One of the most important financial concepts you will need to learn to run your new business is the calculation of gross profit, and the tool you use to maintain gross profit is mark-up.
The gross margin on a product is calculated as follows:
Sales – Cost of Goods Sold = Gross Profit
To understand gross profit, it is important to know the distinction between variable costs and fixed costs.
Variable costs are costs that change with the amount of product produced – and which are incurred as a direct result of the production of the product. They understand:
- The materials used
- Direct labor
- Factory Supervisor Salaries
- Utilities for a factory or warehouse
- Depreciation of production equipment
Fixed costs are generally more static in nature. They understand:
- Office expenses such as supplies, utilities, and desk phones
- Salaries and wages of office staff, salespeople, managers and owners
- Payroll taxes and benefits
- Advertising, promotion and sales costs
- Automobile expenses of sellers
- Professional fees
Variable expenses are recorded in the cost of goods sold. Fixed expenses are accounted for as operating expenses (sometimes referred to as selling and general administrative expenses).
While gross profit is a dollar amount, gross profit margin is expressed as a percentage. It’s just as important to track, as it allows you to keep tabs on profitability trends. This is essential because many companies have had financial problems with an increase in gross profit coinciding with a decline in gross profit margin.
The gross profit margin is calculated as follows:
Gross Profit / Sales = Gross Profit Margin
There are two main ways to improve your gross margin. First, you can raise your prices. Second, you can reduce the cost of producing your goods. Of course, both are easier said than done.
A price increase can cause sales to fall. If sales drop too low, you may not generate enough gross profit to cover operating expenses. Price increases require a very careful reading of inflation rates, competitive factors, and basic supply and demand forecasts for the product you are making.
The second method to increase the gross profit margin is to reduce the variable costs to produce your product. This can be accomplished by lowering material costs or making the product more efficient. Volume discounts are a good way to reduce hardware costs: the more hardware you buy from a vendor, the more discounts they are likely to offer you. Another way to reduce material costs is to find a less expensive supplier, but you risk sacrificing quality if the products purchased are not as well made.
Whether you are starting a manufacturing, wholesale, retail or service business, you should always be on the lookout for ways to deliver your product or service more efficiently. However, you must also balance efficiency and quality.
Let’s look at ABC Clothing Inc.’s gross profit as an example of calculating gross profit margin. For the first year, sales were $1 million and gross profit was $250,000, resulting in a gross profit margin of 25% ($250,000/$1 million). For the second year, sales were $1.5 million and gross profit was $450,000, resulting in a gross profit margin of 30% ($450,000 / $1.5 million). dollars).
It is obvious that ABC Clothing not only achieved more gross profit in the second year, but also a higher gross profit margin. The company has either raised prices, lowered supplier variable material costs, or found a way to produce its garments more efficiently (which typically means fewer labor hours per product produced). ABC Clothing did a better job in year two of managing its profit margin on the clothing products it produced.
Many business owners often get confused when they associate gross profit margin with gross profit margin. They are first cousins in that both calculations deal with the same variables. The difference is that the gross profit margin is expressed as a percentage of the selling price, while the profit margin is expressed as a percentage of the seller’s cost.
The surcharge is calculated as follows:
(Selling Price – Production Cost) / Production Cost = Markup Percentage
Let’s calculate the markup for ABC Clothing for the first year:
($1 million – $750,000) / $750,000 = 33.3%
Now let’s calculate the markup for ABC Clothing for the second year:
($1.5 million – $1.05 million) / $1.05 million = 42.9%
While it is very simple to calculate an entire year’s markup for a business, the day-to-day use of this valuable markup tool for quoting is more complicated. However, it is even more vital. Calculating markup on last year’s numbers helps you understand where you are and gives you a benchmark for your success, but calculating markup on individual jobs will affect your business in the future and can often make the difference in running a profitable operation.