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by Glenn Valliere
Margin and mark-up calculations to determine selling prices are an important point of knowledge for those who are unfamiliar with this business terminology; margins and mark-ups are very different. There is a tendency amongst the uninitiated to use the terms interchangeably, but this is not a good idea. Sales people trying to get distributors to carry their goods are often among the uninitiated. Although their mistakes tend to be innocent, there is a substantial difference in the outcome. Therefore, confusing the two may create dire consequences for your bottom line.
Most organizations use margin calculations to determine selling prices, and this practice is encouraged by those in the know. Very few organizations use mark-ups. If you have inherited a mark-up legacy you need to be aware of the impacts on selling prices that this approach brings.
Some definitions for margin and mark-up to consider are:
The percentage margin is the percentage of the final selling price that is profit.
A markup is what percentage of the cost price you add on to get the selling price.
Other definitions are out there – but the vital information is in the calculations. For example, to lay out a simple calculation based on a $1.00 cost and a 25% market-up and margin value is as following:
Take your purchase price and multiply by the value of one plus the mark-up percentage.
If you buy something for $1.00 dollar and you add a 25% mark-up, it will go on the shelf for $1.25.
Take your purchase price and divide by the value of one less the margin percentage.
If you buy something at $1.00 it will go on the shelf for $1.33.
*I’m sure you may notice that there is eight cents difference between the two, even at a one-dollar cost and a relatively low margin percentage. It’s a big spread.
Making Cost Decisions with Suggested Prices
Especially in the retail sector, you will be presented a Suggested Retail Price (SRP) for new products. Wholesalers may be given a Suggested Wholesale Price (SWP) by producers. Such prices aim to place a product on the shelf at a desirable price (often ending in .99). You will want to compare the SRP request with your margin expectations and need to rearrange the margin calculation formula to get these results. For example,
SRP from supplier = $5.99
Price from supplier = $4.00
Take the supplier price and divide by the SRP, and then subtract from one.
=0.33 – or 33%
If I was expecting a retail margin of 35% then I am coming up a couple of points short. A full 35% margin would price the item at $6.15 and the supplier is expecting to achieve a more desirable price point. Or you may gamble that a lower price point will give you more overall income on higher gross sales.
To Make Things More Complicated, we are talking about gross margins and have not tied these to your operating expenses and sales expectations. We will have our net margins after expenses and other costs are paid from sales income. Most of us will only ever clear between 1 and 5 points of net margin depending on our business maturity and type. Losing a couple of points, here and there, on the gross margin really takes away from your ability to generate surplus and to invest in the future.
We are using a very basic understanding of cost that assumes there are no other considerations except for suppliers’ prices. We have to add-in additional expenses for things such as freight before applying the margin calculations.
The technical distinction revolves around the terms associated with goods Free on Board (FOB). This term derives from old maritime trade and indicated the point at which the goods changed hands from the supplier to the next person in the supply chain. Historically this happened when goods crossed over the rail of the merchant ship (hence the “On Board” reference).
Most of us deal with a simple understanding of FOB arrangements to determine:
- The costs of the goods
- The location where the costs are applicable (e.g. a warehouse in Vancouver or delivered to my door)
- The party looking after the freight costs (and any claims should there be damage or loss en route)
Having these terms clarified protects everyone from surprises and avoids arguments after the fact.
Working with Supply Chains
When working with supply chain partners, we may need to determine more than one layer of margins. The calculations are the same, but are simply stacked one on top of the other.
For example, using a supply involving a food manufacturer with goods priced at $1.00, a distributor with a 27% margin - and a retailer with a 35% margin.
= $1.40 distributor price to retailer
$1.40 distributor price/(1-retail margin)
=$2.15 retail shelf price
While it’s good to know how to determine prices with a calculator, however, these types of calculations are well suited with Excel.
There are some on-line tools available for determining margins but, from experience, you will learn so much more from building something yourself to suit your needs.