Demystifying Profit Margins and Markups
Many of the inventors I meet got started because they wanted an outlet for their creativity or sought more freedom in their careers. Rarely do I meet someone who has approached inventing from a number-crunching background. It seems that many inventors just aren't that comfortable with "the numbers." However, if you create a viable product, you've got to sell it. And pricing and profit margins are a critical part of that process.
Whether you sell directly to end-users or to a retailer or distributor who sells to customers, you need to know how to price your product to ensure everyone in the process will make their required profits. As you probably suspect, this involves a bit of art--and a lot of science.
Common sense dictates that the price you choose should be neither too high nor too low to attract the most customers and generate the greatest amount of profit. Your price also needs to cover the cost of doing business. This is where understanding the basics of "markups" and "gross margins" can help.
Before we get into these concepts, I'd like to define a few terms that people often confuse:
- Retail sales: This is sales of a product to an end user. Example: the price you'll pay for cookies at a grocery store
- Wholesale sales: This means the sales by a manufacturer or distributor to a retailer. Example: the price Nabisco charges grocery stores for its cookies
- Markup: This is the difference (reflected in both dollars and percentage) between what a retailer will pay for a product and its retail price (what the end user will pay). Example: XYZ Cookie Company sells a bag of cookies to the grocery store for $2, and the grocery store charges $5. The markup is $3 per bag.
- Gross margin: This is the percentage of profit derived from a transaction. (Both the manufacturer and the retailer will expect their own gross margin.)
How Markups Work
The best way to illustrate the concept of markups is with a simple example. Assume you, the manufacturer, make a product we'll call Gizmo for $1. You then sell it wholesale to a retail store for $3. Thus, your markup is $2 ($3 - $1 = $2), or 200 percent (2 / 1 = 2.00: Remember, percentages are determined by moving the decimal point two spaces to the right and adding the percentage sign, hence 2.00 = 200%). If the retail store, then sells Gizmo for $8, its markup is $5 ($8 - $3 = $5), or 166 percent (5 / 3 = 1.66).
Figuring Out Your Gross Margin
Now that you know your markup, you can figure out your gross margin. (These two terms are often mistakenly used as though they're synonyms. They are related, but they're not the same.) This number is calculated by dividing the markup by the price to acquire it.
Using the above example, we'll first figure out your gross margin as the manufacturer. Divide your markup ($2) by the price the retailer paid for it ($3). Thus, your gross margin as the manufacturer is 67 percent (2 / 3 = .67). So in this case, a 200 percent markup resulted in a gross margin of 67 percent.
You should also figure out your retailer's gross margin (I'll explain why this is important in the next section). Calculate it the same way, only using the retailer's markup ($5) and price ($8). So: 5 / 8 = .625, or 62.5 percent. Thus, the retailer's 166 percent markup resulted in a 62.5 percent gross margin.
Retailer Markup and Gross Margin
So why is it important to know your retailer's gross margin? Well, retailers often have minimum margin requirements, so this will help determine what price you'll set. Although minimum requirements will vary widely depending on the type of retailer, it's not uncommon for a retailer to expect a minimum gross margin of 50 percent. This is often referred to as a "keystone" markup.
An easy way to figure out this number is to double your wholesale price. For example, if you sell your product wholesale to the retailer for $5, the retailer will need to charge the consumer $10 to achieve a keystone markup. When you need to work backwards to figure out a price that gives your retailer the desired margin, it's helpful to use the 50 percent "keystone" expectation as a starting point.
Another good thing to know is that high-end specialty retailers will often require an even higher gross margin. So don't be shy about asking your retailers their margin requirements--it's how retailers think. Most of the more experienced buyers you'll deal with will offer either a specific number or at least a pretty narrow range.
Now that this is clear, or at least a bit less murky, I'll throw in a new wrinkle--distributors.
Distributor Gross Margin
Distributors are companies that typically buy products (and store inventory) from manufacturers and sell them to retailers. They're commonly used by larger retailers that handle a large volume of products, such as grocery stores.
Distributor margin requirements vary by product price point, industry, segment, country and size, but they're typically lower than retailers--20 to 40 percent is not uncommon. That's because, as the middleman, there are two markups required--the distributor's and the retailer's.
For example, the margins and markups for a product sold through a distributor might look something like this (assume a 50% gross margin for the retailer and a 30 percent gross margin for the distributor):
Gross Margin = GM
$10 retail price - sold by retailer to consumer (Retailer GM = 50%)
$5 wholesale price - sold by distributor to retailer (Distributor GM = 30%)
$3.50 distribution price - sold by you to distributor (Manufacturer GM = 43%)
$2 - your cost to produce product
How Much Is Enough?
There is no one "magic" gross margin to strive for--they vary dramatically by industry and product type. Even within a single industry, they fluctuate. A large, mass-oriented manufacturer may be satisfied with 20 to 30 percent, or less. At a massive sales volume, they can be profitable at this rate. However, many smaller businesses strive for a 50 to 70 percent gross margin. Here are some strategies to figure out where yours should fall.
On the high end, your gross margin should be as much as you can get. The factors influencing this are your own production costs, your retailer's margin expectations and the market price at which your product will sell (this last number is the most important). So if your production cost is extremely low and your product is in such demand that you can sell it for a 1,000 percent gross margin, go for it!
What about the low end? When is your gross margin too low to sustain the cost of doing business? The answer lies in your goals and expenses. Remember that all your company costs, including salaries, rent, marketing and other operating costs, must be covered by the gross margin earned on your sales. There's a term for this, too--"net profit margin," or the percentage of money left after paying for all these expenses plus production costs. So what's a decent net profit margin?
Let's use the following as an example: Assume you can make an 8 to 10 percent return in the stocks and bonds market, without much risk or effort. You may conclude that you need to outperform this return on any output of capital (investment in your business). In other words, if you can make 8 percent relatively easily in stocks, you'll definitely want to make a higher net margin on a business venture in which you're putting so much more time, effort and risk.
Back to gross margin. You'll know it's too low if you find you're unable to meet the costs you regularly incur to operate your business. In this case, you have two options: Find a way to lower your production and operating costs, or raise your price.
A final factor to keep in mind: Your gross margin may grow over time. In the early stages, manufacturing runs are often smaller (thus more expensive per unit). Plus, you need to create demand for your product, so you don't want to set your price too high. Therefore, you may need to forgo large profits in the beginning to get a sense of your market and create sales traction. Then, once your demand begins to grow, your production costs will decrease and your gross margin will grow.