Demystifying Profit Margins and Markups

How Much Is Enough?

There is no one "magic" gross margin to strive for -- they vary dramatically by industry and product type. Even within a single industry, they fluctuate. A large, mass-oriented manufacturer may be satisfied with 20% to 30%, or less. At a massive sales volume, they can be profitable at this rate. However, many smaller businesses strive for a 50% to 70% gross margin. Here are some strategies to figure out where yours should fall.

On the high end, your gross margin should be as much as you can get. The factors influencing this are your own production costs, your retailer's margin expectations and the market price at which your product will sell (this last number is the most important). So if your production cost is extremely low and your product is in such demand that you can sell it for a 1,000% gross margin, go for it!

What about the low end? When is your gross margin too low to sustain the cost of doing business? The answer lies in your goals and expenses. Remember that all your company costs, including salaries, rent, marketing and other operating costs, must be covered by the gross margin earned on your sales. There's a term for this, too -- "net profit margin," or the percentage of money left after paying for all these expenses plus production costs. So what's a decent net-profit margin?

Let's use the following as an example: Assume you can make an 8% to 10% return in the stocks and bonds market, without much risk or effort. You may conclude that you need to outperform this return on any output of capital (investment in your business). In other words, if you can make 8% relatively easily in stocks, you'll definitely want to make a higher net margin on a business venture in which you're putting so much more time, effort and risk.

Back to gross margin. You'll know it's too low if you find you're unable to meet the costs you regularly incur to operate your business. In this case, you have two options: Find a way to lower your production and operating costs, or raise your price.

A final factor to keep in mind: Your gross margin may grow over time. In the early stages, manufacturing runs are often smaller (thus more expensive per unit). Plus, you need to create demand for your product, so you don't want to set your price too high. Therefore, you may need to forgo large profits in the beginning to get a sense of your market and create sales traction. Then, once your demand begins to grow, your production costs will decrease and your gross margin will grow.