What’s the difference between a mark-up and a profit margin? How important is it to get it right? A mark-up is the amount that you determine to put on top of your cost price to be able to make a profit. A profit margin is what you are left with after you have made the sale, and paid for your cost of sales and expenses. Everyone who goes into business does so with an expectation of making a profit, but poor planning could see that profit margin end up being smaller than the effort is worth. While the following points are most applicable to products, you should use the same principles when determining the price of services.
Here are 6 things to consider when determining your mark-up and setting your prices, so that you can make sure that your effort and resources are suitably compensated.
1. Are your costings accurate? Make sure you have included everything that’s directly related to the production of your product and service, and separate the fixed costs from the variable costs. Fixed costs are overheads such as rent, that stay the same regardless of the amount of sales. (You will find that some “fixed costs” will go up and down over time, but the change won’t be related to the amount of sales.) Variable costs fluctuate with the amount of sales such as raw materials and other direct costs. If you have done your costings, and missed out or underestimated a cost, the result of that will come straight out of your profit. Variable costs directly related to the production of your product or service are called “Cost of Sales”. Sales – Cost of Sales = Gross Profit. The fixed costs are called “Expenses” or “Overheads” and are taken from the Gross Profit. Gross Profit – Expenses = Net Profit. Your mark-up is the percentage added onto your Cost of Sales, and all expenses are covered within that mark-up.
2. What is the industry standard mark up? The normal mark-up will vary between retail, wholesale, manufacturing, or service industries. A bit of research will reveal what is acceptable in your industry, but as a general rule of thumb, the higher the dollar value of the end product, the lower the mark up percentage. If you’re buying bottled water, and your end cost price is $0.60 each, a 500% mark up will give you a $3.00 sale price.
Let’s say your expenses are $500 a month. If you end up selling 500 bottles a month, you will have made a profit of $700, or a profit margin of 46%.
500 water bottles @$3.00 each = $1500
Cost of Sales $0.60 x 500 = $300
Gross Profit: $1500 – 300 = $1200
Expenses of $500 per month: $1200 – 500 = $700 Net Profit
Profit Margin: $700 divided by $1500 sales x 100 = 46%
If you were to sell 1000 bottles the next month, your profit margin would increase to 63% ($1900), but your 500% mark-up remains the same.
At the other end of the scale, a high dollar value item would not get away with a 500% mark up. Can you imagine trying that with a car that costs $20,000 to build? A price tag of $100,000 may not see you selling very many, and there are still overheads to pay for out of the gross profit from any sales. Real estate agents work on a commission of maybe around 3 – 5% of the sale price. It may sound low compared to the bottled water, but the sale of 1 house at $500,000 will see them receive $15,000 at 3%, or $25,000 at 5%.
3. How unique or creative is your product? A designer piece of clothing, furniture, or artwork can justifiably demand a much higher price than the common stock standard item. A department store dress would have a reasonable price tag of maybe $50. A designer dress could be sold for $500. It would probably cost more to produce the designer dress, but not that much more! Anything that is special, unique, and/or desirable will be able to demand a higher price, sometimes regardless of the cost price. However, if you are selling the same product as everyone else, there will be fewer things that you could offer as a point of difference. Your price tag may suffer as a result.
4. How much competition do you have? The more options a consumer has to choose from, the smaller the mark up you can put on your products. Everyone will be trying to get their share of the available market, and a lower price is the easiest way to get that. If you want to charge more than the rest, you will need to structure your business with a different competitive edge.
5. What volume of products do you intend to sell? If your product is high volume, such as petrol, bread or milk, you will find that a much smaller mark-up is necessary on each item, simply because you sell so many. Your success will depend on securing enough of the market to ensure that your small mark-up per item will still cover your overheads, and leave you with a profit that is worthwhile. A low-volume product should have a larger mark-up. Consider the financial outlay of keeping the item in stock, the space that it takes up on your shelves, and what that item will end up owing you once it does sell.
6. Do you offer complementary or associated products? Items such as printers, gaming consoles, and other electronics are generally sold with a very low mark-up (or even at a loss), but only because the business can make up the difference through the sales of associated items – like printer ink, games, DVD’s, which have a high mark-up.
While there are a lot of things to consider in determining what your mark-up should be, don’t forget the critical source of information in your target market. If you want to find the balance between a healthy mark-up, and being priced right for the market, you need to listen to the market.
If your price tag is a key issue, you may consider reducing your cost of sales or overheads (or both) to be able to drop the sale price while still maintaining a reasonable mark-up. If there isn’t any room to move there, you may want to look at what can be done to increase the volume of sales units, so that the smaller mark-up can still provide a reasonable profit margin at the end of the day.
Numbers never lie. Our job as business owners is to understand what the numbers are telling us, and to trust the numbers when we make decisions. In next month’s article, we will look at understanding those financial reports.
Until then, keep the numbers working for you.
Evertrue Business Solutions