Two shops on the same street take £5,000 a week. One of them is comfortable and the other is three bad weeks from closing. The difference is not turnover. It is what is left after the cost of what they sold, and one of them has never worked it out.
Turnover is the number people quote at each other. Gross margin is the number that decides whether the business survives.
Margin and markup are not the same thing and the gap is expensive
Buy something for £6 and sell it for £9. Your markup is 50%, because you added half of the cost. Your margin is 33.3%, because £3 of the £9 you took is gross profit.
Markup is calculated on cost. Margin is calculated on the selling price. They are always different and the difference grows as the numbers rise:
- A 25% markup is a 20% margin.
- A 50% markup is a 33.3% margin.
- A 100% markup is a 50% margin.
- A 200% markup is a 66.7% margin.
Businesses lose money by mixing these up. A trade counter told to work on 30% by an owner who means margin, while the person pricing is applying a 30% markup, is giving away roughly seven points of margin on every line. On £400,000 of sales that is £28,000, which is more than most small businesses make in a year.
Do the arithmetic in the direction that gets you the price: selling price equals cost divided by one minus the margin you want. Cost £6, target margin 40%, so £6 divided by 0.6, which is £10. Write that on a card and keep it by the till.
One more thing to get right: use figures excluding VAT. VAT is not yours, it is collected on HMRC's behalf, and including it in either the cost or the sale makes every margin calculation wrong.
A small change in margin outruns a large change in sales
Take a business with £300,000 of sales, a 40% gross margin and £100,000 of fixed overheads. Gross profit is £120,000, so net profit is £20,000.
Now push sales up by 10% through a promotion. Sales become £330,000, gross profit £132,000, and if overheads hold, net profit is £32,000. A 60% increase in profit for a considerable amount of work, extra stock, extra hours and extra risk.
Now instead raise prices by 4% and keep the volume, which moves the margin from 40% to about 42.3%. Sales become £312,000 and gross profit becomes £132,000. The same profit increase, with no extra stock, no extra staff and no extra work.
The point is not that price rises are free. Some volume will go. The point is the leverage: because your fixed costs do not move, everything gained at the gross margin line falls through to the bottom. Equally, margin lost through discounting has to be replaced by a large amount of extra volume just to stand still. If you discount 10% on a 40% margin, you now need to sell a third more to make the same gross profit.
Cost of sales includes things you have not been counting
Gross margin is sales minus cost of sales. The arguments are all about what belongs in cost of sales.
Direct materials obviously. Carriage inwards, because the delivery charge to get the stock to you is part of what it cost. Packaging that goes out with the product. Waste, breakage and theft, because the stock you paid for and did not sell still cost you. Discounts given, because a sale at 10% off is a sale at 10% off, whatever the ticket said.
Labour is the one that splits trades. In a manufacturing or food business, the wages of the people making the product usually sit in cost of sales, because they rise and fall with output. In a shop, the staff are usually an overhead, because they are there whether anyone comes in or not. Either treatment works. Inconsistency does not, because the whole value of the number is being able to compare it with last month.
The most common error in a stock business is calculating margin from invoices instead of from a stock count. If you take opening stock, add purchases and subtract closing stock, you get the cost of what actually left the building, including the part that left through the back door. Businesses that never count stock are usually reporting a margin two or three points better than the one they are earning.
Track it weekly or it tells you nothing you can act on
An annual set of accounts tells you your margin about nine months after you could have done anything about it. By then the supplier price rise you did not notice has run for a full year.
Weekly is enough for most businesses. Take the week's sales excluding VAT, the week's cost of sales, and write the percentage in the same place every Monday. What you are looking for is not the level but the movement. A margin that drifts from 44% to 41% over six weeks is telling you something concrete: a supplier has put prices up, someone is discounting, your sales mix has shifted towards the low-margin lines, or stock is going missing.
Blended margin hides all of this, so break it down where you can. Most businesses find that a small number of lines earn most of the gross profit, and that at least one popular product is close to being sold at cost. That is usually the discovery that pays for the exercise.
Where this shows up in the game
Business Baron calculates gross margin per product line, per week, from actual stock movements rather than from list prices, so waste and theft show up where they belong. Supplier costs move as the years run on from 1930, and a business that never revisits its prices gets slowly squeezed without anything visibly going wrong. Watching a margin drift two points over a game year is a cheaper lesson than watching it happen in a real shop.