I’m sure you’ll have heard someone say “cash is king”. Well, the full saying goes “turnover is vanity, profit is sanity, cash is king”.
What this means, in a nutshell, is that it doesn’t matter how much money you turn over in business, if there’s no profit then there’s going to be no cash.
But what is profit and what’s the difference between gross and net?
Let’s start with net income or net profit.
In most small or self-employed businesses, you’re going to be most interested in this.
Your net income is your profit after all expenses and costs have been taken off your turnover, as opposed to gross profit, which is simply your turnover minus the cost of your work (this is slightly easier to work out if you’re producing physical products).
For example:
- Your turnover is £1000
- You spent £800 on making your product or delivering your service
- Your gross profit is £200
Let’s look at an example where there’s a tangible cost of the work. You make candles and sell them online. Before you can sell a candle you have to make it, and it costs money to buy the wax, wicks, jars, tins, labels, etc. On top of that, there are other costs like packaging, postage, website costs etc etc.
- Your turnover is £1000
- Your products cost £500 to make
- Your net profit is £500
- Your total spend including everything else is £800
- Your gross profit is £200
These are easy calculations and you can track this every month.
Here’s the calculation:
- Turnover MINUS cost of products/sales EQUALS net profit
- Turnover MINUS total business spend EQUALS gross income (or gross profit)
So now try this:
- Costs DIVIDED by turnover EQUALS net profit margin
- Total spend DIVIDED by turnover EQUALS gross profit margin
So to extend our example:
- Your turnover is £1000
- Your products cost 500 to make
- Your gross profit margin is 50%
- Your gross profit is £500
- Your total spend is £800
- Your net profit is £200
- Your net profit margin is 20%
So what is margin and what’s the difference between that and markup?
Most businesses are more interested in margin than markup, because margin is what you keep from a sale.
You can say “I want to add 30% markup to a product then sell it” or “I want to make 30% margin on my product sales”.
These numbers are NOT the same.
- Your product costs £100
- Your markup is 20%
- You sell the product for £120 (because £100+20%)
Now, you haven’t made 20% on your sale because your margin here will be about 16%. You made £20 profit on a sale of £120 and 20 is 16.666% of 120.
This is why margin is easier to work with, because you set the percentage you want to keep from the sale, not what you want to add on.
So if you say “I want to make 20% margin on all products” then it’s easier than adding markup, which would mean you’d then have to work out your profit margin later down the line based on the profit you made by adding 20%, because we know the answer to this isn’t 20%.
Here’s the same product as above but with margin instead of markup.
- Your product costs £100
- You want your margin to be 20%
- You sell the product for £125
- Your profit is £25
- 25 as a percentage of 125 is 20%
A good calculation for this is cost DIVIDED by the decimal you’re prepared to lose. So your margin is 20% and you’re going to lose 80% of the sale to cost, so that’s 0.8.
£100 DIVIDED by 0.8 EQUALS £125
Of course, 20% profit margin isn’t very good, so you want to aim for more. The calculations will remain similar
- Cost ÷ 0.8 for 20%
- Cost ÷ 0.6 for 40%
- Cost ÷ 0.4 for 60%
And so on.
One of the benefits of using margin over markup is it helps you to control your profit margins.
- £52 cost + 45% markup is £75.40 sell price
- This is about 31% margin
- £52 cost with 45% margin is £94.54 sell price
So, if you set your margin rather than your markup you will know where your profit margins are going to be without having to then reverse engineer it.