February 15, 2013
I’ve been reading through some of the responses to the Small Food Business Reader Survey (reminder – if you haven’t added your 2 cents I’d appreciate it if you did.¬† Should take 7 minutes tops and allows me to plan out articles/provide resources¬†based on information you want to know) and I’ve gotten a few questions asking about margins vs. markup and the general confusion between the two.¬† So let’s tackle that today.¬† Also, next week, per reader demand, I’ve got a series of articles called “Why Margins Matter” that will look at margins at every step in the sales channels which is critical information if you want to price your products so that you make money both now and as you grow.
But first let’s¬†address the difference between Margin and Markup because these are two terms you don’t want to get confused.
Markup¬†is a term you hear tossed around from time-to-time – such as “that store really marks-up their products” but what does that actually mean?¬† A Markup is, technically, the amount that’s added to the cost of a product to¬†derive the selling price.¬† For example, a cheese retailer that wants to have a minimum of 50% markup on every product in their store would take the cheese they buy for at wholesale for $5 and give it a retail price of $7.50 for the customer ($5 + (5*50%)) = $7.50.¬† Margin is there to cover all the other costs associated with running the business and selling the product.
Gross Margin is an expression of profitability as it relates to product or service line after the direct costs associated with the product or service have been taken into consideration.¬† Gross Margin is calculated by taking the Price – Cost and dividing that by the Price.¬† For example, the cheese retailer who sells the cheese for $7.50 and it costs him $5 to buy it has a gross margin of 33%.¬† Same cost and price¬†numbers but very different result.
So why is this important?¬† Because in the food world we’re playing a margins game.¬† Margins are what all experienced food manufacturers, distributors, brokers, and retailers are focused on.¬† This is because your Cost of Goods Sold (also know as COGS) only takes into account those things that directly go into the product itself.¬† So, for you as the food entrepreneur, your COGS would include things like the ingredients, the packaging, and the labor that goes into making your product.¬† However, the COGS don’t take into account things like your overhead, your administrative costs (like getting new printer ink so you can print invoices), or your marketing expenses be they promotions to retailers or simple farmers’ market booth fees.¬† Ensuring that you have healthy gross margins enables you to have enough cash to cover the direct costs associated with making your product and all the other aspects of running your business.
Gross margins can also help you set a price for your sales channel partners.¬† For example, let’s say that you’re that cheese manufacturer we referenced earlier and it costs you $2.50 to make your product.¬† That’s your Cost of Goods Sold (COGS) so that’s taking into account all the ingredients, packaging, and labor that goes into making your product.¬† But how do you determine a price that will cover the rest of your expenses so that your business will actually make money?¬† If you’ve figured out that you need margins of 40% for when you sell your product wholesale then you can arrive at your wholesale price as follows:
Wholesale Price = Product Cost / (1 – Desired Margin)
So, in the case of this example we would get a Wholesale Price of $4.16 ($2.50/(1-40%)).¬† The idea being that this $4.16 is a price the cheese manufacturer believes will make the company a profit even after all costs associated with doing business are taken into account.
If all of this is new to you it may seem a little mind-boggling right now but next week we’ll take a look at the average margins you can anticipate for each class of trade.¬† This will help you price your products¬†in a way that regardless of where you’re selling today you have a better shot of turning a profit today and still¬†have room to grow into retail stores/work with distributors/etc.¬† For right now it’s important that you¬†understand that when it comes to the food industry margins are the universal language.
If all of this is really mind-boggling remember that you do have two product cost & pricing options available via this site.