This is Part Two of our series making sense of finance in the marketing process.
In our previous article on Finance for Marketing Managers, we looked quite closely at the first item of the Income Statement, namely Sales and the revenue coming from the effort of selling.
We saw that determining the price upfront was important and that this was not at all an easy task: make a small mistake and the effect can be catastrophic or at least not fixable before one business cycle is over.
Cost of Sales
Now let us go to the next item on the Income Statement, namely Cost of Sales (or ‘cost of the goods sold’ as we have it in the sample Income Statement here).
This refers to the cost of purchasing the materials (inputs) plus production cost plus all costs incurred to make the goods (or services, of course) saleable. Or in graphic form:
These expenses are directly related to the production process and are in the main variable because they happen only if production or sales happen. The more bottles of a soft drink you produce (if you remember our previous article), the more of the liquid and water you will need for this. So, the more you sell the more of these costs you incur:
This means that given the production process, the direct cost of producing one unit of sales is constant.
Marketing decisions may have substantial impact on this section of the income statement. So, for example, a decision to slightly change the shape or size of the product, may affect the cost of sales if more expensive materials are needed or if the process of production becomes more time consuming etc.
The next item on the Income Statement that comes to our attention here is the Gross Margin. The Gross Margin is what you get after you deduct the direct costs of the sales. You can express this either as a percentage of sales or as a percentage of the cost of sales.
Let’s work this out on an example:
The Gross Margin here is 75% of the cost of sales [i.e., (299,000/401,000) x 100], or 43% of sales [i.e., (299,000/700,000) x 100].
What is important to remember is that this is the net result BEFORE you deduct overheads (overheads are costs that are fixed, and not dependent on the volume of sales, for example, advertising is an overhead as that cost will be incurred irrespective of how many units of the product you manage to sell). You can use this margin as an indicator of your performance and to boast that you are selling above expectations BUT we shall come back to overheads as these are quite important and should be monitored. Your selling activities might influence the overheads and that should be taken into account.
Net Profit Before Tax
The net profit before tax is also a margin — in this case, the difference between sales
revenue and total operating costs, i.e., all costs including overheads and not only those costs that vary directly with volume of sales. Thus, when the term ‘margin’ is used it is
important to determine exactly what costs are being considered in order to arrive at
that particular margin, Gross or Net.
Not visible in this Income Statement, but also important, a mark-up is not always the same as gross margin:
Applying These Concepts to Real Life
Case Study One
Suppose you bought 100 items at USD 10 each and you wish to sell at USD 15.
Your planned mark-up per item is USD 5, i.e., 33 1/3 per cent on selling price or 50 per cent on cost. You may expect both your total mark up and gross margin to be USD 500.
But if you diversify your markets and sell 80 items in one market at USD 15, and 20 items in another new market that you want to enter at USD 13, and you incur costs of USD 0.50 each for making changes in the product, your total gross margin will be:
The gross margin is now less than mark-up because we have to adjust the cost of goods sold.
Case Study Two
Another example: an item which costs a manufacturer USD 4 might be sold to a distributor for USD 5. This will yield to the manufacturer a mark-up of USD 1. How do we express this?
This mark-up may be expressed as a percentage of the selling price (USD 5) or as a percentage of the cost (USD 4):
So be aware as to the basis of calculating a mark-up! Retailers normally express mark up on selling price, but do not make any assumptions! Clarify before you enter into a contract or before making your final calculations for next year’s plan.
Setting the Price
Once the cost and mark-up percentages are known how do we then set the price?
Say one Gisgo item costs USD 10 and the desired mark-up is 40 per cent on the selling price; what should the selling price be?
Let’s look at it differently: if the point of reference is the price, let’s assume P is 100. Then the mark-up is 40 and that makes the cost 60.
So the price 100=
To convert a mark-up expressed as a percentage of selling price into one expressed as a percentage of cost use this formula:
In the above table the 40 as a % of C is simply
To convert a mark-up expressed as a percentage of cost into one expressed as a
percentage of selling price:
Taking our example in the table above, it is simply: (40/60)/(1+40/60)=40%
Another way to do this: note that 40% is equivalent to 4/10 or 2/5 and 67% equivalent to 2/3
And vice versa:
If you want to practise further…
The calculation of mark-ups is usually more complicated than this because several intermediaries will be involved.
For example, look at the following situation:
The net profit margin percentage is unlikely to be the same as the gross margin percentage for a particular firm. The reason for this is that a seller's costs generally include more than just the cost of goods sold.
In the example above, the manufacturer's variable costs were EUR 1.00, leaving a gross margin of EUR 0.50 per unit, but of this EUR 0.50, say that another EUR 0.25 had to be allocated to cover other non-manufacturing costs of producing and selling this item, like for example marketing, administration and other office costs. Thus, the net profit margin of the item would be EUR 0.25 per unit. Thus, the net profit margin percentage would be 16.7 per cent.
What is important for you is to understand the story when you are presented with numbers. And do not think that whenever numbers are presented to you these numbers always make sense! You must ask questions without fear in order to ensure that you get the right messages from these numbers.
What is a markdown?
A markdown is the reduction from the original selling price to a new selling
price. For example, suppose a retailer was offering an item purchased for GBP 3.00 at
GBP 5 (a mark-up percentage on selling price of 40 per cent) and later marked it down
to GBP 4 to be able to mobilise more sales. In other words, a GBP 1 markdown has been made. To convert this to a percentage on selling price, the new selling price is usually used.
So the markdown percentage is 25% ( 1/4 x 100).
What customers would be told will depend on the policy of each company. In this case would the item be offered at 20% or 25% discount?
Back to the Income Statement…
It is important to note that gross margins, mark-ups, discounts and markdowns do not appear directly on the income statement. The income statement will only show prices and costs that have been agreed and relate to actual transactions. However, most marketers
keep careful records of gross margins, etc., to assess marketing performance in general and of individual items' performance in particular.
We shall therefore come back to the Income Statement to see how you will use the information there in relation to the information like mark-ups which is kept outside the Income Statement.
In fact, in our next article we will start with Marketing Costs. See you then!