Know Your Margins
Does someone asking you about your margins send you into a cold sweat? Do you know the difference between gross profit and mark up? And importantly, why should you know these? Let’s start with the why and then into go into some details:
Why you should know your margins
Knowing your numbers in your business is essential to being able to understand what is working (and also what isn’t).
If you don’t know the profit you make on a particular product of service then:
You don’t know at what point in time you’ve paid too much for storage for that product line and are no longer making a profit
You don’t know how many you need to sell in order to cover off the rest of the costs in your business
You don’t know what return you need on you ad spend to not erode those profits
You don’t know what discounts and offers you can offer your customers and still make a profit.
So knowing your numbers is pretty essential to be able to make informed decisions within your business.
What is gross profit?
Gross profit is the margin you make on the products / services that you sell. It is calculated as:
Gross profit = sales price – cost of sales
Gross profit % = Gross profit / sales price x 100%
Where sales price is the amount that you sell the product / services for excluding VAT and cost of sales are the costs directly attributed to that sale (ie materials, labour, postage if that is included etc) again excluding VAT.
So for some numbers:
You sell a dress for £150 including VAT. The sales price excluding VAT is then £150/1.2 = £125
The cost of production for this dress is £50 (excluding VAT).
Gross profit = £125 - £50 = £75
Gross profit % = £75 / £125 x 100% = 60%
What is mark up?
Mark up is the amount you have added onto the cost to get to your sale price.
If a product is purchased for £20 and is sold for £30 (ex. VAT) then the mark up % is calculated as follows:
Mark up = (sales price – cost price) / cost price x 100%
Mark up = (30 – 20) / 20 x 100% = 50%
This is not the same as the gross profit (in the above example that would be (£30 - £20)/£30 = 33%.
It is essentially another way of looking at the same figures, it’s just for some people looking at it this way is an easier way to understand and process.
The key is being consistent in what figures you are using to monitor and assess your businesses performance.
Using margins for discounting
If you know that you can’t make less than a certain margin in order to cover all the other costs in your business then you can work backwards to know the lowest price that you can sell your products for in order to cover your costs.
If your cost price is £50 and you need to have a minimum 45% margin to cover costs then you can work out your minimum sale price as follows:
Minimum sale price = costs / (1-gross profit (as a decimal))
Minimum sale price = 50 / (1-0.45) = £91
Knowing this data has allowed this business to make an informed decision about their pricing and what they can drop to and still cover their costs.
Of course, there may be other factors at play around discounting and clearing stock that come into play, but informed decisions allow these to be made on a rational basis rather than sticking a finger in the air.
And finally...
There are lots of other profit figures that finance people refer to:
Profit before tax – this is you bottom line profit after all your costs before you work out the tax that needs to be paid to HMRC
Profit after tax – this is the above but after you’ve allowed for your tax too.
EBITDA – Earnings before interest, tax, depreciation and amortisation – this is essentially you profit before any interest paid/received, the tax your business has to pay and the depreciation charged on your assets – it’s kind of your trading profit as the others are related to how your business is financed (interest paid) or how much cash you have in the bank (interest received) and depreciation is “accounting faffery” to spread the costs of your assets in the business over their life... so again, not part of how your business is trading!
Rachael