Today, let’s dive into understanding margins and markups, a topic that frequently causes a great deal of confusion for many food and beverage entrepreneurs. However, it is essential to understand if you want to be able to have meaningful conversations with distributors and retailers.
Understanding margins and markup.
One of the first questions you will be asked by both retailers and distributors is “what margin can you offer us?”, the expected answer will be between 25% and 45%.
You need to understand what this means for your food business and if you can run it profitably with these margin demands.
Why Margins and Markup Matter
Understanding margins and markup is crucial for food businesses because it helps you:
- Set competitive prices that ensure profitability
- Negotiate better deals with distributors and retailers
- Analyze the financial health of your business
Now, let’s explore how to apply these concepts when working with distributors and retailers.
The Difference Between Margin and Markup
First, let’s clarify the difference between margin and markup, as these terms are often used interchangeably but have distinct meanings:
- Margin refers to the percentage difference between the cost of producing a product and the price at which it’s sold, expressed as a percentage of the selling price. It’s used to determine the profitability of a product.
- Markup is the percentage difference between the cost of producing a product and the price at which it’s sold, expressed as a percentage of the cost price. It’s used to determine how much to add to the cost of a product to reach a desired selling price.
For example, if a product costs $10 to produce and you sell it for $15, the markup is 50% ($5 increase / $10 cost) and the margin is 33.33% ($5 profit / $15 selling price).
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Let’s talk about Markup first
You’re making or purchasing a product for $40 and you’re selling it for $80. You added $40 to your $40 cost, creating a 100% markup.
Would you be selling the product for $50, you would have added $10, creating a 25% markup on your cost of $40.00.
The $50.00 you’re making in the above example is called your “gross profit”. From this, all expenses involved with running your business are subtracted, leading to the “net profit”, the amount that’s left when all expenses are paid for.
To calculate your markup percentage use this formula
Determine your COGS (cost of goods sold, what it costs you to purchase or make the product you’re selling), in our example, we use $40.
Find out your gross profit. Do this by subtracting your cost from your sales price.
- You’re buying for $40
- You’re selling for $50
- Your gross profit is $10
- Divide gross profit by COGS. $10 / $40 = 0.25.
- Express it as a percentage: 0.25 * 100 = 25%.
That’s your markup formula. If want to do this really quickly and easily, here’s a super useful website that I use all the time, offering all kinds of business calculators.
Let’s talk about Margin next
Markup and Margin are closely related and based on the exact same set of numbers. To put it simply:
- Markup is the percentage your profit is of your cost – a 25% markup on $40 is $10 making for a sale price of $50.
- Margin is the percentage of the sales price that’s profit. Essentially, the same but the other way around.
If we use the above example, we’re buying for $40 and selling for $50, we know this is a 25% markup.
To calculate the margin, since we marked up the price by 10 dollars, and we sell it for 50 dollars, the $10 profit represents exactly ⅕ of the sales price, a 20% margin.
A 25% markup correlates to a 20% margin.
Here’s my personal cheat sheet that makes it easy to quickly take a look at the correlation of margin and markup. Save this to your phone to refer to when you’re in meetings and need to do quick calculations.
How to calculate profit margin
- Your COGS (cost of goods sold) is $40.
- Your revenue, how much you sell these goods for, is $50.
- Calculate the gross profit by subtracting the cost from the revenue. $50 – $40 = $10
- Divide gross profit by revenue: $10 / $50 = 0.2
- Express it as percentages: 0.4 * 100 = 20%.
This is how you calculate profit margin
Explaining the difference between gross profit and net profit margin and why distributors and retailers need to ask for such high margins
Gross profit is simply what you sell something for minus what it costs.
If we buy for $40 and sell it for 80 bucks, the gross profit is $40.
Net profit takes all the expenses involved with running a business into account. It’s how much money you really make.
Grocery stores, in addition to purchasing products, have expenses that include
- Marketing costs (website, advertising, discounts)
- Shrink, for wastage, theft, etc
An average grocery store might shoot for a store-wide gross margin, of 40%, meaning they need to mark your product up by 75% when they buy it from you or the distributor.
Once they’re done subtracting all of their expenses, this typically leaves them with less than 8% in net profit.
The same applies to distributors, who are running a business model along very similar lines.
Let’s look at an example of how the retail price of a food product is affected by distribution and retail margins:
You’re selling a product to your distributor for $10
It costs you $5 to make; you’re applying a 100% markup and a 50% gross profit margin. This needs to power your business and cover all of your expenses.
Your distributor buys the product for $10. They need a 33% margin to run their business, so they mark your product up to $15, a 50% markup, and sell it at that price to retailers.
The retailer purchases at $15 and applies a 43% margin, marking the product up 75% or $11.25, leading to a cost on shelf of $26.25.
Want to learn more?
Read on to learn all about distributor deductions and how they affect your margins and profitability. It’s not pretty, and it’s not fun, but it’s essential to understand if you want to run a profitable food business.