Mark-up vs Gross Profit (GP)

Mark-up is the percentage that we add onto the cost price of a product or service to determine the selling price or mark-up is the difference between the selling price and the cost price of a product or service. The gross profit is the actual profit that we make on the transaction. 

Many mistakenly believe that if a product or service is marked up by 50%, the result will be a 50% gross margin. However, a 50% mark-up produces a gross margin percentage of only 33.3.%.

For example: A product costs 100 and we add a 50% mark-up then the selling price is 150. However the gross profit is only 33%. Why? Lets look at the following calculations using the same cost and selling prices:

Mark-up:          100 x 50% = 150

Gross profit:      50 / 150 = 33.3%

We bank the GP as profit. so we are banking 50 of the selling price which is 33.3.% of the selling price. When looking at your business margins you should be working on your GP percentage and not your mark-up.

Different industries, products and services attract different GP's. This is true within a single store. Convenience stores have a GP on milk and bread of 10% but on cool drinks this rises to +30% and on their emergency grocery products to over 50%. Their average GP comes out at between 25% and 32%.

To determine your average mark-up:    GP / cost of sales x 100

To determine your GP:                         (Selling price - Cost price) / selling price x 100

To determine your ave GP:                   Gross profit / total sales

To calculate selling price where you have determined your GP%, for example if you want a 25% GP margin then use this formula:

                                   Sales Price = cost price / ( 1- GP margin percentage)

Why would we be concerned about GP margin. Well the GP margin is the percentage of every Rand that is earned which can be applied towards the costs of running the business. If your operating cost is running at 40% of sales and your GP margin is only 23% (even though your mark-up appears healthy at 30%) then you are heading for bankruptcy. Below is an extract from an article from Warren Buffet giving a simple explanation.

Note: 

1. Exclude VAT or Sales Tax from both your cost and selling prices. Add Vat or Sales Tax onto the selling price after you are happy that you have the right GP margin and that the market will pay the final selling price.

2. You can work the selling price backwards by determining what your GP% will be however this is more complicated. Tables are available to simply these calculations (available at: http://www.mrhvac.com/download/free/MarginMarkup.htm.)

"A Message from Warren E. Buffett
Chairman, Berkshire Hathaway Inc.

What You Should Know About the Jewelry Business
You don't need to understand the economics of a generating plant in order to intelligently buy electricity. If your neighbor is an expert on that subject and you are a neophyte, your electric rates will be identical.

But jewelry purchases are different. What you pay for an item vs. what your neighbor pays for a comparable item can be, and often is, widely different. Understanding the economics of the business will tell you why.

To begin with, all jewelers turn their inventory very slowly, and that ties up a lot of capital. A once-a-year turn is par for the course. The reason is simple: People buy jewelry infrequently, and when they do, they are making both a major and very individual purchase. Therefore, they want to view a wide selection of pieces before zeroing in on a single item. 

Given that their turnover is low, a jeweler must obtain a relatively wide profit margin on sales in order to achieve even a mediocre return on their investment. In this respect, the jewelry business is just the opposite of the grocery business, in which rapid turnover of inventory allows good returns on investment though profit margins are low.

In order to establish a selling price for their merchandise, a jeweler must add to the price they pay for that merchandise, both their operating costs and desired profit margin. Operating costs seldom run less than 40% of sales and often exceed that level. This fact requires most jewelers to price their merchandise at double its cost to them or even more. The math is simple: Jewelers charge $1 for merchandise that has cost them 50 cents. Then, from their gross profit of 50 cents they typically pay 40 cents for operating costs, which leaves 10 cents of pre-tax earnings for every $1 of sales. Taking into account the massive investment in inventory, the 10-cent profit is adequate but far from exciting.

At Borsheim's the equation is far different from what I have just described. Because of our single location and the huge volume we generate, our operating expense ratio is usually around 20% of sales. As a percentage of sales, our rent costs alone are fully five points below those of our typical competitor. Therefore, we can, and do, price our goods far below the prices charged by other jewelers. In fact, if they priced to match us, they would operate at very substantial losses. Moreover, in a virtuous circle, our low prices generate ever increasing sales, further driving down our expense ratio, which allows us to reduce prices still more ..."

For the full article go to: http://shop.borsheims.com/Borsheims/CustomerServices-Buffett.aspx