Marginal Cost Of Production

Let’s start with profits. No, no. Different prophets. (Sorry, Ghandi, Moses and Buddha.) Gross. Operating. Net.

Those are the big three for now, anyway.

If you don't recall the income statement that gave you those margins, here it is, in all its glory: Our awesome Lemonade Stand. So, from a resources allocation perspective, margins drive…everything.

Ever read Animal Farm? If you look in the very fine print, you'll see that it really says, "High margins good; higher margins better." But margins are a contextual thing. They are evaluated on a relative basis.

Basically, the more of a commodity something is, generally speaking, the more rivalrous the industry they are in... and thus the lower the margins of the companies competing in that industry.

Think about the very mature and declining paper and pulp industry. Long history. Unions. Tons of competitors selling old dead trees. Less and less demand for them each year as everything moves online.

Polluters (mostly overseas) have a structural advantage over non-polluters. In the U.S., Weyerhauser is the paper and pulp gorilla, and in a great year, it has only 10%-ish margins. Weyerhauser sells a ton of pulp for some 3 grand...which cost it just 2 grand and change to manufacture.

Then, if you add in operating costs, like shipping, union pension funds, senior management, lawyers, rent, and more lawyers even at scale, that 3 grand of revenues from a ton of pulp sold... cost Weyerhauser something well over 2500 bucks.

Compare Weyerhauser with Google's search business. Google "owns the world" in that business, with over 80% of all searches. Essentially no competitors today. They make money by selling virtual real estate or clicks. And views.

A typical click on a highly bid keyword like "taxes help" or "Mesothelioma Ambulance Chasing Lawyers" is something like 50 cents or more. Google's marginal cost for that click? Uh…not a lot. The electricity to serve the page, but...that's about it. Call it a penny.

So Google's search business alone is like an 90+% ish gross margin business, pre-tax. They have almost no marginal cost of goods sold. They have no cost of shipping, and a small handful of engineers, call it a few hundred who actually matter to the process, created a mathematical algorithm that truly scales.

The marginal additional cost of one more click is almost nothing, and is a vast contrast to the marginal additional cost of another ton of paper pulp where yet more forests have to be planted, more lumberjacks need to be hired, more trees need to be killed and shipped and chemically altered, and on and on and on.

So relative to its competitors, Weyerhauser might be doing great with 10+% margins, but the paper and pulp business is a lousy business when compared with the search industry, whose n+1th, or additional units sold, cost Google almost nothing.

The basic idea is that you have to understand margin in the context of an industry and of an economic climate:

Good, bad, and ugly.