Markup and Gross Margin
The Key to Managing Cash Flow
Maintaining a healthy Gross Margin is a financial management tool that is critical for generating ample cash flow and operating at a profit.
The Gross Margin, often called Gross Profit, in a company is defined as the difference between sales revenue and the cost of the product or service being sold. These are the costs that are directly attributed to sales and often referred to as Cost of Goods Sold (COGS), or Direct Cost. They are commonly positioned on the Profit and Loss Statement below Sales and before Overhead Costs.
The Gross Margin percentage is computed as the Gross Margin divided by Total Sales. It is important to know this percentage to ensure it covers the overhead expenses and profit. It is also good to know how this percentage compares to other businesses in your industry. If struggling to get bills paid or make payroll, it may be that you need to improve this margin.
Improving Gross Margin
There are only two ways to improve your Gross Margin; more revenue or less direct cost.
To increase revenue, the first strategy that comes to mind is to get more customers. However, your direct Cost of Goods Sold increases proportionately with Sales. So, even though you are making a larger dollar volume of Gross Margin, the percentage remains unchanged.
Reducing direct expenses has a more of an impact on cash flow stability. The strategy of cutting costs will continue to reap dividends as sales volume grows. For example, let’s look at $1,000 in Sales with a $700 Cost of Goods Sold. This results in a $300 Gross Margin, or 30%.
Sales $1,000
COGS $700 70% of Sales
Gross Profit $300 30% of Sales
When we increase Sales 20%, COGS goes up too.
Sales $1,200 (increase 20%)
COGS $840 70% of Sales
Gross Profit $360 30% of Sales
Yes, we have $60 more dollars than we did before. But the margin percentage is unchanged.
If we focused on lowering expenses to generate a 40% margin along with increasing sales, the result compounds:
Sales $1,200 (increase 20%)
COGS $720 60% of Sales
Gross Profit $480 40% of Sales
The impact on improving the margin, coupled with increasing sales, has now generated and extra $180. That is 3 times more than increasing sales alone.
The question is, what should this margin be in order to supply the cash flow needed for operations and result in a profit?
What Is a Healthy Gross Margin Percentage?
The objective of the Gross Margin is two-fold:
- Cover Overhead Expenses
- Generate a Net Profit
Covering Overhead Expenses
Overhead Expenses are sometimes referred to as “fixed” expenses, which isn’t entirely accurate. They will go up as Sales increase, but not as fast as Direct Costs. And as Sales go up, the increase to overhead goes up in steps; additional warehouse space, added staff, new equipment, etc.
However, a good place to start in examining a healthy Gross Margin is to look at the Overhead Expenses as a percentage of total Sales. If for example, Overhead is 30% of Sales, then a 30% Gross Margin is necessary just to break even.
The danger of breaking even is just that, you only break even. The timing of cash flow, sales revenue coming in to cover bills and payroll when they are due, often results in frustration when the company is spending every dollar earned. Any disruption in sales, or unexpected expense can be devastating.
Generating a Net Profit
If a 10% Net Profit is desired, the amount left over after deducting all expenses, then the Gross Margin in this example needs to be 40%. That is, the 30% Overhead Expenses plus the 10% Net Profit.
Generating a Net Profit is a presumption for being in business. Yet, the amount of profit to generate is often taken for granted. A goal needs to be set. And from that goal, the desired amount of Net Profit plus Overhead sets the target margin to be achieved.
A Net Profit is not only desirable, it is necessary for the financial health of the company. It acts as a cash flow buffer for any unseen downturns the company may face. It also adds to the company’s value. A history of consistent profits is very desirable to lending institutions, investors, and potential buyers who want to own the business.
What If the Margin Needed Is Too High?
As we saw earlier, increasing Gross Margin is the result of increasing Sales Revenue and reducing Direct Cost. What happens when increasing sales or reducing costs isn’t working? This occurs when prices have been raised as far as the market can bear, and the market isn’t bringing a new wave of customers. It also occurs when there are no more ways to reasonably cut expenses.
One answer, cut overhead. Many of the general and administrative expenses incurred in a company can be reduced. Careful examination of each expense item on the Profit & Loss Report will reveal areas that are no longer necessary to the company.
Another answer, consider a different market. The problem could be where the value is no longer appreciated by your current customers. Look for the customers who appreciate the value of your product and service you provide. Determine the problems they want solved. And market to their needs.
If you are unable to generate the revenue or reduce the cost to generate the Gross Profit margin you need, research the industry. A simple internet search will provide insight on what other companies in the industry are doing. What is their Margin percentage? What is their Overhead Cost percentage? What markets and strategies are they using in today’s economy?
The Difference Between Markup and Margin
Business owners often get confused between the difference of markup and margin. They are not the same. And to confuse them can be very costly. So, let me explain it in plain English.
Margin: What You Keep
This is the topic we have been talking about thus far. Margin is the percentage of the selling price that you keep after covering the direct cost of sales. And by direct cost, I am referring to the expenses that are directly related to the sale; e.g. the wholesale price of merchandise you sell, the cost of labor, equipment, and subcontractors used to manufacture or construct the product you sell, etc. In other words, the expenses that are not overhead.
Markup: How Much You Increase the Cost to Set the Selling Price
Here is where many companies get into trouble.
When figuring out the sales price, many make the mistake of using the gross margin percentage as the markup. From the example above, they take the cost of $60 and mark it up 40%. That is only $84! That is $16 short of the sales price needed to generate a 40% margin. To generate a 40% margin on $60 the sales price must be $100.
So, how do you compute the sales price to generate the margin you need?
Here is the formula:
Sales Price = Cost divided by 1 minus the margin
In this example it would be:
Sales Price = 60 divided by 1 – 0.40, or
$100 = $60 / 0.60
Apply this formula to those costs that are directly related to sales; the wholesale price of materials, labor, and supplies used in producing the end product to your customer.
Summary
Margin is critical to generating ample cash flow in day-to-day business, and is the secret to generating a healthy profit that increases the value of the company and makes it attractive to potential investors and lending institutions.
Markup is the strategy used to create the desired Margin.
Understanding these two concepts is vital to the sustainability of the company, and provides the guidelines for deciding who to sell to, for how much, and what costs are vital to the operation of the company.
