Muddling mark up and margin leads to business failure, as does reliance on percentages without any appreciation of the raw numbers. I show you an example with real consequences later. And a few tips on how to price for profit. You can have more in our free e-book Secrets of Pricing for Profit. Simply email nick@hixsons.co.uk for a copy.
Let’s get some quick definitions out of the way.
Cost of sales means things that you buy to sell. That could be simply something you buy and then resell, or it could be components that you put together to sell such as parts in a computer, or it could be your teams’ time that you sell.
Direct costs are expenses you incur in achieving the sale. The obvious one is carriage. All other costs are overheads.
Your margin is the difference between the cost of sales and the sales for a particular item.
The gross profit percentage is margin divided by sales.
Markup vs margin
Often people talk about markup. That means cost plus a profit figure to arrive at sales price. The difficulty arises when they muddle both terms.
Here’s a simple example. Let’s say sales price is £7.50, and cost of sales is £5
The markup from £5 to £7.50 is £2.50. But it’s only 33.3% gross profit. That’s £2.50 / £7.50.
Example
It’s quite common to see people work only in percentages and end up making a loss this way. We used to have a client who sold computers and made this exact mistake. He thought, using those figures, that he was making 50% margin and constructed his business to fit with that assumption (see below), with reality in the second column:
| Assumption | Reality | |||||
| Sales | 100% | 100% | ||||
| Cost of sales | 50% | 66% | ||||
| Gross profit (margin) % | 50% | 33% | ||||
| Premises costs | 10% | 10% | ||||
| Team costs | 20% | 20% | ||||
| Other costs | 10% | 10% | ||||
| Profit/loss | 10% | – 7% |
He never believed the accounts we produced, even when we reconciled them to his books and showed him what his mistake was. He persisted with his assumption, and sadly the company and he went bankrupt. We’ve mentioned this problem before in How to game yourself with numbers, which is the sobering story of how Asus took over large parts of Dell’s business. There is a simple lesson here. Understand what percentages mean, but don’t treat them as the only number you want. Get back to the real numbers as well. And of course, if you need to price for profit, make sure you don’t muddle markup with margin.
Pricing and contribution
You can’t always get what you want. You may want a 50% gross profit (there’s a table of common markup and related margins at the bottom) but you can’t always get it. How can you work out whether it’s worthwhile taking something at a lower margin? Here’s how to work out a decent price that still makes you money. First, two more quick definitions.
Fixed and variable costs – know the difference
Fixed costs do not change with activity levels. The obvious fixed cost is rent. Until you get so busy you must go to bigger premises the rent is fixed. It is something you must pay every month or quarter and you must have enough sales at enough margin to pay it. Most other premises costs are pretty much fixed, such as the business rates, and light and heat. Often salaries are effectively fixed, month to month.
All other costs vary with activity. So, for example sales team commissions, or motor expenses might vary with the level of sales.
Knowing the difference between fixed and variable costs is crucial to price setting
Recognising which are the variable costs and how they move with the activity levels will tell you how much extra variable cost you’re going to incur in selling one more thing. That eats into your margin but gives you a clearer idea how you can price something and still make a profit. So, whilst you may not get your full margin, you’re still making something which will soak up some of your fixed costs and contribute to profit.
Here’s a simple example.
| Sales | 1000 @10 | 10000 | ||
| Cost of sales | 1000 @5 | 5000 | ||
| Margin (gross profit) | 1000 @5 | 5000 | ||
| Fixed costs | 2000 | |||
| Variable costs | 1 per unit | 2000 | ||
| Profit | 1000 |
Every unit sold costs £10, has costs of sales of £5 and a variable cost of £1. Which means that every unit has a contribution of £4 towards fixed overheads and profit. From that, it’s easy to decide how much you can discount a unit and still make a worthwhile profit. You will have other decisions, such as whether the customer will want that discount every time or can you make it a one-off, can you squeeze more volume sales to justify the price cut, etc. More about that in Secrets of Pricing for Profit.
Common markup and related margins
| Mark up | Margin (Gross profit %) | ||
| 100% | 50% | ||
| 60% | 37.5% | ||
| 50% | 33.3% | ||
| 40% | 28.5% | ||
| 30% | 23% | ||
| 25% | 20% |
Anything smaller than this – ask why are you selling it?
You don’t have to be brilliant to make money, just avoid common mistakes. A straightforward way to do this to use your bookkeeping as an early warning system. Does it look right? Should I ask for a second opinion? And if you want to make a change in your pricing, and you’re not sure what the implications are, ask us. We would much prefer to have a pre mortem before the decision, than a post mortem afterwards. Here’s a Halloween story to show you how.
Helping hand
At Hixsons we make sure our clients are agile, flexible and resilient so that they are better able to respond to shocks. You can also read the helping in a crisis stories of how we helped 6 local businesses turn things around in the early days of the pandemic.
In the spirit of helping our business community we have helpful resources in our Learning centre where you will find various tools and templates for your business. We do not ask for your data, and it’s completely free.