Understanding Gross Profit, Margin & Markup Pricing For Profit:

Presented by Larry Hunt

Volunteer, Pinellas County SCORE

Introduction

This webinar targets:

Pricing Fundamentals

with a financial overview of:

Gross Profit, Margin and Markup

and how they affect your pricing and ultimately, your profitability.

Do You Even Have a Pricing Strategy?

Information from Inc. Magazine article of Feb. 28, 2013

- According to MIT Sloan Management Review: Pricing receives scant

attention in most companies.

- Fewer than 5 percent of Fortune 500 companies have a full-time function

dedicated to pricing, according to data from the professional pricing

society.

- McKinsey Company estimates that fewer than 15 percent of companies

do systematic pricing research.

- Above is puzzling since the authors say that small variations in price can

raise or lower profitability by 20 to 50 percent.

Initial Thoughts on Pricing

A. The Product Life Cycle: 4 Phases

1. Introductory

2. Growth

3. Maturity

4. Decline

B. Trade Associations

The Product Life Cycle: 4 Phases

1. Introductory Phase – very little pressure on price and more

concern by the customer that they can get the product.

Introductory

The Product Life Cycle: 4 Phases

2. Growth Phase – Still little pressure on price, but product is

more available and competition gets stronger.

Introductory

The Product Life Cycle: 4 Phases

3. Maturity Phase – Competition gets heavy. This phase can last

for years or decades. Pricing is typically under pressure.

Introductory

The Product Life Cycle: 4 Phases

4. Decline Phase – Price pressure is great. Generally happens

when a new product replaces the existing one.

Introductory

The Product Life Cycle: 4 Phases

Where is your product in the life cycle?

Introductory

Very little price

pressure;

more concern

by customer

that they can

get the product.

Little price

pressure;

product is

more available;

stronger

competition.

Heavy

competition;

pricing under

pressure;

lasts for years

Heavy price

pressure;

new product

replaces the

existing product

Growth Maturity Decline

Factors that Impact Pricing Strategy

Supply and Demand Theory - Prices will tend to rise when demand increases or

supplies decrease. Prices will tend to fall when the opposite happens. Is your product

subject to frequent swings in supplies availability?

Price Elasticity of Demand – How much will demand change when prices are

increased or decreased? A low elasticity of demand will more easily allow for a price

increase.

Attitudes Toward Price

1. By the price setter – Most price setters believe that prices should move

parallel with costs. The price should have some constant markup to the cost to

produce the product.

2. By the customer – They want to get good “value” for their money. They also

generally believe “you get what you pay for”.

Topics of Discussion

• Market Awareness

• Common Pricing Strategies

• Variable Costs

• Fixed Costs

• Gross Profit

• Gross Profit Margin

• Markup Vs. Margin Percentages

Market Awareness

• Do you know who your potential customers are?

– Retail or Commercial?

– Young or Old?

– High Income or Low Income?

– Value Buyers or Price Buyers?

– Etc.

• Do you know who your competitors are?

– Other Similar Operations?

– Online Competition?

– New Technology?

Market Awareness

• Do you know what your competitors charge?

– It’s important to have a ballpark idea of competitive prices.

• Do you wonder how your competitor can make a profit

at their prices?

– They may produce higher volume

– They may have more automated equipment

– They may have more productive workers

– They may be losing money on every order

• How do you represent your company/service?

– Based upon value…

– Based upon price…

Common Pricing Strategies

Price to Market - Setting a price based upon analysis and research compiled from

the target market.

The danger is that you do not cover your costs and make a

reasonable profit.

Cost Pricing - This is the simplest pricing method. The selling price is based on

a markup of the cost to produce the product.

The danger is that the selling price is too high to provide

enough sales to make a reasonable profit.

Cost To Produce A Product

Variable Costs:

• Materials used

• Direct labor costs, including fringe benefits

• Packaging

• Freight/Transportation

Variable costs are those that are incurred based on the amount of

product being produced.

They are recorded as “Cost of Goods Sold”.

Other Costs

Fixed Costs:

• Office expenses such as supplies, utilities and phones

• Salaries, wages and fringes of office staff, salespeople and officers

and owners

• Auto expenses for salespeople

• Advertising, promotional and other sales expenses

• Insurance

• Depreciation

• Professional fees

• Rent

Fixed expenses are commonly referred to as “Overhead”.

Gross Profit

Achieving a good gross profit is a critical first step in becoming a

profitable company.

The tool that you use to achieve gross profit is markup.

The gross profit on a product is computed as:

Gross Profit =

Sales - Cost of Goods Sold

Gross Profit Calculation Example

Sales/Revenues $ 500,000.00

Cost of Goods Sold (Variable Costs)

Materials $ 75,500.00

Labor $ 110,000.00

Other Variable Costs $ 100,000.00

Total Cost of Goods Sold $ 285,500.00

Implied Markup in this Example 75.0%

Gross Profit (Sales – Cost of Goods Sold) $ 214,500.00

Gross Profit Margin (Percentage) 42.9%

Importance of Gross Profit Margin

Gross Profit Margin =

Gross Profit ÷ Sales

Gross profit margin is 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 amount of gross profit dollars that coincided with a declining gross profit margin.

The gross profit margin is computed as follows:

How to Improve Gross Profit Margin

There are two key ways to improve your gross profit margin:

1. Increase selling prices.

Can be a good way to increase gross profit margin

Danger: While this will increase sales dollars per unit, it may cause

units of sales to decline and actually lower overall gross profit

dollars.

2. Decrease the costs to produce the product or service.

This can be accomplished by decreasing the material costs or by

operating more efficiently.

Markup vs. Margin Percentages

Many business owners get confused when relating markup to gross profit margin.

While they have some similarities, they are actually quite different.

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:

Markup Percentage =

(Selling Price - Cost to Produce) ÷ Cost to Produce

Selling Price = $175 Cost to Produce = $100

$175 Price - $100 Cost = Gross Profit of $75

$75 Gross Profit ÷ $100 Cost = Markup Percentage of 75%

$75 Gross Profit ÷ $175 Sales = Gross Profit Margin of 42.9%

Example:

Markup vs. Margin Chart

15% Markup = 13.0% Gross Profit (margin)

20% Markup = 16.7% Gross Profit

25% Markup = 20.0% Gross Profit

30% Markup = 23.0% Gross Profit

33.3% Markup = 25.0% Gross Profit

40% Markup = 28.6% Gross Profit

43% Markup = 30.0% Gross Profit

50% Markup = 33.3% Gross Profit

75% Markup = 42.9% Gross Profit

100% Markup = 50.0% Gross Profit

Profit and Loss Calculation Example

Sales/Revenues $ 500,000.00

Cost of Goods Sold (Variable Costs) $ 285,500.00

Gross Profit (Sales – Costs of Goods Sold) $ 214,500.00

Gross Profit Margin (Percentage) 42.9%

Fixed Costs $164,500.00

Fixed Costs (Percentage) 32.9%

Net Profit (Gross Profit – Fixed Costs) $ 50,000.00

Net Profit Margin (Percentage) 10.0%

Positive Effects of a 4% Price Increase

Current

4% Price

Increase

Sales/Revenues $500,000 $520,000

Cost of Goods Sold (Variable Costs) $285,500 $285,500

Gross Profit (Sales – Cost of Goods Sold) $214,500 $234,500

Gross Profit Margin (Percentage) 42.9% 45.1%

Fixed Costs $164,500 $164,500

Fixed Costs (Percentage) 32.9% 31.6%

Net Profit (Gross Profit – Fixed Costs) $50,000 $70,000

Net Profit Margin (Percentage) 10% 13.5%

Summary

• Developing a Pricing Strategy is an Important Key to Making Good Profits

• Fully Understanding Markup Vs. Margin is Critical to Success in Pricing Your Product or Service

• Keeping Abreast of Current/Local Market Conditions is Crucial – Especially as it Relates to Pricing

• Maintaining Accurate Financial Statements (Income Statement, P&L, and Balance Sheet) is Essential including past periods, current period and forecast of the future

• Regular Reviews of Your financial Statements/Condition is Critical in Maximizing Your Potential for Good Profitability

Thank You for Attending Questions?

SCORE Mentors

www.score.org/mentors

800-634-0245