Lately, most of us will have been dealing with rising costs in our businesses. In particular, the rising cost of materials. This is not a new phenomenon, but the frequency of rises on materials has hit new highs and is not showing any signs of relenting any time soon.

When it comes to dealing with price increases, I often field a barrage of questions, or to be more precise, many variations on the same question. “What margin should I put on materials?”

To answer the question, we need to consider what model you are running for pricing.

Cost +:

I find this model is what is most common.

Simply, a business looks at the latest price they paid for an item and then they apply a margin to it to get the sell price (hence the Cost-plus phrase). Nice and easy – no problem.

Well, unfortunately there are a few problems with this.

Generally, it works well when the cost price either stays the same or increases. What happens when the cost price goes down?? (“Yeah Right” I hear you shout!!)

So how many of you get a trade discount on your purchases? If you do, do you apply the margin to the discounted cost (what you actually paid) or the unadjusted cost? If you are applying your margin to the discounted cost price, then you are giving away margin for no real reason. The benefit of the discount is to your business, so why hand it on??

Well, I am told it is usually because the sell price to the customer can only be so much. Ah ha, then what you are telling me is something that is NOT a Cost + strategy.

Rev -:

If you know (or believe you know) the maximum price a customer will pay, then setting the price to that level, or very close to it is what is called a Revenue Minus (Rev -) strategy. That is, you get the most you can for the item and then deduct the Cost of the Goods from that to determine the margin.

Most businesses tell me they are a Cost + model when in fact they are actually a Rev – operation. How do I know this? Because most owners can only tell me how much money they have left over at the end of the year rather than how much money they should have made for the year.

Seems a bit odd, doesn’t it? Let’s take a closer look.

Using the Cost + model, let’s say a business sells candy bars. It buys in supplies of candy bars that it intends to sell at a margin. Then, some consideration is given as to “what Margin should I apply to the candy bar?” Let’s say the decision is to apply a margin of 35%

So, the candy bar is priced accordingly and sold.

When we consider the question “what sort of margin do you get in your business?”, the answer (using the candy bar example) is usually something like………. “we make 35% on everything”.

I strike this many times over, across many industry types. It is a common misnomer that the % amount you put on an item is the margin of the business.

It isn’t. Not even close.

If we now examine the sale in question along the lines of “how much money do you make from a sale” then we can dig a little deeper. This is where we can find some clues that help us answer things like, “why am I not making any money?” Or “where has the money gone?” “After all, I am getting a good margin, right?”

So, if we consider the same example, and ask the same question, but this time from the Rev – model we get the following:

“What sort of margin do you get in the business” – our thoughts tend to be more about how much money was generated from the sale rather than how much we added to the cost of the item.

Now were talking!

You cannot bank percentages. When it comes to the margin in your business, you should be talking dollars, not percentages. Yes, you use percentages in the calculations, but that is the maths. The level of detail required to understand what is going on is to relate it back into dollars.

Once we know that the candy bar is sitting at the top end of pricing, then we look at what it means to our business.

Now we look at how much money does the business get from the sale of the candy bar? This is your Gross Profit $. It is the amount of money generated from the sale after deducting all the direct costs of the goods.

To put it another way, it is the money you have left to run the business. When looking at the bills, do you think “I have 35% to play with” or do you say something like “I have $x. in the bank to cover the bills”?

When you take a Rev – approach it focusses you on dollars. It also then makes you think, “crikey, is that enough to pay the bills?”

This is gold. Now you are thinking about the business and the impact of your pricing vs the amount of money required for running the business. If the amount is not enough to pay the bills, then you look at other ways to make up the difference. This could be:  

  1. Put the sell price up of the candy bar
  2. Negotiate better purchase rate on the candy bars
  3. Reduce other costs in the business
  4. ALL of the above.

What if it is none of the above? Then it is a case of selling something else (this is a subject for later).

It is also useful to measure the impact of events on your $ and how they relate to margin in the business. For example, let’s consider that one of the candy bars gets dropped and the wrapper is damaged so that it can no longer be sold. You decide to put it into the social club Hamper for the staff raffle. What is the $ impact of this?

Well, to describe it in words, we have reduced the Gross Margin. In order to replace it, we need to use some of the profit.

Let’s assume you buy the candy bar for $3.75 and sell it for $5.

So, the margin in terms of dollars is $1.25.

Because we use $1.25 from each candy bar to run the business – we need to fund the replacement candy bar from what is left over. If we don’t, we run the risk that some bills won’t be paid. (This is a common occurrence).

After the bills are paid, let’s assume in this business, the $1.25 ends up being 25 cents. This is the Profit before you pay any tax.

This is what contributes to your lifestyle. It is an important part of why you are in business. But before that, you need to pay for the $3.75 candy bar in the staff raffle.

In order to cover the $3.75, you need to sell another…………………… 15 candy bars!!!!!!

In simple terms, you pay for damages out of your wallet.

So, when we talk margin in your business, we need to be clear about a few things.

  1. What is your pricing model (Cost + or Rev -)
  2. When assessing the impact of activity in your business, you should think about it in terms of the $ from your wallet.
  3. You need to know your Gross Margin $ = the money you use to pay the other bills.
  4. You need to know your Profit $ = the money that funds your lifestyle.
  5. When something unexpected happens (Good or bad), work out the impact in $ on your wallet.

Too often we live in the “% speak”.

So, what is in a margin?

Well, if I asked “what would you prefer”

  1. A business that makes 35% GP on everything, or/
  2. A business that makes $40,000 Net Profit

What would you say?