Profit

Part III of a Four Part Pricing Series (Part I, Part II, Part IV)

If, hypothetically speaking, you were to set your wholesale prices to match your total costs, you would break even as a business. All of your bills would be covered, and everyone would be getting paid, since you factored wages and salaries into your costs. The problem is, the business itself wouldn’t be generating any profit. But why do you need to make a profit? Why not set your product prices at their break-even points, and dominate the market as the low price leader? Amazon is famous for this strategy — at this writing, Amazon is the 18th highest-revenue business in the US, but its total profits for its entire existence are less than what ExxonMobil makes every 2.5 weeks.¹

Amazon’s approach is highly unorthodox and it would be insanely risky for most businesses. It is only viable for them because of the large market share they captured in the early days of e-commerce. Furthermore, the reason they’re taking this approach is because their long term goal is to eliminate a specific competitive advantage that neighborhood brick-and-mortar shops have over e-commerce: proximity. Eliminating proximity from a customer’s decision process would give them a nearly endless market share. Free, next day delivery isn’t enough for Amazon, so they’re actually exploring the possibility drone delivery within minutes of placing your order.²

Amazon is publicly traded and has access to vast amounts of capital to finance its growth and development, whereas most businesses must rely largely on the profits they make selling their goods and services. Therefore, profit must be figured into pricing on top of costs so that there is money available to finance a business’ growth and development.

Profit doesn’t have to be retained within the business, of course — it can be disbursed as bonuses for employees and profit sharing for partners. But retained profits are an important source of finance for most privately-owned businesses, among other reasons because the business is not beholden to any outside investors or lenders for how profits are used. It is also a cheap source of financing when compared with the interest that must be paid on a bank loan.³

Retained profits can be used for any number of improvements, such as purchasing new equipment, increasing storage space so that you can order supplies in larger volume, investing in software upgrades, giving raises to your employees, building cash reserves for emergencies, remodeling your building, or increasing your advertising and marketing spend. Of course, many of these expenditures will increase your costs in the short term, but if made wisely, they should pay for themselves through increased sales (marketing or advertising) or through reduced long term costs (larger volume supply purchases means reduced cost per unit).

In short, profit creates breathing room for a business. It is indeed so vital for a business that it should be treated like a fixed expense, such as a loan payment or payroll. Build it into your wholesale price, and it will always be there to fuel your growth.

Calculating Profit
In the previous couple posts, our woodworker’s Gross Profit and Net Profit were said to be as follows:

The terms “gross” and “net,” as applied to profit, refer to which costs are taken into account. Gross only takes COGS into account, while Net takes both COGS and Overhead into account.

Gross Profit (GP) is what you get when you subtract COGs from your selling price. If it costs our woodworker $13 to make a cutting board and she wholesales it for $25, her Gross Profit per sale is as follows:

GP = Price — COGS = $25 — $13 = $12

Gross Margin (GM) is the percentage that results when you divide your gross profit by your selling price. For our woodworker, that would look like this:

GM = GP / Price = $12 / $25 = .48

Thus she is fetching a 48% margin on this style of cutting board.

Note: In wholesale and retail, Gross Margin is what is referred to when someone simply says “Margin.” Margin does not include Overhead Expenses (that would be Net Margin, see below). This is because pricing discussions generally focus on gross margin instead of net margin, since it is assumed that part of the margin will be used to service overhead costs.⁴

Net Profit (NP) is what you get when you subtract your overhead expenses from your GP. Now that we understand GP, we can calculate our overhead expenses using our 30% overhead percentage (from previous post), as follows:

Overhead Expenses = GP x 30% = $12 x .30 = $3.60

Her NP per sale, then, is:

NP = GP — Overhead = $12 — $3.60 = $8.40 (pre-tax)

Net Margin (NM) is the percentage that results when you divide your net profit by your selling price. For our woodworker, that would look like this:

NM = NP / Price = $8.40 / $25 = .34 (pre-tax)

Thus she is fetching a 34% net margin on this style of cutting board.

Note: In wholesale and retail, Net Margin is what is commonly referred to as “Profit Margin.” It is the the famous “bottom line,” and the most comprehensive measure of a product’s (or company’s) profitability.

A business’ margin, then, must be sufficiently large to accommodate both overhead and whatever NP the business requires to finance its growth and development. This figure will depend on the business and industry, but any small wholesale producer should shoot for something in the range of 40–60%.⁵ ⁶ ⁷ This range of margin is important for two other reasons:

1. Your margin is what gives you the ability to weather volatility in the cost of your materials and supplies, as well as shipping costs.
2. Margin is an important measure of the profitability of a business, and profitability strengthens your application for loans and appeal to potential investors.

Some businesses have higher overheads than others — for example, a business with a retail location will likely have a higher rent overhead than a business that is strictly wholesaling their goods. On the other hand, if a business’ overheads are comparatively low, then its owners can yield an acceptable net profit from a lower margin, meaning that they can afford to wholesale their products for less than the competition if they so choose, resulting in a lower shelf price.

On that note, let’s turn to the final factor that goes into our wholesale price: shelf price.

Up Next: Part IV of IV

¹ http://www.investopedia.com/stock-analysis/031414/amazon-never-makes-money-no-one-cares-amzn-aapl-wag-azo.aspx
² http://www.nytimes.com/2016/08/11/technology/think-amazons-drone-delivery-idea-is-a-gimmick-think-again.html
³ http://www.tutor2u.net/business/reference/finance-how-is-profit-used-by-a-business
⁴ http://www.investopedia.com/terms/g/grossmargin.asp
⁵ http://www.modernsoapmaking.com/knowing-real-cost-products/
⁶ Good Food, Great Business, Susie Wyshak, Chronicle Books, 2014, p164.
⁷ http://gredio.com/blog/how-to-price-your-food-product-and-still-make-money/