healthy bottom line, while thin margins require large sales volumes to turn a profit.
Several factors can significantly affect profit margins, including:
- Cost of goods sold (COGS): For product businesses, this includes direct materials, labor, and manufacturing overhead costs associated with sales.
- Pricing strategy: Whether you choose to lead with a cost-plus approach, competitive pricing, or value-based pricing can affect your margins.
- Operational efficiency: Streamlined processes and lean operations can reduce unnecessary costs and improve margins.
- Market demand: High demand can allow for higher prices and better margins.
- Economic conditions: Fluctuations in the economy can affect the cost of goods, labor and consumer purchasing power, all of which can affect margins.
- Competitive landscape: In a crowded market, price competition can squeeze margins, while differentiation can lead to the ability to command higher prices.
Profit margins in product-based businesses
Product businesses typically have higher initial investment requirements, but also the potential for significant profit margins. After product development costs are covered, each subsequent sale contributes more to the bottom line. However, ongoing costs for marketing, storage and inspection periods may be included in these margins.
Some examples of high-margin product businesses include high-end clothing, jewelry, and technology items that often carry significant premiums for their perceived value. Niche products like vegan protein powders or specialty supplements can command higher prices and better margins.
However, it is important to consider the challenges faced by product businesses, such as:
- Market saturation and differentiation: Standing out in a crowded market requires exceptional branding and unique selling propositions.
- Seasonal demand: Some products may experience high seasonality, which requires strong cash flow management.
- Inventory management: Too much or too little inventory can lead to increased costs or missed sales opportunities.
Profit margins in service-based businesses
Service businesses have lower operating and upfront costs, which means profit margins can be realized more quickly. However, maintaining high margins can be difficult due to the intangible nature of services and the labor-intensive aspect of their delivery.
Some examples of high profit margin service businesses include financial consulting services, digital marketing services for agencies that specialize in SEO, PPC, and content marketing due to their high fees and low material costs.
Challenges and considerations facing service businesses include:
- Customer acquisition costs: Intangible services often require significant investment in marketing and sales to acquire new customers.
- Scalability: Unlike products, services are labor-intensive, making it difficult to scale quickly without compromising quality or margins.
- Market volatility: Market demands can change quickly, affecting the need for certain services and thus affecting revenue and margins.
Factors to consider
Which model is best for you depends on various factors, such as your interests. Consider your experience and passion. Do you enjoy interacting with customers face-to-face, or is an e-commerce store more suitable for you? Want to work from home or own a jewelry business? Consider your long-term business goals and how each model aligns with them.
The bottom line is that the decision to start a product- or service-based business has implications for profitability, expansion, and sustainability. The high pricing and passive income potential of products may be desirable, while others may value the immediate returns and low start-up costs of service businesses. The key is to align your choice with your strengths, market demand and long-term vision.
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Melissa Houston, CPA, is the author of Cash Confident: An Entrepreneur’s Guide to Creating a Profitable Business. She is the creator of She Means Profit, a podcast and blog. As a Financial Strategist for small business owners, Melissa helps successful business owners increase their profit margins so they keep more money in their pockets and increase their net worth.
The opinions expressed in this article are not intended to be a substitute for any professional or expert accounting and/or tax advice.