One of the most important financial concepts you will need to learn in running your new business is the computation of gross profit. And the tool that you use to maintain gross profit is markup. The gross profit on a product sold is computed as:

Sales - Cost of Goods Sold = Gross Profit

To understand gross profit, it is important to know the distinction between variable and fixed costs. Variable costs are those that change based on the amount of product being made and are incurred as a direct result of producing the product. Variable costs include:

  • Materials used
  • Direct labor
  • Packaging
  • Freight
  • Plant supervisor salaries
  • Utilities for a plant or warehouse
  • Depreciation expense on production equipment and machinery

Fixed costs generally are more static in nature. They include:

  • Office expenses such as supplies, utilities and a telephone for the office
  • Salaries and wages of office staff, salespeople and officers and owners
  • Payroll taxes and employee benefits
  • Advertising, promotional and other sales expenses
  • Insurance
  • Auto expenses for salespeople
  • Professional fees
  • Rent

Variable expenses are recorded as cost of goods sold. Fixed expenses are counted as operating expenses (sometimes called selling and general and administrative expenses).

Gross Profit Margin
While the gross profit is a dollar amount, the gross profit margin is expressed as a percentage. It is equally important to track since it allows you to keep an eye on profitability trends. This is critical because many businesses have gotten into financial trouble with an increasing gross profit that coincided with a declining gross profit margin. The gross profit margin is computed as follows:

Gross Profit/Sales = Gross Profit Margin

There are two key ways for you to improve your gross profit margin. First, you can increase your prices. Second, you can decrease the costs to produce your goods. Of course, both are easier said than done. An increase in prices can cause sales to drop. If sales drop too far, you may not generate enough gross profit dollars to cover operating expenses. Price increases require a careful reading of inflation rates, competitive factors and basic supply and demand for the product you are producing.

The second method of increasing gross profit margin is to lower the variable costs to produce your product. This can be accomplished by decreasing material costs or making the product more efficiently. Volume discounts are a good way to reduce material costs. The more material you buy from a supplier, the more likely they are to offer you discounts. Another way to reduce material costs is to find a less costly supplier. However, you might sacrifice quality if the goods purchased are not made as well.

Whether you are starting a manufacturing, wholesaling, retailing or service business, you should always be on the lookout for ways to deliver your product or service more efficiently. However, you also must balance efficiency and quality issues to ensure that they do not get out of balance.

Computing Markup
ABC Clothing did a better job in Year 2 of managing its markup on the clothing products it manufactured. Many business owners often get confused when relating markup to gross profit margin. They are first cousins in that both computations deal with the same variables. The difference is that gross profit margin is figured as a percentage of the selling price, while markup is figured as a percentage of the seller's cost. Markup is computed as follows:

(Selling Price - Cost to Produce)/Cost to Produce = Markup Percentage

While computing markup for an entire year for a business is very simple, using this valuable markup tool daily to work up price quotes is a bit more complicated. However, it is even more vital. Computing markup on last year's numbers helps you understand where you have been and gives you a benchmark for success. But computing markup on individual jobs will affect your business going forward and can often make the difference in running a profitable operation.

In bidding individual jobs you must carefully estimate the variable costs associated with each job. And the calculation is different in that you typically seek a desired markup with a known cost to arrive at the price quote. Here is the computation to find a price quote using markup:

(Desired Markup x Total Variable Costs) + Total Variable Costs = Price Quote

What if you're a new business owner and don't have any experience to base an estimate on? Then you need to research material costs by getting quotes from suppliers as well as study the labor rates in the area. You should also research industry manufacturing prices. Armed with this information, you will have a well-educated "guess" to base your job quote on.

How you use markup to set prices will depend on the type of business you are starting. If you are launching a manufacturing, wholesale or retail operation, you will be able to compute markup using the above formulas to factor in all the variables in the cost of producing or generating the items you will be selling. Markup can also be used to bid one job or to set prices for an entire product line.

If you are starting a service business, however, markup is more difficult to calculate, particularly for new business owners. With most service businesses, the key variable cost associated with delivering the service to your customers will be you and your employees' time. In computing proper markup for a service business, you must pay close attention to the time spent to provide the service to customers, as well as to market prices of the services provided. In starting a service business, you will need to research the going rate paid to employees and the market prices for the services you will be providing.

For instance, if you are starting a temporary help agency, you will need to know what rate is typically paid to employees in this industry, as well as the market rate charged to your customers for temporary labor. This will enable you to compute the proper markup in setting your price to ensure that you will be profitable.

Excerpted from Start Your Own Business: The Only Start-Up Book You'll Ever Need, by Rieva Lesonsky and the Staff of Entrepreneur Magazine, © 1998 Entrepreneur Press