Markup On Cost Versus Gross Profit Margin
by Veronica Stone on July 17th, 2007
One of the most effective ways to improve the gross margin you earn on each sale is to focus on gross margin rather than markup on cost.
As I have written many times, it’s easy to get into a markup rut; that is, into the habit of using the same old markups over and over again to arrive at your sell prices. While this is certainly a convenient way to price merchandise, it is not healthy for yours or your company’s gross margin.
One of the most effective ways to optimize gross margin when pricing is to "think gross margin." In other words, think in terms of how much gross margin you wish to earn on a sale and price accordingly.
The way this is done, of course, is to divide the cost of the product(s) you sell by the inverse of the gross margin you wish to achieve.
What’s the inverse of the gross margin you wish to achieve? Well, here’s how you calculate it: To arrive at the inverse, subtract from 100 the gross margin you wish to achieve. The example I used in my gross margin book was 44%.
When you subtract 44 from 100, you get 56, which is the inverse.
Then divide the cost of the product by 56 and you’ll arrive at the price you must sell the product for to earn a 44% gross margin.
If your cost were $1 and you divided $1 by 56, you’d arrive at a sell price of $1.79, which would yield a gross margin of 44.13%.
But if you really want to optimize gross margin, you need to go one step further by testing what the market will bear. Right now, a lot of your competitors are low-balling commodities to try and buy some business, but there are several thousand products that you sell every month that don’t fall into the commodity category. If you experiment with what the market will bear on those products, it will help offset the gross margin you may be losing right now on commodities.
When I say test, I mean just that…test. If you’re selling a non-price sensitive product now for $22.49, try $22.89. If after a week or so you don’t receive any pricing resistance at $22.89, you might try $23.26, then $23.52, etc.
Nine out of ten companies use arbitrary markups or gross margin calculations when they price the products they sell. These same companies are leaving gross margin dollars on the table because they aren’t paying attention to the ultimate pricing criterion: what the market will bear or what a customer is willing to pay.
The better job your company does at differentiating its offering from its competitors’ offerings, the higher price the market will bear. The higher your customers perceive your personal value and your company’s value to be, the higher price the market will bear.
Always remember that there are a lot more factors that affect sell price than merely the cost of the product. If you think about it carefully, cost really should have absolutely nothing to do with the calculation of sell price. What you sell something for should be determined by what customers will pay for it.
Try these techniques for a few months and watch your gross margin improve.
Bill Lee is author of Gross Margin: 26 Factors Affecting Your Bottom Line ($21.95) and 30 Ways Managers Shoot Themselves in the Foot ($21.95) Plus $6 S&H for the first book and $1 S&H for each additional book. To order, See Shopping Cart at http://www.BillLeeOnLine.com
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