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Profitability & Margins: a Shark Tank deconstruction

Three important margins, gross, operating, and net, are key profitability indicators for any venture business. How are they calculated and what do they mean? Let's dive in.

Profitability is a cornerstone metric for any venture/business. There are a few ways to measure it; each measure has a specific interpretation and limitation. While it may not be necessary to know all the profitability metrics, two important ones are:

gross margin,
operating margin, and
net margin

Let’s understand these terms and how to calculate them, using a Shark Tank pitch.

You can skip the first 3 minutes of the video unless you want context.

Salient financial information

Let’s take an inventory of the quantitative information that the founder’s provided:

two (2) product offerings: mechanical and key FOB-bluetooth
mechanical offering: price is $182/unit and COGS is $67/unit
key FOB-bluetooth offering: price is $359/unit and COGS is $175/unit
landed cost for the mechanical offering = $82/unit
2000 locks sold
$250,000 total sales revenue
profit margin on the mechanical offering = 55%

The rest of the information focuses on valuation, equity, and dilution - about which you can learn using the menu options above.

Our objectives

We want to quantify the three types of profit margins. They’ll tell us about how profitability erodes through the course of business. We could simply accept their statement that profit margin (not sure which type) is 55%, but a gross profit margin of 55% is far different than a net profit margin of 55%. Let’s use the data the founders provided during their pitch to work our way into a rudimentary and practical income statement.

The reverse-engineered income statement

Here’s what we know at a product level:

This information was given to us by the founders during their pitch.

Let’s try to figure out the units sold. To accomplish this task, we will break our efforts into parts.

Part 1: We know a total of 2000 locks were sold, but we don’t know the distribution. One way of estimating distribution is by looking at the price. The Key FOB product sells for 1.9x the mechanical version. Therefore, we can estimate that the demand for the mechanical version is 1.9x that of the key fob version.

Part 2: We know that total sales revenue is $250,000. That means ∑(units sold)*(price per unit) will equal the total sales revenue.

(units sold mechanical)*(price per unit mechanical) + (units sold key fob)*(price per unit key fob) = $250,000

Part 3: If we provide Excel with some constraints, we can determine a reasonable and quantitatively-justified number of units sold in each product line.

Units sold

Using Solver in Excel, we deduce the number of units sold.

Now let’s look at the landed cost of $82/unit. This is the total cost of goods sold (COGS) plus all the shipping costs. It’s just another way of absorbing all the related costs into the COGS. We know the landed cost for the mechanical product line - we can assume that it would be identical for the key FOB product line (after all, they look nearly identical on the video).

Net profit margin

We know the profit margin is 55%, and it is unlikely to be the net profit margin. Why? A net profit margin of 55% would mean that the business retains 55% of the sales revenue it generates, after paying for the inventory, building/machine rent, interest, accounting for depreciation of the building/machines, obsolescent or defective inventory expenses, labor expenses, and taxes. A net profit margin of 55% is impressive and would be inconsistent with a venture that needs to raise capital. Net margin ≦ 55%.

Note: there really is no reason to go through the above exercise to figure this out. It’s an exercise that will be useful when you don’t have as much information during a pitch. There’s no guarantee that the person making the pitch will give you this metric.

COGS and gross profit margin

Now that we have a justifiable number of units sold for each product line, and the founders told us the total COGS (cost per unit + shipping cost = landed cost), we know the COGS and can calculate the gross profit margin.

The gross profit margin for the mechanical product line is exactly what the founders suggested: 55%. This suggests that our assumptions about the units sold for each product are correct.

We have deduced the gross profit margin of the key FOB product line: 46%, and the business overall: 50%. Half of the revenue earned is gone (poof) before any of the other expenses are paid: interest, accounting for depreciation of the building/machines, obsolescent or defective inventory expenses, and taxes. That fact can be concerning to a potential investor.

Operating profit margin

In order to calculate the operating profit margin, we need to know the SG&A costs: selling, general, and administrative. These costs are generally the overhead costs needed to get the product to the customer: IT costs, customer service labor costs, things like that. The founders never give this information and we can’t back our way into it. So we’ll take an estimate from other companies that operate in the space (locks) as this venture.

The NYU Table of Profit Margins can help us here. Among other things, it gives us the general ratio of SG&A to sales revenue by industry. The venture in question is in the Retail (General) industry.

The NYU Table of Profit Margins indicates that the average SG&A/Sales ratio is 18.57%.

Two-thirds of the revenue is already gone - vanished by the COGS and SG&A: both of which are necessary operations for any business venture.

Net profit margin

After the operating profit, we need to deduct depreciation, interest, and tax expenses. We don’t know the first two and it will be difficult to back into these numbers. The founders didn’t give us enough information. Thus, we’ll assume the best case scenario: $0 for both.

Taxes are up next. For a C-corporation, the average tax rate is 21%. Let’s apply that to our reverse engineered income statement.

Three-quarters of the revenue is gone. The net profit margin is estimated to be 25%.

Summary

Gross profit margin (overall): 50%
Operating profit margin (overall): 32%
Net profit margin (overall): 25%

Are these numbers bad? That’s not a question for me to answer. If you’re an investor, you’d have to make that determination on your own (as I would for myself).

Income erosion

Here is the income erosion (per unit for each of the two product lines) that this venture is experiencing, using reasonable assumptions from well-sourced references.

Imperfect information

You'll note that of the five (5) constraints we placed on our reverse-engineered income statement, only four (4) were satisfied. The number of units sold does not add up to 2000.

The reason is imperfect information. You can find more information about imperfect information in the Labor|Decisions option in the menu above. For this example, we could not mathematically achieve all the constraints. Imperfect information is common in entrepreneurial settings and is the reason why you perform due diligence before making a final commitment. In this example, eliminating the first constraint allowed us to meet the remaining 4 constraints: a tradeoff that we had to make because of the imperfect information we received in the Shark Tank pitch.

I hope this helps. Leave a comment/question if you have any. I’d love to hear from you.

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