I’ve told you many times that your profit margins are important. It’s one of the 4 P’s of Business. I call it Percentage, but that really means profit margin.
If you don’t know your percentage, you’re not really in business.
At best, you’re gambling. You might be a good gambler, or you might not be in business for very long. I’ve told you all of this before.
What I haven’t done, though, is show you how to calculate your profit margins properly. Today, that changes.
Why Calculate Profit Margins
No matter whether you’re operating online or off, something to keep in mind is what a profit margin is for.
Obviously, you should calculate your profit to cover your cost and then some. The place folks usually stop is “…and then some.” They don’t think about how much more they need to make.
Instead of only covering the cost of your product, you should also determine how much more you need to make.
For this, you need a reasonable understanding of the volume you can expect. You also need to account for all your costs, not just the cost of the product.
How to Know How Much Money You Need To Stay In Business
It’s math time, kiddos. Good news is that this math is easy. If you can do basic math, you can do business.
- Take all of your monthly expenses. This is the cost of inventory, any utilities, payroll, whatever. Literally every single expense you will incur in a month’s time.
- Multiply by 12. There are 12 months in the year.
- Multiply by 0.03 and add the result back into your total expenses. This is to account for inflation. Inflation might be more or less than 3% per year, but we’re using the average of the past 100 years. If you don’t make more than inflation, your business will eventually wither away.
- Account for your growth rate the same way you accounted for inflation. If you’re already in business, you can use last year’s growth rate. If you’re not, you’ll have to use your best guess. The volume of sales of similar products can be a good guide.
- Add your equity into your total expenses. The money you’ve put into the business has to be taken into account. We’re not concerned with equity in flux, either – only add what you put into the business as startup operating money.
- Divide by 12. This tells you what you need to make in a month’s time. Profit STARTS at one penny above this number.
Now the part where I pull numbers out of my ass to show you what this translates into.
Let’s say your monthly expenses are $20,000. Let’s assume an optimistic average growth rate of 8% annually. We’ll say we put $50,000 into the business at the outset.
With those figures, you’d need to make $26,414.66 just to stay in business. Profit STARTS at one penny above this number, at $26,414.67.
It isn’t enough to cover the cost of your product in your profit margins, you must cover everything. Many don’t do this, and it’s a big part of the reason most businesses fail.
You could take that number, in this case $26,414.66, multiply it by 12 then divide it by 365 to know how much you need to make daily. In this case, you’d need to make $868.42 in sales every single day just to stay in business.
If you can make $1000 every single day, congratulations. You’ve profited $48,026.70 in a year’s time. Too bad real life is never as simple as basic math.
These numbers are to guide you, to give you a workable model. You’ll still have to navigate the chaos of daily life as the big boss man.
Now that we have a clearer idea of why we’re calculating profit margins, and know how much we need to make, let’s focus on four different methods of calculating profit margins.
4 Methods for Calculating Profit Margins
This is by no means a comprehensive list. These are simply the four methods I’ve encountered most while consulting with businesses offline.
We will cover them in order of least desirable to most desirable. I’ll also explain why the less desirable are less desirable.
Calculating Profit Margins With The Duh Huh Method
The name says it all. The worst way to calculate your profit margins is to not calculate them at all.
This “method” gives you the illusion of thinking you’ve actually done something productive. That makes it not just inadequate, but dangerous.
You might say, “No one does this.” You would be wrong. I’ve worked with people many times who do exactly this.
When asked, “How did you determine this price?” regarding any particular item, their answer was almost always, “It’s what my competition sells it for.”
Doing this doesn’t answer the issues above, regarding how much you need to make. If you know how much you need to make, you should know better than to do this nonsense.
I won’t belabor the point. You already know better than this. Next we’ll discuss the first serious method people actually use, and why I don’t recommend it.
Calculating Profit Margins With Penny Profits
On the surface, the idea of Penny Profits is a good one. You know and have record of how much money you make on any given product. It’s expressed in simplest form. How many pennies are you making on this product?
I still don’t recommend Penny Profits. Why?
Have you ever heard the expression, “Borrowing from Peter to pay Paul?”
That’s the mentality that penny profits will instill. You will say, “I can afford to sell Product A below cost, because I will recoup that loss with Product B”.
The problem with this is that Product A and Product B are not the same product. They will sell at different rates. Doing this turns business into gambling.
If you want to gamble, then gamble. Don’t gamble and lie to yourself about being in business. They are two different things.
Penny Profits can be done right, but only if done in a way we’ll discuss later. You can use the system I describe later to convert your calculation from percentages into dollars and cents. You could, but I wouldn’t.
I ignore the system of Penny Profits altogether, because all it really does is add unnecessary complication. I can always determine the cash equivalent of any step in any other process, and so can you.
The only reason people use Penny Profits is, like the Duh Huh Method, it is simple and easy to understand. Its utility is limited.
Now let’s talk about a more serious method that is more useful.
Calculating Profit Margins With A Mark Up
The Mark Up is a simple idea, like Penny Profits, but has more utility. Instead of determining how many pennies you want to make on each specific product, you can set a standard Mark Up per product category.
You simply “mark up” the sale price a certain percentage over cost. This is a percentage increase, increasing the price by a percentage of itself.
That will be important later, and is why I don’t recommend you use this method. If you wanted to use it, though, it has a lot going for it.
Calculating a Mark Up is simple. When I worked with older business owners, they’re already familiar with the concept and it takes no time to explain.
Its big value is in setting a flat rate Mark Up for an entire product category. If you’re selling products from several different companies, this allows you to be honest and fair.
No one will be able to say you’re giving Company X better representation and sales than you are giving Company Y. If both products are being marked up by the same percentage, the only reason demand will be lower is price or inherent demand.
If the cost of the product is too high, you can use that to work out a deal with the representative. “Sell it to me at a better price and I will be able to sell it to the customer at a better price. Then you’ll sell more than your competitor.”
If the demand for the product is inherently lower than competing products you also sell, think about that. Why are you selling two different brands of the same product if one of them clearly outperforms the other?
There is another common method with more utility than this one, which is the only reason the Mark Up isn’t my recommended method.
Calculating Profit Margins With A Gross Margin
At first brush, there seems to be no difference in the Mark Up and the Gross Margin. Nothing could be further from the truth.
All you have to do is look at the sale price. Using the exact same percentage and the exact same cost price, you get two different sale prices.
How could this be?
Remember, the Mark Up is a percentage increase. You are increasing the cost by a percentage of itself to get the sale price.
Gross Margin is a representation. Of every dollar that is spent on that product, what percentage of that is profit?
Use these two figures in the examples, $11 and $11.11, to understand a few things.
- When you use a Mark Up, your margin does not tell you what percentage of every dollar spent is profit.
- At $11, even though you have Marked Up the product 10% above cost, you are sacrificing $0.11 under 10% profit.
- At a sale price of $11, with a Mark Up of 10%, your actual profit margin is 9.9%.
How important is that 1/10th of 1%? That depends entirely on your volume and how much money you need to make to stay in business.
How large is your margin of error? How close are you to operating on equity? Those are questions I can’t answer for you.
Let’s look at the main value of using the Gross Margin calculation for your profit margins in greater detail.
Using Data From Profit Margins
Data can be useful. It can also be mental masturbation. What data you have and how you’re using it are what makes the difference.
When you pull numbers out of thin air with the Duh Huh Method, you have no data whatsoever. The best you can do is guess and think happy thoughts. I don’t recommend you do that.
When you set your margins according to Penny Profits, what data you have depends on how you determined how many pennies you needed to profit. If you pulled them out of thin air, you have nothing. If you used one of the other two methods, see below.
When you use a mark up, you can compare sales figures within product categories. If you sell scented candles, you can compare between Brand X and Brand Y. If you also sell car air fresheners, though, your scented candle figures and air freshener figures don’t relate.
What I’m saying is that you can’t compare products across categories.
With a mark up, you can only compare similar products in similar categories. They must either have the same cost or the same mark up to be comparable. Otherwise you’re comparing apples to oranges.
When you use a gross margin, you can compare anything in your business. Using a gross margin to calculate your profit margins means you always compare apples to apples.
Comparing Apples to Apples With Gross Profit Margins
When your method of calculating your profit margins is to determine what percentage of each dollar spent is profit, you can compare anything you sell.
You can compare two products that, on the surface, appear to have nothing in common. You can look at how inherently profitable these products are.
Do this by finding price equilibrium for each product. The price at which supply meets demand. When you find price equilibrium for two different products, you can compare how inherently profitable they are.
If one product carries a 10% profit margin at price equilibrium and another carries an 80% profit margin, that tells you some things.
You shouldn’t dedicate much effort to a product that is unprofitable. If supply meets demand at the price you set and 90% of every dollar you make on it goes back into buying more of it, you’re wasting time hustling it. At least, you are if you can do better than 10%.
For some products, a profit margin as low as 7% is normal. A lot of this hinges on exactly what your product is.
How To Calculate Your Profit Margins Properly
If you only sell one type of product, you can use either the Mark Up or the Gross Margin. Either one will let you compare your products intelligently. You could even convert that to Penny Profits afterward if you wanted to simplify things.
If you sell many different types of products, use the Gross Margin. If you use any of the other common methods, you’re missing out on relevant data. You can’t compare products across different categories. I wouldn’t recommend converting to Penny Profits if you sell multiple product types, for that reason.
Use your profit margins to determine your profit. Then, you can take your volume together with your profit to determine whether or not you’ll make what you need.
At the very least, you can take your profit per product and your goal amount to determine your goal volume. You have the formula and the pieces of the equation. I’ve given you the tools.
Go do something with them.