To understand the concept of profit margin we begin with the definition of the profit margin itself. In accounting and finance, a profit margin is a measure of a company’s earnings (or profits) relative to its revenue. The three main profit margin metrics are gross profit margin (total revenue minus cost of goods sold (COGS) ), operating profit margin (revenue minus COGS and operating expenses), and net profit margin (revenue minus all expenses, including interest and taxes). When assessing the profitability of a company, there are three primary margin ratios to consider: gross, operating, and net. Below is a breakdown of each profit margin formula:
1)Gross Profit Margin = Gross Profit / Revenue x 100
2)Operating Profit Margin = Operating Profit / Revenue x 100
3)Net Profit Margin = Net Income / Revenue x 100
A good margin will vary considerably by industry, but as a rule of thumb, a 10% net profit margin is considered average, a 20% margin is considered high (or “good”), and a 5% margin is low. Again, these guidelines vary widely by industry and company size, and can be impacted by a variety of other factors.
You often see or hear retailers' advertisem*nts that promise you "quality merchandise at a fair price." Well, just what is a "fair price?" As you enter the retailing arena, you will soon learn that there really is no universally accepted definition. Most of the time the answer is "It depends." It depends on how much you paid for the merchandise, who you bought it from, what your competitors are charging, your overhead expenses, your sales volume, and a hundred other variables.
How you establish prices for your merchandise will be one of the most important decisions you will make, since it directly affects that all-important variable, profit. You must strike a delicate balance, setting a price that is high enough to allow you to achieve a reasonable profit margin and yet low enough to keep your merchandise affordable and competitive. Even though there is no hard and fast rule for pricing merchandise, most retailers use a 50 percent mark-up, known in the trade as keystone. What this means, in plain language, is doubling your cost to establish the retail price. Because mark-up is figured as a percentage of the sales price, doubling the cost means a 50 percent mark-up. For example, if your cost on an item is $1, your selling price will be $2. Fifty percent of $2 is $1, which is your mark-up. This definition of mark-up was probably developed to avoid using a term that admits to a 100 percent increase. Most consumers would be appalled that you are selling something for double what you paid for it. They would be inclined to ask why you do not carry a gun and wear a mask. Most consumers have had no exposure to the myriad costs associated with retailing and they are used to thinking in terms of net profit margins they have heard in the media. For example, an article in the business section of a newspaper might report that Mega-Mart had sales of $500 million and earned a net profit of 4 percent. An uninitiated reader might conclude that Mega-Mart marks up its goods only 4 percent. In reality, net profit is calculated after overhead expenses have been subtracted from gross profit (total sales less cost of merchandise).
Although it is true that higher volumes will make up for lower prices to some extent, unless you can sell as much as a Kmart or Wal-Mart, you absolutely need at least a 50 percent mark-up (keystone) to survive in a small retail shop. Although doubling the price may sound outrageous, it does not result in excessive profits when you consider the expenses for rent, taxes, insurance, supplies, labour, etc., that you must pay.
Sometimes you will have to sell an item at a lower mark-up, if you believe you cannot compete at a full keystone mark-up. Be careful, however, not to price too many items this way or you will find nothing left for yourself at the end of the year. You can try to balance it out by marking some items up slightly higher to compensate for the lower mark-ups on others. You can do this when you get a special discount or are able to buy items direct from a manufacturer. If you decide to use a mark-up other than the standard keystone
(50 percent), here is a quick way to calculate your selling price:
Selling price = [(cost of item) ÷ (100 - mark-up percentage)] × 100
For example, assume an item costs you $10 and you want to use a mark-up of 35 percent. The selling price would then be calculated as follows:
Selling price = [(10.00) ÷ (100 - 35)] × 100
Selling price = (10.00 ÷ 65) × 100 = $15.38
Do not multiply the cost by 35 percent and add that amount to the cost. That will produce a retail mark-up of 17.5 percent, not the desired 35 percent. Do not overlook freight costs in your cost of merchandise. If your competition will allow, add the freight cost before you apply the mark-up.
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