Small business Tip of the Week: Don't confuse mark-ups with profits
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My retail clients seem to share common answers to these questions: What is your method for pricing goods or services, and what is your gross profit?
The answer to the first question usually is "two to three times my cost," and the second answer is either "I'm not sure" or a blank stare.
A popular pricing strategy seems to be taking the cost of an item or product, multiplying it by two or three, and arriving at the selling cost. The pricing of two-to-three times cost usually leads to the belief of making a profit of 200 to 300 percent. This always reminds me of my introductions to profit-making and pricing of goods.
At the time, I was working for my future father-in-law, John Ritz, in his retail store. A vendor was calling on him, attempting to sell a product. He told Mr. Ritz, "You can make 100 percent profit selling this item."
I will never forget Mr. Ritz telling the sales representative, "Fella, are you giving me the item? If not, I can't make 100 percent profit." An interesting discussion of making a profit usually followed, with Mr. Ritz prevailing.
The sales representative referred to a markup of the cost of the item he was selling. If he sold the item to a store owner for $1, and the suggested price was $2, then a multiple of two is applied to the item cost. The resulting markup - 100 percent - was added to the cost, which created the $2 sales price.
The profit on the item is very different, but uses the same numbers.
Using the same sales price, $2, less the cost of the item, $1, leaves a gross profit of $1. The $1 in profit is then divided by the $2 sale price to arrive at the gross profit of the sale, or 50 percent. For a retail business, the gross profit of the business is a very important number and one the owner should fully understand.
Gross profit is the cost of the merchandise or inventory sold during an accounting period. A consistent allocation of this "Cost of Goods" expense results in a gross profit number the business owner should use to monitor his business.
For example, if you price your goods to obtain a 50 percent profit, your gross profit on your financial statement should reflect this number. If not, it is time to investigate the cause of a lower-than-expected return.
This time of the year, most retailers are gearing up for the expected holiday sales. This would be a good time to make sure your business model checkup includes verifying your gross profit and pricing structures.
The University of Houston-Victoria Small Business Development Center can work with you in a confidential, one-on-one setting, in your facility. We will be happy to schedule an appointment with you and your business.
Joe Humphreys is associate director of the University of Houston-Victoria Small Business Development Center.