Margin and Markup – Does your team know the difference?
There is a lot of focus in business on net profit, ebit, roi, or other similar measures. However before all that a business needs margin. It is imperative that all in the team understand margin and what affects margin.
Margin is the sale price of the good or service less the costs incurred directly in making/purchasing the goods or services available for sale(also known as variable costs). Margin is also known as gross profit. This gross profit is what covers overheads, fixed costs and hopefully there is net profit.
Each type of business will have different norms for what variable costs and gross margin are. For example in a retail business it could be as follows:-
Sales 100
Variable Costs 70
Gross Profit 30
Overheads / Fixed Costs 25
Net Profit 5
In a retail business the majority of the variable costs are usually tied up in stock / inventory. Other sectors would have different standards.
From this we need to explore margin and markup which are often confused. Markup is the sum applied to the cost of goods sold to determine the sales price. Margin is the sales less cost of goods sold. In percentage terms margin can only be between 1 to 100% whereas markup range from 1 to over 5000% percent. At 50% margin the markup is 100% but after this as margin increase the markup increase exponentially.
One of the biggest item that impacts on margin is discounting. This seems to be the first tool to increase volume of sales. But before any discounting is entered we must consider the impact of the discount on the margin and calculate exactly much extra sales the business will need to recover the discount. Volume sales is not the only way to make profit. Smaller volume sold at a better margin can lead to more profit.
Another issue is adjusting prices to reflect the change in the cost of goods. When you import goods the currency changes can significantly affect the margin. So if the costs have increased and the margin is declined by 10% points, how much does the prices need to increase? No the answer is not 10%. If you put the prices up 10% then you would only increase margin by 9% points not 10. Now if you were turning over $30 million per annum then this could cost the business $300,000 in profit.
In setting the price of goods ensure that you know whether the software you are using is using markup or margin. If you put 30% into the program and it is set as markup when you wanted 30% margin then you have just lost 6.9% of your profit. If the desired margin was 80% and instead the goods were priced at 80% markup this would mean you have lost 22.8% profit.
Now none of this is necessarily sophisticated analysis but does your team understand these issues. What happens if the sales person in negotiating with a buyer applies 40% markup instead of 40% margin which the business wants. The buyer would have got a bargain. This message is applicable to a small business as it is a large business. GM in the States went under because it could not sell enough cars at high enough margin.
Photo courtesy of agentakit
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