Gross Profit Margin And Markup

Figuring out when you're making a profit is key to business success

One of the most important financial concepts you will need tolearn in running your new business is the computation of grossprofit. And the tool that you use to maintain gross profit ismarkup. 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 thedistinction between variable and fixed costs. Variable costs arethose that change based on the amount of product being made and areincurred as a direct result of producing the product. Variablecosts 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. Theyinclude:

  • Office expenses such as supplies, utilities and a telephone forthe office
  • Salaries and wages of office staff, salespeople and officersand 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. Fixedexpenses are counted as operating expenses (sometimes calledselling and general and administrative expenses).

Gross Profit Margin
While the gross profit is a dollar amount, the gross profit marginis expressed as a percentage. It is equally important to tracksince it allows you to keep an eye on profitability trends. This iscritical because many businesses have gotten into financial troublewith an increasing gross profit that coincided with a declininggross profit margin. The gross profit margin is computed asfollows:

Gross Profit/Sales = Gross Profit Margin

There are two key ways for you to improve your gross profitmargin. First, you can increase your prices. Second, you candecrease the costs to produce your goods. Of course, both areeasier said than done. An increase in prices can cause sales todrop. If sales drop too far, you may not generate enough grossprofit dollars to cover operating expenses. Price increases requirea careful reading of inflation rates, competitive factors and basicsupply and demand for the product you are producing.

The second method of increasing gross profit margin is to lowerthe variable costs to produce your product. This can beaccomplished by decreasing material costs or making the productmore efficiently. Volume discounts are a good way to reducematerial costs. The more material you buy from a supplier, the morelikely they are to offer you discounts. Another way to reducematerial costs is to find a less costly supplier. However, youmight sacrifice quality if the goods purchased are not made aswell.

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

Computing Markup
ABC Clothing did a better job in Year 2 of managing its markup onthe clothing products it manufactured. Many business owners oftenget confused when relating markup to gross profit margin. They arefirst cousins in that both computations deal with the samevariables. The difference is that gross profit margin is figured asa percentage of the selling price, while markup is figured as apercentage of the seller's cost. Markup is computed asfollows:

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

While computing markup for an entire year for a business is verysimple, using this valuable markup tool daily to work up pricequotes is a bit more complicated. However, it is even more vital.Computing markup on last year's numbers helps you understandwhere you have been and gives you a benchmark for success. Butcomputing markup on individual jobs will affect your business goingforward and can often make the difference in running a profitableoperation.

In bidding individual jobs you must carefully estimate thevariable costs associated with each job. And the calculation isdifferent in that you typically seek a desired markup with a knowncost to arrive at the price quote. Here is the computation to finda price quote using markup:

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

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

How you use markup to set prices will depend on the type ofbusiness you are starting. If you are launching a manufacturing,wholesale or retail operation, you will be able to compute markupusing the above formulas to factor in all the variables in the costof producing or generating the items you will be selling. Markupcan also be used to bid one job or to set prices for an entireproduct line.

If you are starting a service business, however, markup is moredifficult to calculate, particularly for new business owners. Withmost service businesses, the key variable cost associated withdelivering the service to your customers will be you and youremployees' time. In computing proper markup for a servicebusiness, you must pay close attention to the time spent to providethe service to customers, as well as to market prices of theservices provided. In starting a service business, you will need toresearch the going rate paid to employees and the market prices forthe services you will be providing.

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

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

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