I was once talking to a student who was puzzled about Gross Margin – “Is it Gross because its big or is it that it is ugly?” he asked. (Was he joking???). If you are well versed in these terms no need to read further.
However, I have come across small businesses that are not monitoring these measures. They are not even sure what they are. These are about the most important measures that you need to watch all the time… every day. They are critical keys to whether your business will succeed or not.
Let’s start with some definitions.
Gross Profit = Sales – Cost of Sales. There … that was not too hard.
Then what is the margin? Margin refers to a percentage. What percentage profit do I make when I sell something?
Gross Margin = Gross Profit/Sales. For example, you want to make 35% profit from each sale.
Or alternatively: Gross Margin = (Sales – Cost of Sales)/Sales.
Then what is Mark-up? Mark-up is not the same as margin. Mark-up is the multiplier that you use to derive a selling price knowing the cost price of the item that you are about to sell.
If you are not aware of the difference, you might say, “Well, I want to make 35% profit on the sale of this product so I will multiply the cost by 135%. Yes?”
No! Say the cost is $100. Then your selling price would be 100 x 1.35 using your formula. That is $135. But the Gross Margin will not be 35%.
Gross Margin = (135-100)/135 (as per our formula above) = 25.9% Not what you wanted.
How do you work out the correct mark-up then?
Mark-up = 1/(1-Gross Margin) = (in this example) 1/(1-0.35) = 1.54.
Thus, the correct selling price should be Cost ($100) x Mark-up (1.54) = $154.
Now, Gross Margin – (154-100)/154 = 35% or the profit required from the sale.
There … easy when you know how!