I read The Hartford’s business newsletter pretty religiously. Some of the issues focus on articles about specific business topics, and others contain BuzzFeed-style lists. This past week’s newsletter contained one such list, which left me wanting to elaborate on a number of topics. I’ve written about being financially literate before, but the #3 Business Mistake in the newsletter list, “Don’t ignore the math,” reminded me of how important it is to know the numbers.
The post-pandemic world is now close at hand, and we’re beginning to see signs of the strain on shipping capacities. In addition, transportation and raw material costs are skyrocketing. Question: How are you insulating your business from these threats to your margins? Because let’s face it: They can crush your margins if you do nothing to protect yourself. We all know that the old adage, “We’ll make it up in volume,” does not work long-term in most cases. Although that strategy can provide a steady cash flow, if your margin gets too thin, the risk grows more and more serious, and a sudden reduction in volume can capsize your business.
Let’s talk about markup and margin.
Markup is a percentage increase above the cost of an item. For example, if a speaker costs me $100 and I sell it for $150, my markup is 50 percent. If a speaker costs me $100 and I sell it for $200, we’re talking about a markup of 100 percent.
Here is the formula for markup:
Markup % = (Sale Price/Cost) – 1
Using the numbers in the second example above, we get:
(200/100) – 1 = 1
The answer 1 translates to a 100 percent markup.
Margin is defined as the gross profit percentage.
If my cost for an item is $100 and I sell it for $150, the margin is 33.33 percent. If my cost for an item is $100 and I sell it for $200, the margin is 50 percent.
Here is the formula for margin:
Margin % = (Sale Price – Cost)/Sale Price
Using the numbers in the second example above, we get:
(200 – 100)/200 = ½
The answer ½ translates to a 50 percent margin.
Why are these numbers important?
On their own, they don’t really affect your day-to-day operation except they may lead to some concerns that your margin is too small, or you may claim some bragging rights instead because your margin is AWESOME. But when combined with other financial information, these numbers can be used to project your breakeven point, to forecast expansion, and to identify how either cost increases or increases in price to the consumer could affect your bottom line. These numbers can also help you figure out whether you can afford to take on additional expenses—and also whether you need to impose seasonal or temporary price increases in order to offset one-time costs. In short, you can use this information to guide you in your business and pricing decisions.
Let’s take a look at the concept of breakeven. To understand this idea, you first need to identify and list your fixed and variable expenses. For the sake of simplicity in this example, I’m going to lump the two kinds of expenses (fixed and variable) together, but keep in mind that utilities and payroll are both variable expenses, and as your business grows or contracts, these two costs can scale up or down in response to your customers’ fluctuating demand for your services and/or goods.
For this example, we will use average monthly expenses, as follows:
- Rent: $3000
- Insurance: $500
- Payroll/Payroll Taxes: $7000
- Cable/Internet/Phone/Electric/Gas/Water/Utilities: $1000
- Interest on Business Loan: $1000
- Office supplies/consumables (not part of the sales process): $500
- Web/Advertising commitments: $2000
- The total for those expenses is $15,000.
If my operating expenses are $15,000 per month, which translates to $180,000 per year, and my Gross Margin (after credit card processing fees) is 30 percent, how much business do I need to do annually to break even?
We take Operating Expenses for the year and divide it by the Gross Margin. Using the numbers cited above, we get:
$180,000/0.30 = $600,000
Suppose the $7000 for Payroll/Payroll Taxes only factored in your employees’ salaries, not your own compensation. In that case, the $600,000 breakeven point keeps your business afloat, but you would have made nothing from the enterprise. There would be nothing left over for you. This calculation also did not factor in any one-time costs (for example, replacing an HVAC, an unexpected repair, etc.).
Now imagine that the $1000/month interest-only loan we factored into our calculation also now requires a principal payment totaling $2000/month. Now you would have to gross another $6666.67/month in sales to reach a breakeven cash flow. Here is the calculation:
- $2000/mo 12 mo = $24,000
- $24,000/0.3 = $80,000
- $80,000/12 [months] = $6666.67/mo
Why do you need to sell more?
Let’s define a few terms before we give an answer to that question. Profit equals sales minus expenses. Cash flow, sometimes called free cash, is the money left on hand after paying expenses and the principal on any loan. (Principal payments also go by the name debt service.) Because interest payments count as expenses, by definition, they have an impact on a company’s profitability, but debt service does not count as an expense. (This is because debt service is not considered to be an expense, like the interest on a loan. Therefore, it cannot be used to reduce your business’s taxable income.) In other words, you could very easily have a profitable business on paper even though you have no free cash on hand due to your business’s debt service. So now let’s answer that question. The breakeven cash flow in our revised example ($680,000) is $80,000 higher than the breakeven point in our original example ($600,000). Why? Because the debt service exceeds the profit.
Now let’s take a look at what would happen if your margin shrank from 30 percent to 25 percent (because the cost of goods rose as a result of a combination of increases in your transportation and merchandise costs). The calculation changes.
- $180,000/0.25 = $720,000
In other words, if your margin dropped to 25% from 30%, without the principal payment, you now need to gross $720,000/year to break even. To break even with the note payment ($2000/month in debt service costs, which translates to an annual total of $24,000/year), the numbers get even worse. Now your annual loan payment totals $204,000 ($180,000 + $24,000).
- $204,000/0.25 = $816,000
Your breakeven point has skyrocketed. Your sales have to grow by nearly $100,000/year more!
Let’s look at what happens if you raised your prices so that you got to a 35 percent margin.
- $180,000/0.35 = ~$514,285 and $204,000/0.35= ~$582,857
You can see that raising your gross margin 5 percent—from 30 percent to 35 percent—lowered your sales requirement from $600k to ~$515k. Margin plays a very big role in the success of your business. Understanding how it works is critical for long-term success in any business. It’s also important to note that in most businesses, the margin is not the same across every product that you sell. In my music store, for example, some brands allow me better margins than other brands. The margins of some brands are 40 percent (when sold at full price), and the margins of some other brands are as small as 15 percent (when sold at full price).
This discussion can serve as an introduction to next week’s topic: sales mix and how it affects your overall blended margin. In the next few posts, I will also address the cost of losing a customer due to higher pricing—and also how many customers you can afford to lose and still remain net neutral with a price increase.
As the world continues to struggle with labor shortages (leading to higher payroll costs), increases in raw materials costs (also due largely in part to the labor shortage), and transportation shortages and price increases (also due largely in part to the labor shortage), it’s important to understand the numbers and how your margin needs to be adjusted (by increasing prices that outpace the increase in cost wherever possible). This kind of analysis allows you to figure out ways to offset the rapidly rising costs that are affecting businesses everywhere. I hope these simple models have helped illustrate for you the basics of margin and markup and what they mean to your business. Like Dorothy in The Wizard of Oz, just keep repeating one phrase over and over again. No, not “There’s no place like home.” Instead: “Don’t ignore the numbers. Don’t ignore the numbers. Don’t ignore the numbers….”