The pricing of a product or service has a very direct bearing on a company’s profitability. Therefore, companies must strive to ensure that they are pricing their goods and services in the most advantageous way possible. One of the key elements in this regard is understanding the value of gross margin rather than mark-up.
Gross margin is considered the most effective metric for pricing goods and services, as it provides companies with an accurate picture of the value of their products and services based on the cost of production. By comparing the prices of goods and services against the total cost of production, companies can identify where costs have been inadvertently covered or taken into account in the final price.
In this article, we will explore the importance of considering price in terms of gross margin rather than mark up, as well as why companies should price each job to a target gross margin. We will also discuss how mark-ups can help set the price but must always be taken into account with respect to calculating the gross margin before a final decision is made.
What is the difference between mark up and gross margin?
Markup is simply the difference between the cost of an item and the price to be charged. It is a percentage of the difference between the cost of production and the sale price, and is generally represented as a percentage of the cost price. For example, if a product costs $10 to produce and is sold for $11, then the mark-up is 10%.
Gross Margin, on the other hand, is the difference between the total cost and the sale price, but expressed as a percentage of the sale price. For example, if a product costs $10 to produce and is sold for $11, then the gross margin is 9%.
Why is gross margin used for pricing?
Gross margin is the preferred method of pricing products and services as it allows companies to accurately identify their profit margins. When using the gross margin method, companies can identify exactly how much of their sale price can be attributed to profit, rather than from other costs. This allows companies to accurately assess the profitability of their sales and to ensure that they are actually obtaining a profit on the sale of their products or services.
In addition to this, companies that employ the gross margin method of pricing are better equipped to identify when a turnover is occurring at a loss rather than at a profit. This early identification is invaluable as it allows companies to address the issue before it has a major impact on their profits.
Price every job to a target gross margin
It is important to price every Job to a target gross margin in order to ensure that the company is properly accruing the profits they set out to achieve in the first place. When pricing a job, a company should determine the total cost of all parts, materials, labour and overheads and then use this information to calculate the price they should charge. Once they calculate the price they should charge, they should then compare it with their target gross margin.
If the calculated price is smaller than the target margin, then the company should look for ways to increase the price without impacting the quality or quantity of the product or service. If the calculated price is greater than the target margin, then the company must look to reduce their costs without compromising the quality or quantity of their product or service.
Use your mark-ups to help set your price
Mark-ups can be a useful tool in assisting companies to price their products and services accurately. When using mark-ups, the company considers their own cost structure as well as that of their competitors. This allows them to more accurately determine how much they should mark up the cost of their product or service.
It is important to note, however, that when using mark-ups, companies should always factor in their target gross margin. If a company is trying to reach a set gross margin and fails to factor in the cost of production and other overheads, then the mark-up alone will not be sufficient to accurately determine their price.
Always calculate the gross margin before making a final decision on price
Ultimately, before making a final decision on price, companies should always calculate the gross margin. Mark-ups can be a useful tool to help set a price but they should always be taken into account in conjunction with the total cost of production and other overheads when calculating the profits a company is set to gain from a sale.
By pricing to a target gross margin, companies can accurately determine their expected profits, as well as identify instances where they will be making a loss on turnover. This allows them to act quickly and make any necessary adjustments to their price or cost structures in order to reach an acceptable level of profitability.
Conclusion
When pricing products or services, companies must carefully consider the method of calculation they are using in order to properly accrue the profits they are set to earn. Gross margin, not mark-up, is the most effective metric for pricing goods and services, as it allows companies to accurately identify their profit margin and avoid instances of making a turnover at a loss. As such, companies should price every job to a target gross margin and use mark-ups to help set their price but always calculate the gross margin before making a final decision on price.