One of the most important financial concepts you will need to learn in running your business is the computation of gross profit.
And the tool that you use to maintain gross profit is markup.
The gross profit on a product sold is computed as:
Sales – Cost of Goods Sold = Gross Profit
To understand gross profit, it is important to know the distinction between variable and fixed costs. Variable costs are those that change based on the amount of product being made and are incurred as a direct result of producing the product.
Gross Profit Margin
While the gross profit is a dollar amount, the gross profit margin expressed as a percentage. It is equally 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 gross profit that coincided with a declining gross profit margin.
The gross profit margin is computed as follows:
Gross Profit/Sales = Gross Profit Margin
There are two key ways for you to improve your gross profit margin:
- Increase your prices
- Decrease the costs to produce your goods
Of course, both are easier said than done.
An increase in prices can cause sales to drop. If sales drop too far, you may not generate enough gross profit dollars to cover operating expenses. Price increases require a careful reading of inflation rates, competitive factors and basic supply and demand for the product you are producing.
The second method of increasing gross profit margin is to lower the variable costs to produce your product. This can be accomplished by:
- Decreasing material costs or making the product more efficiently.
- Volume discounts are a good way to reduce material costs. The more material you buy from a supplier, the more likely they are to offer you discounts.
- Find a less costly supplier. However, you might sacrifice quality if the goods purchased are not made as well.
Whether you are starting a manufacturing, wholesaling, retailing or service business, you should always be on the lookout for ways to deliver your product or service more efficiently. However, you also must balance efficiency and quality issues to ensure that they do not get out of balance.
Fancy Clothing did a better job in Year 2 of managing its markup on the clothing products it manufactured. Many business owners often get confused when relating markup to gross profit margin. They are first cousins in that both computations deal with the same variables. 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:
(Selling Price – Cost to Produce)/Cost to Produce = Markup Percentage
While computing markup for an entire year for a business is very simple, using this valuable markup tool daily to work up price quotes is a bit more complicated. However, it is even more vital.
Computing markup on last year’s numbers helps you understand where you have been and gives you a benchmark for success.
But computing markup on individual jobs will affect your business going forward and can often make the difference in running a profitable operation. In bidding individual jobs you must carefully estimate the variable costs associated with each job. And the calculation is different in that you typically seek a desired markup with a known cost to arrive at the price quote.
Here is the computation to find a price quote using markup:
(Desired Markup x Total Variable Costs) + Total Variable Costs = Price
Whatever your business challenge is, we can help you starting today.
Simply click the link below to schedule your free 30 minute, no obligation, phone consultation. We’ll focus on your #1 challenge, and at the end of the call we’ll give you at least one practical strategy so that you can move forward immediately.
Schedule your free 30 minute
business assessment session today!
Or you can follow the link and our business experts can provide a Complimentary Business Evaluation for your business.
Start increasing your bottom line today.