Mark-up vs. margin... This is a topic we encounter regularly with our clients. Often when a client comes to us with concerns about their cash flow, there are a few areas of the financial statements that we can turn to for answers. Pricing is usually one of the areas that inconspicuously sabotages cash flow if the cost structure is not understood when a company prices it's products or services. After the costs structures are understood, then it becomes an exercise in algebra to make sure that the pricing of the product or services maintains the integrity of the margin we are seeking.
Many business owners tend to focus strictly on the dollar value of the margin they are seeking or worse yet, setting the price based on a percentage of increase they think is the margin.
The example below is what happens if the business owner keeps the focus on making that $ or % of gross margin: notice we kept $30 in gross margin dollars, but look at our margin %. Our company is failing. This is what happens to many companies and explains why companies fail even when sales are increasing. They tend to forget that costs (direct costs) increase proportionately with sales.
Another common mistake that business owners make is they calculate the price by multiplying the known costs by the percentage of margin they want. In the scenario below, each of the costs were multiplied by 30%, the desired margin, and then 30% of the cost was added to the cost to establish the price. The problem is, this doesn't reflect the actual margin. Notice that the actual margin came in at 23% in each case.
The example below is what happens when the business owner understands their cost structure and then establishes a price that maintains the profit margin they are looking for.
It really does become an algebraic equation at this point. In the example above, we know that our direct costs (direct material and labor) are 70% of our desired price because we wish to maintain a 30% profit margin. The equation looks something like this: P = .70x with x representing our known costs. To solve, you divide both sides of the equation by .70 to come up with the price needed to maintain a 30% profit margin.
Scenario 1 gives us a profit of $90 while scenario 2 gives us a profit of $99 and scenario 3 give us a profit of $142. This is a difference of $9 and $52 respectively, due to erroneous pricing assumptions.
What questions do you have?
Accounting - Payroll