There are two common models for figuring out what to charge your customers: Markup and Margin. And confusing these two concepts can have disastrous results on your dealership’s profit and overall sustainability.
Figuring Price By Markup
Many dealers and remodeling industry professionals choose to “markup” a percentage on top of their cost to figure out what to charge a customer. The formula looks like this:
Markup = Cost * (1 + Markup%)
Joe Markup is a sales rep for Cabinets At a Loss, Inc., and he prices by the Markup method. He also does not understand the difference between Markup and Gross Margin. He has a new customer and a kitchen which costs out at exactly $1,000 (hey, it’s my example and it’s easy math). A 28% markup means Joe will charge his customer like this:
1,000 * (1 + .28) = $1,280
Joe smiles because at a 28% Markup/Margin (remember he sees Markup and Gross Margin as identical) he’s a happy camper. It just so happens that his overhead is 24% so he thinks he just pocketed 4% profit (28% – 24%) in the bank. Not bad for a few hours work, right? Well, not really.
In fact, it is so “not really” right that it is causing Joe Markup to be unprofitable and threatening the livelihood of his business. He just doesn’t know it yet.
Figuring Price By Gross Margin
Gross Margin is the money you have left over after paying your Cost of Goods. The formula looks like this:
Gross Margin = Revenue – Cost of Goods
To compute your Gross Margin Percent the formula looks like this:
Gross Margin Percent = ( (Revenue – Cost) / Revenue ) * 100
Kevin Gross Margin is a sales rep for Cabinets At a Profit, Inc., and he prices by the Gross Margin method. He intimately understands the difference between Markup and Gross Margin. After all, it’s his last name. Kevin has a new customer and a kitchen which just so happens to also cost out at $1,000. Interestingly enough he also runs at a 24% overhead and wants to target a 28% Gross Margin. To do this, he calculates the price as follows (notice I rearranged the formula a little so Kevin can compute the desired Revenue in the formula):
Revenue = Cost / (1 – Gross Margin Percent)
Revenue = $1,000 / (1 – .28)
Revenue = $1,389
Hmmm. Comparing the two examples, Kevin Gross Margin netted an additional $109 ($1,389 – $1,280) over Joe Markup’s method. What just happened? Let’s look a little further by computing the actual Gross Margin Percent Joe Markup was obtaining:
Gross Margin Percent = ( ($1,280 – $1,000) / $1,280) * 100 = 21.88%
Wow. That doesn’t even cover his 24% overhead. He is actually more than 2% under his overhead figure with a Markup of 28%, so he’s running at a net loss. So what would Joe Markup have had to charge as a Markup % to yield the same profit as Kevin? Here’s the formula:
( (Revenue / Cost) – 1 ) * 100= Markup %
( ($1,389 / $1,000) – 1 ) * 100 = 38.9%
Ouch. Joe Markup’s 28% was a little shy of what it really needed to be. More than 10 percentage points shy in this example, and that’s just one job. Sadly enough, Joe Markup is losing his shirt on every job and smiling as he accepts his customer’s down payments to begin work.
Why did these two methods yield such different prices to the customer?
Because Markup and Gross Margin are two totally different concepts. You can’t compare Markup to Gross Margin just like you can’t compare Markup to your overhead percent. It’s like comparing cow patties and a rose: two completely different things that smell very different upon closer inspection.
Let’s put it another way: a 28% Markup is equivalent to a 21.88% Margin!
In summary, Gross Margin is a superior way for dealers and other industry professionals to price their jobs for several reasons. First, it does not obscure your net profit since it allows you to compare roses to roses. Second, you can ensure your Gross Margin % is always enough to cover your overhead % you so frequently see the numbers for, so you know you’re making money. And third, if you teach Markup to your sales reps, you also have to teach them Gross Margin anyway so they understand the difference to price correctly. Great, yet another area for sales people to make mistakes – like we don’t have enough of that going on already!
So why not just teach them one concept that everyone can understand and communicate clearly from? Gross Margin, it’s the only way to go.