Margin, Margin, Margin!

To run a business, you must have a basic understanding of a few key metrics. Margin is about as key as you can get. If you don't understand margin, you are already losing money, plus you're a sucker. How did you even get this job? Let's cover the basics quick before someone finds out you don't already know them.

Margin is a percentage of the total revenue produced by a good or service. What the percentage means depends on what kind of margin we're talking about - gross margin or net margin. Gross margin is the relationship between gross profit and cost-of-goods-sold (COGS, also known as 'cost-of-sales' - how much it costs to produce the item or sell and provide the service; 
it doesn't include office expenses, rent, administrative costs, etc.).

Let's do some math:

(Revenue - COGS)/Revenue * 100% = Gross Margin Percentage

Let's say we sell a particular product for $50, and our COGS is $12:

($50 - $12)/$50 * 100% = 76% (or $38 per product sold)

The amount of Gross Margin that you assign to a given product is not arbitrary; although COGS covers your overhead and fixed costs such as wages, etc., it does not necessarily take into consideration the things that make your business last, such as future product development, future growth (including additional payroll), future technology requirements, etc. All of that has to come out of that $38. And if you are partnered with a venture capital firm or your organization is part of a public corporation, you may not see any of that $38 at all.

Another pressure on Gross Margin is competition. If you have a competitor who can produce a similar good or service to yours for a lower COGS, your margin is going to be squeezed. (Think of how the iPad squeezes other tablet makers, and how the Kindle Fire squeezes the iPad.)

In general, depending upon sales frequency (or inventory turns, if you're in retail), you want to choose a Gross Margin percentage that allows you to cover all of the tangibles plus unforeseen expenses such as the above. Once you figure out what that percentage is, and you know the COGS, it's easy to figure out how much to sell the product for:

Gross Margin + COGS = How Much It Costs the Customer

If we know that we want a GM of 6% and our COGS is $32, it goes like this:

((6/(100-6)) * $32 = $2.04 (this is your Gross Margin in dollars)
$32 + $2.04 = $34.04

Here are couple more formulas to add to your tool box:

Net Sales = Gross Margin + COGS

(Gross Margin/Net Sales) * 100 = Gross Margin

And here's one more that is always a toughie: Suppose you have salespeople (even if you don't call them that). How do you figure out whether or not what you pay them (or their manager) is "right"? Easy, and it's a formula that will help you stay out of trouble when it comes to compensation:

An adequate salesperson (or sales manager) should sell 10 times their wage (including commissions, bonuses, and other perks).

See how easy that was? Now gimme 10 laps and hit the showers.

No comments:

Post a Comment