Pricing is often a difficult task for small businesses. However, it is crucial that the business owner and all managers and employees understand the basic relationship between sales, pricing and profits. Small companies simply do not have the expertise or the resources to determine supply and demand economically; therefore, small businesses must manage supply and demand practically to achieve the desired profit.
In a competitive or declining market, it can be difficult to maintain volume and profit, particularly when there is no definite competitive advantage beyond pricing. Therefore, the natural tendency is to cut prices directly or by creating “promotions” or providing discounts, at least temporarily. This is highly unfortunate because this is not the answer.
To avoid undercutting your costs in your pricing even when you didn’t intend to do so, you need to fully understand the difference between mark up and margin.
MARK UP AND MARGIN DIFFERENCE
Owners and managers must know the difference between mark up and margin. Mark up is the amount or percentage by which the company increases product or service delivery prices to “cover” the costs of operation. For a particular product or service, the Gross Profit Margin, or Gross Margin, is the difference between the sales price and the cost of the product or service.
By applying a simple formula to costs, a number that is the same for mark up and margin can be determined. For example, marking up an item that costs $20.00 by 50% results in a selling price of $30.00. However, this does not result in a 50% profit margin. Instead, the true profit margin is 33%!! ($20.00/$30.00 = 66% cost. 100% sale price – 66.6% cost = 33.4% profit margin).
To set a price that will result in a desired profit margin, you must divide the cost of the item by the reciprocal of the desired profit margin. For example, if you want a 25% profit margin, you divide the cost of the item by 75%. ($20.00 cost divided by .75 = $26.67 sales price.) This translates to a 33% mark up. Had you only marked this up by 25%, the actual profit margin would have been 20%. ($20.00 x 1.25 = $25.00. $20.00/$25.00 = 80% cost. 100% sale price – 80% cost = 20% profit margin.)
To prove the validity of the multiplier, multiply the cost of the services by the mark up multiplier. Multiply the results by your desired Gross Margin. The result is your Gross Profit. (Remember, Gross Margin is a percentage, and Gross Profit is an actual number.) By dividing this result by the price that you charge for the services, you determine the effective Gross Margin.
Example: We paid $48 for an item and want a 40% GM.
Multiply $48 by 1.667 = $80; this is the price we charge the customer.
To prove it is correct, multiply $80 x .4 (GM) = $32 (Gross Profit);
$32 /80 = 0.4. This proves that this is an effective Gross Margin by using the 1.667 multiplier.
MARK UPS CHART
(Use this chart to quickly determine what multiplier you need to use to obtain the mark up you actually intend/desire.)
**Check out the continued primer on pricing on Tuesday, October 10.**