Some confusion is doing the rounds again. Mark-ups and gross margins are mathematically tied to one another, but they are not the same thing. Business owners are generally entrepreneurs, not accountants or mathematicians.
When I ask a business owner what his GP is, it means “what is your gross profit percentage?” The question in its original and colloquial form is deficient in that it leaves out the crucial “percentage” word, but it is never the less a common form of enquiry.
When the business owner responds brashly with “Oh it’s 300%”, he stoops to my level of sloppiness in his understanding because you simply cannot have something which is three times itself. But I understand what he means, which is really: “My mark-up is 300%”.
I know what he means, so we move on. Here is why:
- When you pay 100 ZARs for something and sell it for 200, your mark-up is 100%. If you sell the same article for 300 ZARs, your mark-up is 200%. In the initial exchange with our business owner, what he clearly meant was that if his raws cost him 100 to acquire and increase in value and he sells them for 400.
- 300% is not his margin; it is his mark-up. His margin is 75%. 25% is his cost of sale (or cost of production). Slowly:
- He sells for 400 ZARs (100%)
- To get it ready for market costs 100 ZARs (25% of 400)
- The gross profit he makes on the sale is 300 ZARs (75% of 400)
- His selling price will always total 100% (25% plus 75%)
- If he manages to lower his production cost by say 5 ZARs to 20, but keep his selling price at 400, his cost of production is 20%, and his gross margin is now 80% (20% +80% = 100%) His new mark-up is 400%.
This is why it is important to understand the relationship between the two. Where we talk about large mark-ups of 100% or more, the mistake can be glossed over without any risk to buyer, seller or broker, because it can only ever mean mark-up. But when the mark-up is less than 100%, we have the potential for damage.
Let’s say that a mark-up percentage is 75%. This means that for 100 ZARs of product cost, the business would add 75% of the production cost onto its cost, and sell for 175. The cost of production is therefore 100 divided by 175 as a percentage, which is 57.14%. The margin is now 100% minus 57.14% which is 42.86%.
Getting 75% and 42% mixed up is a potential drama.
Imagine a purchaser asks about gross margin % (gross profit %, GP%, or just plain “GP”). The seller tells him that it is 75% when it is really 42%, causing the purchaser to get excited, put his funds on standby, mobilise his auditors for a due diligence, and consult his attorneys about drafting an offer to purchase.
OK, so generally the damage is a lot less dire, and a good intermediary should sort out the confusion ahead of time. But what about this:
Your mate has just sold his almost identical business to yours, except that he tells you that his margin is 75% when it is really 42%. First you kick yourself for either charging your customers so little, or paying too much for your production, and then with great frustration, you start to make changes to match your friend’s metrics.
Understanding the difference, and understanding that others may perhaps be honestly mistaken is simple, but prudent.