Every business wants to make a profit. For an eCommerce business to do this properly you’ll need to understand the dynamics of selling inventory and that means you’ll need to understand profit margin, gross profit and markup.
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Smaller businesses are faced with a challenge that larger businesses do not have. The owner is not necessarily an accounting professional and as a small business may not have the resources to have a controller on staff. One of the classic mistakes people make when starting a small business is that they don’t do the right financial planning for it. They set out to charge the going market rate for something and fail to take into account that they may not be able to compete if other companies are already buying and selling similar products in large volume. This doesn’t mean they shouldn’t go into business. It means that the dynamics need to be considered and used in making important decisions about how to structure things.
If you are going to sell a product and compete with some big companies out there then I have essentially 2 choices.
The first one is to sell a high end version of the product thereby justifying a higher price compared with the “mass produced” lower quality products.
The second choice is to get enough start-up capital to be able to purchase enough inventory so that the unit cost is low enough to be competitive.
There are obviously other options in between the two so it is just a matter of getting creative. You will still be left with the same decision in the end.
How do you price your product?
If you don’t have a market research department and a CFO, this is going to be up to you as the entrepreneur to figure out. People have asked me how businesses get themselves in a situation where they aren’t making enough money even though the sales are there, and this is why – always lack of planning.
There are essentially 3 kinds of businesses out there– those that sell products, those that sell services and those that sell both.
Serviced based businesses are a little simpler business model because you don’t have the elements of inventory, process cost, and related analytics with respect to cost, markup, selling price, gross profit, and gross profit margin. There are also inventory carrying costs, and inventory tracking and management costs. Then if you are selling retail you need to become concerned with Sales Taxes which are an added bookkeeping cost in terms of capturing, reporting and payment.
When companies sell products they are faced with a challenge.
How to price the product? How much is it worth and is that enough to cover the costs directly associated with either production (if we are involved in manufacturing them) or procurement if we are simply purchasing something for resale. The difference between what you sell it for and those immediate costs is of course the Gross Profit (in terms of dollars).
Then the Gross Margin or Gross Profit Margin is the percentage of Gross profit Dollars to Total Revenue (or selling price). So the gross profit percentage looks at the Gross profit dollars in relation to total selling price.
Gross Margin = Gross Profit ÷ Total Selling Price
Then there is the Markup percentage. This is in a way the flip side of the Gross Profit Margin. It looks at the cost in relation to profit. This is calculated as the gross profit divided by the cost.
Markup = Gross Profit ÷ Cost
The trick to this is not just to make a gross profit. There has to be enough gross profit to pay for all of your overhead costs (office expenses, utilities, payroll, marketing etc..). Then hopefully after all of that there is still something left over so that we have a Net Profit.
So here’s the simple recap on gross and net profit:
Total Selling Price – Cost of Goods Sold = Gross Profit
Gross Profit – Overhead = Net profit.
So what is considered Cost of Goods Sold vs. Overhead?
The true definition of cost of goods sold are all costs necessary in order to get the products ready for sale.
The classic question is whether or not Freight is considered cost of goods sold. The answer is yes and no!
Freight In is the cost I pay to have the goods delivered to me before I’ve sold them. This is considered part of Cost of Goods Sold.
Freight Out is the freight I pay to ship my goods to my customer. This happens after the sale is made which means it is NOT a cost incurred in getting the products “ready” for sale so it is considered a selling, general, & administrative expense or overhead.
Now how do you price your product?
As indicated above and In the simplest forms there are 2 basic selling models. Either charge a lower price = lower profit margin and generate a high sales volume, or (the high end model) charge a high selling price = higher profit margin and lower sales volume.
You may be in a situation where every deal is different based on what you negotiate and it also may be more complex than just being able to choose from among the 2 models described above.
Many businesses use a margin calculator to figure it out.
You will need to have an idea of what you expect your sales volume to be. You also need to have an idea of how much your overhead is. This way you can back into the calculation based on expected sales volume.
Using a very simple example if I know conservatively I am going to be able to sell 1000 products and my overhead is $10,000 then I need to be making a gross profit of $10/unit just to break even.
Then if my cost of goods sold is $3,000 (for 1,000 products) I need to sell them for a total of $13,000 to break even.
Next I need to factor in how much profit I want to make and that may be determined for me based on fair market value.
If the “going rate” for my product is $20, then I can charge that and gross $20,000, pay my $3,000 cost and $10,000 in overhead and have $7,000.
That may or may not be a good deal for me – it really depends on how much effort I have to put in to generate that sales volume combined with what I need to net monthly.
What do you need to net monthly?
This is where my theory breaks off from the traditional.
Traditional financial professionals will mostly say you need one expert on business finance and another on personal. I disagree completely. This is why.
As a business owner you need to look at your personal expenses – mortgage, car payments, insurance, food- the works. If $7,000/month is enough to cover it than this business model works.
If $7,000 is not enough then you need to revise the model by charging more for your product.
If this means you are charging more than market you need to work out how you are going to justify that.
The easiest thing to do is make sure that you are providing superior service. People will pay extra for good service and in this day and age most companies fall real short in that area (my opinion of course).
So all you really need to do is make sure your company is really there for the customer and you can charge over market.
Wait! There’s More!
You can play around with the variables to see what you can do in terms of cost, selling price, gross profit, markup, and gross profit.
There are many free margin calculators on the web, which will do the simple calculation for you. You can enter your cost, and revenue and see the profit margins. Some that I found will even let you play around with some of the variables, but the one most important one to me I could not find anywhere.
The scenario is that you are looking at your cost, selling price and related gross profit and markup and now your prospect comes to you and says that your total price for the 1,000 products he or she is about to purchase is outside of their budget.
Your proposed selling price for the 1,000 units was $20,000 ($20/each) and they had really only budgeted for $15,500.
Now you want to be able to drop the total selling price to see one of two things – either the reduced quantity I need to sell them, or the reduced gross profit margin.
No margin calculators that I found on the web let you do this. Then you might be looking at the variables and you may know that you want your gross profit margin to be somewhere between 30-40%.
You want to be able to enter the cost per unit, selling price per unit, and the quantity, but then go and adjust the Gross profit margin % to keep it in your range and see the resulting total selling price. Again none of the web based calculators are this dynamic.
Based on this I developed something that is easy to use that works.
The result my Profit Margin Calculator.
It is designed in MS Excel, but you don’t need to know anything about Excel to be able to use this very easily.
It lets you start by entering the basics and then you can move into any of 5 different scenarios that change what you can enter and what gets calculated.
This way you can look at lowering the total sales price to get a lower quantity OR look at lowering the total sales price to get a lower gross profit (so your customer gets a better deal).
Watch the video above to see what this looks like.