- The costs in running a business are separated into two categories: Fixed and variable. Fixed costs are those expenses that must be paid every month, regardless of the sales volume. These include rent, utility bills, administrative salaries and insurance premiums. Variable costs are those related to the cost of production, and vary with sales volume. These are the costs of direct labor, materials and supplies related to production.
Gross profit is calculated by subtracting variable costs from the sales volume. This figure is expressed either in dollars or as a percentage. A product that sells for $15.00 and has direct cost of manufacture of $10.00 would produce a gross profit of $5.00, or 33 percent ($5.00 divided by $15.00 equals 33 percent). Gross profit is then used to pay fixed expenses, with the remainder being the net profit of the business. - Mark up is a method used by many businesses to set the selling price of their products. It is determined by multiplying a product's direct costs by a percentage. For example, if a product cost $10.00 to manufacture, then a 50% mark up would produce a selling price of $15.00.
While every business owner wants to mark up his products as much as he can to maximize profits, he cannot charge more than the market will bear. Conversely, if his mark up is too low, then profits will be lost. Every industry has a rule of thumb used as a guideline for mark ups. Grocery retailers have a mark up of around 12 percent, while the clothing industry uses a mark up of 100 percent or more. - Since gross profit is used to pay fixed expenses, it is important for a business owner to know what kind of sales he needs to generate to cover his overhead expenses and make a profit. If fixed expenses are $100,000, for example, and the business produces a gross profit of 20 percent, then the owner will need $500,000 in sales to break even ($100,000/.20 = $500,000). The owner then knows he must generate $41,667 in sales ($500,000/12) every month to cover his costs.
The mark up method gives the owner a starting point to price his products. However, over time, discounts and special sales pricing will erode the overall mark up for the business. An owner has to monitor the final mark up on each product to find the proper balance between price and demand. - It is important to make the distinction between gross profit and mark up in evaluating the performance of a business. A mark up of 50 percent does not produce a gross profit of 50 percent; it produces a gross profit of 33 percent. An owner would be mistaken if he thinks that he is making a 50 percent profit, or that it should be enough to cover fixed overhead expenses. Continuous evaluation of mark up and gross profit will enable the manager to measure the health of his business, and make adjustments to selling prices and costs when necessary.
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