You’ve heard the term many times before and know you should understand it, but what exactly is margin, and how does it affect the price you charge for your products?
There are two types of margins: the gross margin and the net margin. The gross margin is what you make on the sale of a product after deducting the variable costs. Variable costs are those costs that can be directly traced to a sale, for example, the cost you paid your supplier, commissions, merchant fees, and so on. In other words, variable costs are costs that vary depending on sales volume. Variable costs are also referred to as cost of goods sold, or COGS.
Let’s look at an example. Assume you sell shoes, and you charge $50 per pair. You pay $22 to your supplier for a pair of shoes, and Visa charges you a $2 merchant fee on the sale. Your COGS is $24. Your gross margin is $26 and gross margin percentage is 52 percent, which is calculated as follows:
Gross margin = price – variable costs
Gross margin percentage = gross margin / sales x 100%
The net margin, also known as net profit, is what you make after deducting the variable costs and fixed costs from sales. Fixed costs are costs and expenses that must be paid regardless of sales volume, such as rent, salaries, and so on. Using the previous example, let’s assume your fixed costs are $5,000 per month and you sold 250 pairs of shoes. Your net margin would be $1,500, or 12 percent, which is calculated as follows:
- Volume (number of pairs sold): 250
- Sales (price x volume or $50 x 250): $12,500
- COGS (variable costs x volume or $24 x 250): $6,000
- Gross margin: $6,500
- Fixed costs: $5,000
- Net margin (gross margin – fixed costs): $1,500
- Net margin percent (net margin / sales x 100%): 12 percent
With this basic information you can see how margin affects the price you charge for your products. Unless you have a nonprofit organization, you are in business to make money, or at least you need to make money to stay in business. You make money when your net margin is positive; and net margin is positive when your gross margin is more than enough to cover your fixed costs.
Your gross margin depends on price and volume. The higher you set your prices, the higher your potential gross margin. But you still have to be competitive; you can’t raise your price too high or your volume will fall. Using the previous example, if you set your price to $60 per pair but only sell 200 pairs, your net margin is still $1,500. Generally, but not always, the higher you set your prices, the lower the volume of sales. Your goal is to find the right mix between price and volume so that your business generates a positive net margin. Finance people call this price-volume-profit analysis.
If you have one of the lucky businesses with a unique product or brand recognition, you may have some room to raise prices without affecting volume. But be careful not to overdo it.
Ian Benoliel is the CEO and founder of NumberCruncher.com, a developer of inventory and order management software for entrepreneurial businesses.