Pricing For Profit: Understanding Gross Profit, Margin & Markup. Presented by Larry Hunt Volunteer, Pinellas County SCORE

Transcription

1 Pricing For Profit: Understanding Gross Profit, Margin & Markup Presented by Larry Hunt Volunteer, Pinellas County SCORE

2 Introduction This webinar targets: Pricing Fundamentals with a financial overview of: Gross Profit, Margin and Markup and how they affect your pricing and ultimately, your profitability.

3 Do You Even Have a Pricing Strategy? Information from Inc. Magazine article of Feb. 28, According to MIT Sloan Management Review: Pricing receives scant attention in most companies. - Fewer than 5 percent of Fortune 500 companies have a full-time function dedicated to pricing, according to data from the professional pricing society. - McKinsey Company estimates that fewer than 15 percent of companies do systematic pricing research. - Above is puzzling since the authors say that small variations in price can raise or lower profitability by 20 to 50 percent.

4 Initial Thoughts on Pricing A. The Product Life Cycle: 4 Phases 1. Introductory 2. Growth 3. Maturity 4. Decline B. Trade Associations

5 The Product Life Cycle: 4 Phases 1. Introductory Phase very little pressure on price and more concern by the customer that they can get the product. Introductory

6 The Product Life Cycle: 4 Phases 2. Growth Phase Still little pressure on price, but product is more available and competition gets stronger. Introductory

7 The Product Life Cycle: 4 Phases 3. Maturity Phase Competition gets heavy. This phase can last for years or decades. Pricing is typically under pressure. Introductory

8 The Product Life Cycle: 4 Phases 4. Decline Phase Price pressure is great. Generally happens when a new product replaces the existing one. Introductory

9 The Product Life Cycle: 4 Phases Where is your product in the life cycle? Introductory Very little price pressure; more concern by customer that they can get the product. Growth Maturity Decline Little price pressure; product is more available; stronger competition. Heavy competition; pricing under pressure; lasts for years Heavy price pressure; new product replaces the existing product

10 Factors that Impact Pricing Strategy Supply and Demand Theory - Prices will tend to rise when demand increases or supplies decrease. Prices will tend to fall when the opposite happens. Is your product subject to frequent swings in supplies availability? Price Elasticity of Demand How much will demand change when prices are increased or decreased? A low elasticity of demand will more easily allow for a price increase. Attitudes Toward Price 1. By the price setter Most price setters believe that prices should move parallel with costs. The price should have some constant markup to the cost to produce the product. 2. By the customer They want to get good value for their money. They also generally believe you get what you pay for.

11 Topics of Discussion Market Awareness Common Pricing Strategies Variable Costs Fixed Costs Gross Profit Gross Profit Margin Markup Vs. Margin Percentages

12 Market Awareness Do you know who your potential customers are? Retail or Commercial? Young or Old? High Income or Low Income? Value Buyers or Price Buyers? Etc. Do you know who your competitors are? Other Similar Operations? Online Competition? New Technology?

13 Market Awareness Do you know what your competitors charge? It s important to have a ballpark idea of competitive prices. Do you wonder how your competitor can make a profit at their prices? They may produce higher volume They may have more automated equipment They may have more productive workers They may be losing money on every order How do you represent your company/service? Based upon value Based upon price

14 Common Pricing Strategies Price to Market - Setting a price based upon analysis and research compiled from the target market. The danger is that you do not cover your costs and make a reasonable profit. Cost Pricing - This is the simplest pricing method. The selling price is based on a markup of the cost to produce the product. The danger is that the selling price is too high to provide enough sales to make a reasonable profit.

15 Cost To Produce A Product Variable Costs: Materials used Direct labor costs, including fringe benefits Packaging Freight/Transportation Variable costs are those that are incurred based on the amount of product being produced. They are recorded as Cost of Goods Sold.

16 Other Costs Fixed Costs: Office expenses such as supplies, utilities and phones Salaries, wages and fringes of office staff, salespeople and officers and owners Auto expenses for salespeople Advertising, promotional and other sales expenses Insurance Depreciation Professional fees Rent Fixed expenses are commonly referred to as Overhead.

17 Gross Profit Achieving a good gross profit is a critical first step in becoming a profitable company. The tool that you use to achieve gross profit is markup. The gross profit on a product is computed as: Gross Profit = Sales - Cost of Goods Sold

18 Gross Profit Calculation Example Sales/Revenues $ 500, Cost of Goods Sold (Variable Costs) Materials $ 75, Labor $ 110, Other Variable Costs $ 100, Total Cost of Goods Sold $ 285, Implied Markup in this Example 75.0% Gross Profit (Sales Cost of Goods Sold) $ 214, Gross Profit Margin (Percentage) 42.9%

19 Importance of Gross Profit Margin Gross profit margin is important to track since it allows you to keep an eye on profitability trends. This is critical because many businesses have gotten into financial trouble with an increasing amount of gross profit dollars that coincided with a declining gross profit margin. The gross profit margin is computed as follows: Gross Profit Margin = Gross Profit Sales

20 How to Improve Gross Profit Margin There are two key ways to improve your gross profit margin: 1. Increase selling prices. Can be a good way to increase gross profit margin Danger: While this will increase sales dollars per unit, it may cause units of sales to decline and actually lower overall gross profit dollars. 2. Decrease the costs to produce the product or service. This can be accomplished by decreasing the material costs or by operating more efficiently.

21 Markup vs. Margin Percentages Many business owners get confused when relating markup to gross profit margin. While they have some similarities, they are actually quite different. The difference is that gross profit margin is figured as a percentage of the selling price, while markup is figured as a percentage of the seller's cost. Markup is computed as follows: Markup Percentage = (Selling Price - Cost to Produce) Cost to Produce Example: Selling Price = $175 Cost to Produce = $100 $175 Price - $100 Cost = Gross Profit of $75 $75 Gross Profit $100 Cost = Markup Percentage of 75% $75 Gross Profit $175 Sales = Gross Profit Margin of 42.9%

22 Markup vs. Margin Chart 15% Markup = 13.0% Gross Profit (margin) 20% Markup = 16.7% Gross Profit 25% Markup = 20.0% Gross Profit 30% Markup = 23.0% Gross Profit 33.3% Markup = 25.0% Gross Profit 40% Markup = 28.6% Gross Profit 43% Markup = 30.0% Gross Profit 50% Markup = 33.3% Gross Profit 75% Markup = 42.9% Gross Profit 100% Markup = 50.0% Gross Profit

23 Profit and Loss Calculation Example Sales/Revenues $ 500, Cost of Goods Sold (Variable Costs) $ 285, Gross Profit (Sales Costs of Goods Sold) $ 214, Gross Profit Margin (Percentage) 42.9% Fixed Costs $164, Fixed Costs (Percentage) 32.9% Net Profit (Gross Profit Fixed Costs) $ 50, Net Profit Margin (Percentage) 10.0%

24 Positive Effects of a 4% Price Increase Current 4% Price Increase Sales/Revenues $500,000 $520,000 Cost of Goods Sold (Variable Costs) $285,500 $285,500 Gross Profit (Sales Cost of Goods Sold) $214,500 $234,500 Gross Profit Margin (Percentage) 42.9% 45.1% Fixed Costs $164,500 $164,500 Fixed Costs (Percentage) 32.9% 31.6% Net Profit (Gross Profit Fixed Costs) $50,000 $70,000 Net Profit Margin (Percentage) 10% 13.5%

25 Summary Developing a Pricing Strategy is an Important Key to Making Good Profits Fully Understanding Markup Vs. Margin is Critical to Success in Pricing Your Product or Service Keeping Abreast of Current/Local Market Conditions is Crucial Especially as it Relates to Pricing Maintaining Accurate Financial Statements (Income Statement, P&L, and Balance Sheet) is Essential including past periods, current period and forecast of the future Regular Reviews of Your financial Statements/Condition is Critical in Maximizing Your Potential for Good Profitability

26 Thank You for Attending Questions? SCORE Mentors