SmartCapitalist.com

Selling Too Much?

Tuesday, March 07, 2006
Many businesses, especially public corporations, believe that more sales are better. Then, so long as they are above break-even point, they are happy. This school of thought is very incorrect. Investors such as Warren Buffett understand the flaws of this system and seek out companies that do not use this methodology.

To truly maximize profits, your goal should be to produce at the point where marginal price equals marginal revenue. If you go past this point you are cutting into profit margins and working too hard. The marginal price is the cost to produce one additional good. When you calculate the marginal price you ignore all the fixed expenses that are already spent to produce the given capacity, and focus on simply what would be spent to create another good.

When you maximize profits, if you want to produce more, you should consider either a way to increase the sale price or a way to reduce costs. Reducing costs is often the more effective way to increase your profit-maximizing quantity. Adding capital to reduce variable costs, or creating a more efficient production organization can do this.

Beyond trying to produce the number of goods where marginal product equals marginal revenue, Warren Buffett also looks for companies that understand capital expenditures. Many companies try to grow so much that they get committed to a business model where they have to increase capital expenditures drastically if they want to bring in more net profit. Not subtracting capital expenditures from net profit can be a dangerous way of thinking that will get you locked into this type of business model.

Certain industries are more capital intensive than others, so it is sometimes hard to judge how you are doing. The thing you need to concentrate on is how to keep profit up while minimizing capital expenditures.

While these models are great for manufacturing businesses, restaurants, etc. it can still be applied to online businesses. Producing a production model for your business should greatly benefit any company, even online publishing firms.