Are you looking for a good metric to inform your approach to inventory management? Consider turning to your profit margin. Determining your business’s profit margin is an important part of inventory management.
Profit margin can help you determine two primary things: whether your business is performing well with the inventory you’re stocking and whether certain items should be marked up more in order to realize an optimum profit. Combined with inventory forecasting, which gives you a data-based picture of how many items you need to stock to account for demand, profit margin is a powerful tool.
What Is Profit Margin?
Profit margin is a mathematical expression of profit — it’s the amount of money your business takes in, expressed as a percentage that takes into account your business costs. For our purposes, there are two types of margins to consider: gross profit margin and net profit margin.
- Gross profit margin: The difference between the sales price and the total cost of production, including labor cost and material cost.
- Net profit margin: The difference between total business revenue and total business expenses.
While net profit margin is a useful KPI for the entire business, gross profit margin is the more useful KPI for inventory management. That said, your net profit margin reflects the overall success of your strategy. If you’re calculating the effectiveness of inventory forecasting as well your ROI for marketing spend, your net profit margin tells you what you need to know. One way to maximize your net profit margin is to choose a free inventory management tool that allows you to improve efficiency without subtracting from your bottom line.
Profit Margin vs. Revenue
While the profit margin takes costs into account, revenue is the total amount of money your business brings in, with no consideration of business costs. Part of your revenue will go towards acquiring inventory, part of it will go towards operating the business, and the rest will be realized as profit.
What Is Markup?
Markup is the dollar amount you add to the cost of products to set sales prices. You can express markup as: selling price minus cost, divided by cost. For example, if a product costs you $20 to produce (including the cost of labor) and you sell it for $60, the markup formula is ($60 – $20) / $20 = 200%. In other words, you’re marking the product up 200%. Your markup amount determines your profit margin.
Profit Margin Formula
For your inventory management needs, the gross profit margin is the most applicable profit measurement form. The gross profit margin formula is:
Net sales – total cost of inventory / net sales = gross profit margin;
You express the final number as a percentage. For example, if you recorded $8,000 in sales for a single month and your inventory cost was $6,500, the profit margin formula would look like this:
$8,000 – $6,500 / $8,000 = 18.75%
You can use this formula to drill down and determine the profit margin for various product categories, or you can use it to figure out the profit for all categories combined.
How to Calculate Markup
To calculate markup amounts, consider your operating costs in addition to inventory costs, and ultimately decide how much profit you need to realize in order to meet your long-term goals.
Answering the question, “How much should I mark up my products?” is not as simple as it might seem. When deciding markup, you must choose between revenue maximization and profit maximization. A high markup will earn you a greater profit for a product category, but could decrease revenue if you sell a lesser quantity of the product. Potential customers may be turned away by the high price of a product.
Additionally, Entrepreneur’s Randy Myers notes that a high markup doesn’t mean you’re realizing a good sales margin. In one case, a Silicon Valley entrepreneur thought his highest-priced product was delivering the biggest profit margin, but it turned out the customers that were ordering the product were costing him a lot of money on customer service after the sale. Once he featured his lower-cost, higher-profit-margin products more prominently on his website, sales went down by about $1 million but profits rose by about $150,000.To calculate the ideal markup, integrate business software solutions to get an easy look at all sales, shipping, and inventory data. This will give you an accurate view of your costs versus your sales. Then use profit maximization strategies and consider lowering the markup on products that aren’t doing as well. Improve marketing and placement of products that have good profit margins. Keep an eye on profit margins month to month, and you’ll have a better understanding of how you’re doing when it comes to markup.