June 19, 2025

The Perils of Profit Margins: How This Seemingly Simple Metric Backfires

The article was generated from the video transcript and edited by Dr. Hermann J. Stern.

We often hear about aligning executive pay with performance, and metrics like "return on sales" or "profit margin" sound like logical choices. After all, a higher margin seems to indicate a more profitable and efficient business, right? However, as Dr. Hermann J. Stern explored in a recent lecture at the University of St. Gallen, this seemingly straightforward metric can harbor surprisingly perverse incentives, potentially leading to actions that are actually detrimental to the long-term health and growth of a company.

To illustrate this point, let's consider a simplified corporation with just two products: the humble apple and the vibrant orange. Imagine that oranges boast a healthy profit margin of 20%, while apples generate a more modest 10%. Now, the question posed to the students was direct: as an executive whose compensation is tied to improving the overall profit margin of the company, what strategic moves could you make?

The initial responses were sensible: "Reduce the cost of producing apples" or "Increase the sales of oranges." Both actions would indeed contribute to a higher overall profit margin. However, one astute student identified a far more insidious, yet effective, strategy: stop selling apples altogether.

Think about the immediate impact. By discontinuing the sale of the lower-margin product (apples at 10%), the company's overall profit margin instantly jumps to the margin of the remaining product – oranges at 20%. Mission accomplished, at least as far as the profit margin metric is concerned.

But what are the broader implications? Absolut profit decreases because the profit from the apples has vanished. In a company with a diverse portfolio of products, each with varying profit margins, tying executive pay to overall profit margin creates a clear incentive: prioritize high-margin products and strategically eliminate or neglect lower-margin ones. This can lead to a dangerous erosion of product diversity and potentially alienate customer segments who value those lower-margin offerings.

Consider a retail giant like Walmart. Their success wasn't built solely on high-profit luxury goods. They thrived by offering many products, many with thin profit margins but high sales volumes. Each of those "small profit" items contributes to the overall profitability of the company. By focusing exclusively on high-margin items, a company risks losing significant revenue streams and market share.

The crucial lesson here is that it can be far easier to boost your pay, when tied to profit margins, simply by not doing something – like selling a lower-margin product – rather than by actively growing the business in a balanced and sustainable way. This creates a fundamental misalignment of incentives, where executives are rewarded for potentially shrinking the product portfolio and neglecting valuable segments of the business.

In essence, profit margins, while seemingly a direct measure of efficiency, can be a deeply flawed metric in executive compensation, particularly in complex organizations with diverse product lines. It can incentivize executives to chase short-term gains by shedding lower-margin but strategically important products, ultimately acting against the long-term interests and overall value of the company.

This short video vividly illustrates this critical flaw in using profit margins for executive pay. Witness the "aha!" moment as the students grasp the counterintuitive incentives this seemingly simple metric can create. Understanding this potential pitfall is crucial for designing effective compensation schemes that truly drive sustainable growth and value. Click play in the video above to see the explanation and perhaps reconsider the next time you encounter "return on sales" as a key performance indicator.