Understand Mark-up versus Profit Margin
Mix them up and you may rip yourself off!
* Pricing Right = Good Mark-up
* Profiting Well = Good Margin
You can’t calculate margin without first establishing your mark-up
Margin and mark-up are rooted in the same concept – both are ways of expressing what you get to take home at the end of the day; both can be expressed as either Dollar Values or Percentages.
* Mark-up – the amount added on top of production and purchase costs to create your selling price – the basis of this calculation are your expenses.
* Profit Margin – the proportion of the selling price that is profit – the basis of this calculation are your selling prices.
Profit Margin % x Cost Price ≠ Selling Price
Setting your price involves totalling-up all of your costs (both direct and indirect) and then adding an extra bit on top of your total to give you a profit, this is called your mark-up.
Knowing how much mark-up to add is a matter of researching conventions and industry standards, and then tailoring these numbers to your company’s specific circumstances. Your mark-up should probably differ from your competitors because your costs will be slightly different, and if your price doesn’t reflect all the cost differences your profit may be eroded.
The direct costs (in this case the ingredients) are usually quite easy to total-up and allocate out on a piece by piece basis. But accurately predicting, and then allocating the value of your overheads (indirect costs) across each one of your products can prove very difficult, and is extra difficult where you offer a service instead of products.
Consequently often Mark-up is often calculated by starting with Direct Costs only – then including a “guestimate” portion that is hopefully sufficient to cover the rest of the costs, plus adding an extra bit for profit, on a per unit basis – see the Cake example below.
Both Profit Margins and mark-ups can be positive and negative: when the profit margin is negative the selling price is insufficient to cover the costs of production. So let’s quickly look at a few other ways these calculations can go haywire:
A mark-down is the amount a product is reduced below cost to establish a selling price, this may be necessary to clear a backlog of slow-moving stock especially in the case where regaining a portion of costs is preferable to simply discarding the products at -100% mark-down (or zero sales value).
In the cake example above this may mean selling yesterday’s cakes at $5.00 which would be a mark-down of $5.50 ($10.50 net cost price – $5.50 markdown = $5.00 selling price).
Negative Profit Margins can be caused by an informed decision (usually involving a mark-down or discount to move older stock) or unintentionally which always rapidly leads to a business crisis. Negative Profit margins most commonly arise when the mark-up is calculated on only Cost of Goods Sold and not Total Costs. i.e. the Gross Margin is the driver rather than the Net Margin.
NOTE: your profit isn’t your salary: if you work in your own business you are entitled to both take home pay for the work you do and a profit, for the risk you take in running a business. Many SME and micro-business owners omit to add in their own time as part of their product cost before adding a profit margin. BOTH should form part of the equation in any owner operated enterprise.
Remember it is possible to set your mark-up so you lose money and have a negative margin
The process of setting a mark-up and establishing the profit margin is also ongoing – it is important to regularly re-evaluate whether these are sufficient to cover all the business expenses (they will be negative profit margins if your costs are not covered), PLUS give you a good return for the risk you are taking for owning the business.
The easiest way to explain this is with an example – using something pretty basic… Let’s decide to run a cake stall at the local market – selling 10 cakes each weekend. OK so it wont make us millionaires, but it will help out the local school…
DIRECT COSTS: Having started with some maths we calculate every cake costs $5.50 in ingredients, and packaging.
INDIRECT COSTS: Plus we need to add some tiny portion of our rent and electricity (by taking a guess of the cost), a small charge for our time baking selling and organising, and we want to print a few flyers that will cost $10 – we reckon all this costs about $50 in total each week so you work out this is $5.00 of overheads per cake…
TOTAL COSTS: That takes the total costs up to $10.50 per cake.
We then agree to sell our cakes at $15 each so:
We then decide to sell our cakes at $15 each so:
* MARK-UP: is $4.50 ($10.50 cost + $4.50 mark-up= $15.00 sales price)
which is a mark-up of 43% ($4.50 mark-up ÷ $10.50 cost price = 43% mark-up)
* PROFIT MARGIN: is $4.50 profit margin ($15.00 sales price – $10.50 cost = $4.50 profit margin)
which is a 30% profit margin ($4.50 mark-up ÷ $15.00 sales price = 30% profit margin)
So in this example if we stick to looking at the dollar values both the margin and the mark-up are $4.50 – the same and annoyingly confusing!
But the calculation of the Percentages differ because one is based on cost and one is based on profit. Using percentages is really important if you have several product lines and are making a change, or adding new products/services – don’t get caught out.
Profit Margin % x Cost Price ≠ Selling Price
In this example that exact calculation will only give a mark-up $3.15 instead of the $4.50
(i.e. $10.50 x 30% = $3.15, and $10.50 + $3.15 = $13.65 – not $15.00)
This is why it is so important to understand the difference between mark-up and margin; mix them up and you may rip yourself off!
I know this is a bit maths-ey.. Don’t let that put you off – you are actually doing this maths every time you set a price… B using these simply maths calculation you are putting some more specific rigor behind your guesses and it will mean your price setting becomes less “gut feel” and much more profitable.