By Shane Bender
The other day I received a call from a client. He said there was something very wrong with my pricing spreadsheet I gave them. He said the margin was off significantly, and there must be an error in the sheet. After some discussion, we discovered they were mixing up markup and margin. Then he said he thought they had been mixing this up for a long time.
Cost plus a percentage. You take the cost of something and add a percentage such as 50% to get the sales price.
Example: Your cost is $1,000 and you want to add a markup of 50%. You would add $500 (50% x $1,000) to get your sales price. This is very different than Gross Margin. If you sold this for $1,500, then your Gross Margin is 33% ($1,500 – $1,000 = $500 / $1,500).
Sales – Cost of Services (Goods). In this case, you have to back into the sales price differently. Take the cost and divide this by 1 minus the desired Gross Margin percentage.
Example: Your cost is $1,000 and you want a margin of 45%. $1,000 / (1-45%) = $1,818.
If you and used markup and multiplied 45% by $1,000, your sales price would be $1,450 (1,000 * 1.45). This is much less than $1,818. Your Gross Margin is only 31% ($450 / $1,450), which is much worse than the desired gross margin of 45%.
Solutions to Pricing Risk
Pricing is very important to the profitability of your company. As you review an Income Statement, it is important to look at Gross Margin and see if you are meeting your expectations. If your sales team is using the wrong formula, you could be taking a huge hit to your profitability.
Training solves many problems. Make sure your sales team and those involved in pricing fully understand how to price items. Make sure they understand markup and margin. Setup a good review process so any risky or low margin items are reviewed by a supervisor of Finance.
2. Pricing Template
Use a standard pricing template that allows the salespeople to enter some numbers and provide a recommended sales price. The complexity of your pricing structure may make this challenging. If you have many items, this will not work, and you need to have an approved pricing sheet. If you need help with the pricing template, email me at email@example.com.
3. Review Prices
It is common to increases prices from time to time. Usually, you can increase prices at least 5% a year without much risk of a customer leaving. If you wait too long to increase your prices, you may find that you have to increase it by more than 5%. A 10% increase may then make your customers start to look elsewhere. Check out this article “How to Raise Prices Without Losing Customers” for more ideas.
4. Understand your Overhead
Suppose you have a goal of 40% Gross Margin and your average sales price is $1,000, which means your Gross Margin is $400. If you have overhead costs within your organization from employee costs, rent, marketing, training, office expenses, etc that cost $500 for every $1,000, then you are losing money. The best way to understand your overhead is to have good bookkeeping and then forecast out your expenses for the next 12 months. A good overhead forecast that adjusts as you grow will be essential. If you are structuring your business correctly, you should see your percentage of overhead costs to sales decrease as you grow, which will increase your profitability.
Algebra Does Matter
I know that numbers can get confusing sometimes as we apply this to business. Maybe you thought you would never use Algebra again after you left that class in high school. In business, Algebra can matter as you understand the difference between Markup and Gross Margin. With proper training, templates, review, and financial understanding, you can grow your business and profitability.
If you want to learn more about forecasting for business and nonprofits, check out my award-nominated book and audiobook Forecast your Future: How Small Businesses Exchange Stress and Chaos for Cash and Clarity. Also, check out my course for even more guidance.