Retailing is not third grade math
Why we need to learn margins, turn, and dollar contribution
Math was easy for most of us for the first couple of years of elementary school; just adding and subtracting. The challenges of math picked up when we got to the point of learning multiplication. With the help of a teacher and plenty of practice, most of us mastered the concept doing some of it in our head and the rest of it with pencil and paper.
Visiting with retailers, we are finding many are putting that skill to work as they determine the price of the products they sell.
Take the cost of the item and multiply it by a certain number and you have the selling price. This has become the dominant factor in determining the price meaning the only consideration in the selling price of any item is what it cost you. One of the most obvious downsides to this is the occasion when the competition is able to buy the same item for a lower price and, when using the same pricing strategy, will have a lower price than your store.
This seems to defeat the purpose of going to a trade show and finding new merchandise for your store. If you find a better deal (lower cost) it means there is no advantage to you. And when you find that item that none of your competitors are stocking, it means that you will not be squeezing out some additional margin by being exclusive.
When you go to the trade show, for most of us there are expenses such as hotel, meals and airfare. There is also the added expense of additional help to cover the salesfloor in your absence. For many stores this just becomes an operating expense. However, for some finding these deals and unique items is a way of gaining some extra margin which will in turn pay for the expense of attending the trade show. Today we need to take a look at all of this and consider the possibility of an alternative plan.
Looking at an initial item for an example, take the cost of an item ($2.00), multiply the cost by two (often referred to as “keystone”), and you have the selling price of $4.00.
As the cost is half, or 50%, of the selling price you have a 50% margin or markup. All you have to do is decide what number you are going to use to multiply the cost; right? It could be two, three, four, or even something like 2.5 times the cost.
All of this is so wrong for so many reasons. As a buyer of merchandise, you have many responsibilities. One of those is to determine the selling price of an item. Another is to make as much profit as you can using the three ways we discuss later in this article. A third responsibility is ordering the right quantity which can be a factor of what the selling price is as well as working to see that you minimize the amount of left over merchandise and markdowns for products that have a seasonality to them. Let’s start with our explanations of what is wrong and ways to improve the way you are buying and selling merchandise.
The first reason is that in using a multiplier you can be assured you will more often be pricing the item too high or too low as compared to getting the price right. What we find is that retailers too often use a basic formula; cost multiplied by a certain number for thread; another for zippers; a different multiplier for fabrics, and so on.
When you find a unique thread that no one else in the area stocks, you are going to have the same multiplier as the thread that even the chain stores have. In this example you will likely find the thread that is the same as the chain store is priced too high and the unique thread is priced too low. Your customer may see how you have priced the common thread and walk out after seeing your priced. You will not even have the time to tell them about the thread and other products you have that are unique.
There is even another unique, but not correct, method of determining the selling price and calling it a margin or markup. This is when the buyer takes our example item with a cost of $2.00 and says they want a 50% margin or markup.
Knowing that 50% of the $2.00 cost is $1.00, they add the $1.00 to the $2.00 cost to have a selling price of $3.00; we aren’t sure what to call this one.
Our second reason this is wrong is that cost should nothing to do with what something is sold for. The determining factor for the price is asking, “What will the customer pay for this item”? Once you have made that decision we can then consider how we are going to sell the item and if it is worth the effort of stocking the item. This is where other buyer responsibilities come into play; deciding where and how to display the item within your shop. The buyer also needs to know when the peaks and valleys of the sales cycle is for that item. Without these considerations we will have too much inventory at some point during the year. However, in answering the question of what the customer will pay for the item, we are going to look at more than just margin in another of our reasons.
If cost is the sole determination factor in how something is priced, consider the situation in which you have decided to add a new line of thread. At the show you place an order which provides a new display rack as well as plenty of spools of each thread. It is the best price you can get for the thread. With that cost in mind, you establish the retail price.
As you continue to sell through the product, you need to reorder. However your order is not sizable enough to place an order through the manufacture so you order the thread, at a higher cost, from a local wholesaler.
Now how do you price the product? Using the current technique for pricing, aren’t you going to have some colors at one price and other colors of the same thread at a different selling price?
The customer does not care how you purchased the thread. The only issue for them is deciding which color and if they believe it is a fair price. Perhaps we have too often hear the advertising by other businesses, especially auto dealerships, who state, “We buy for less so we can sell for less”.
That may be a neat advertising tag line, but realistically, why would you work hard to pay a lesser price for an item followed by selling for a lesser price? All this means is that with this extra effort, you are going to be making the same profit as the other businesses. It should be that by being an exceptional buyer, you will have increased margins and increased profits.
If you are the buyer working for the owner of the store, the only way you are going to get an increase in pay is by your increasing the profit; not just increasing the sales. Your additional pay has to come from additional profit.
The third reason this is wrong is the aspect of the terms, “margin” and “markup”. No, they are not interchangeable. The margin is calculated as we previously described. Note that the math for margin is the same as what is used in your profit and loss statement. Hence, it is the “correct” reference for retailing.
Markup, using the same cost and retail as previously described, is 100% because you are taking 100% of the cost and adding it to the cost of the product to determine the retail price.
You can never have a margin that is 100% (this would mean you got the merchandise for free) and if you use markup, you can have an answer that is higher than 100%. If there are two of you in the conversation, you and the sales representative, you should make sure both of you are using the same terminology and the same method of calculating the answer.
However, in considering the suggestion of the sales representative for the selling price of the item, remember that in today’s market the idea of items having the same price in every retailer that stocks the item has gone by the wayside.
The fourth reason is that so far we have talked about margins and markups. What is important when you want a profitable store is that you look at the checking account and the profit and loss statement. Both of them use dollars; not percentages.
Let’s take a look at three methods are making as many dollars as possible in our store. We will call the three methods turn, dollar contribution, and margin. Each of them have the appropriate place in your store in creating the best opportunity for profit as well as not having your customer see you as a high priced local store.
There is one of the most expensive items in your shop. It sells for $999.99 and has a cost of $700.00 to your business. For the past several years you have sold, on average, two a year. The gross profit this item drives to the bottom line of the profit and loss statement of your business is just under $600. each year. Your gross margin on this item is 30%. (To calculate the gross margin you take the selling price and subtract the cost to determine your gross profit. The second step is to divide the gross profit by the selling price. The answer, stated as a percentage is your gross margin. And remember, we do not use markup!)
With this item you have only two of them in the shop at any given time. When you sell one, you reorder one so that you are never out of stock. This is referred to as, “One to show and one to go”.
Out second item sells for $2.00 and has a cost of $1.75 meaning with each transaction you make twenty-five cents as a gross profit. Using the math we just explained, the gross margin is a mere 13%, however over the course of the year your shop sells 2,400 of this item. That twenty-five cent profit along with the quantity you sell drives $600. to that same bottom line of the profit and loss statement. And as you are reordering this product every two weeks, the turn rate is tremendous.
If you are selling 2,400 of this each year and have only 200 on the shelf at any given time, your turn rate is 12. This is calculated by dividing the quantity sold by the average quantity on hand in the shop.
The third item is selling for $9.99 and has a cost of $6.00 meaning you have a gross profit of almost $4.00 on each sale. Over the same year, your shop sells 150 of this item. And, using the same formulas offered previously, we find this item has a 40% gross margin and drives $600.00 to the profit and loss statement bottom line. The turn rate on this may be a mere two or three times a year.
Of the three methods offered, which one do you want for your quilt shop? It is a trick question as the correct answer is that you want all three methods in their appropriate places. You also note that all three create a gross profit of $600 for your business. You pay bills with this cash; you do not pay bills with the percentages in the margins (or markups for those we have not yet convinced to change). Dollar contribution, turn rate, and margin are all necessary so that your merchandise is priced right.
Using only the multiplier of cost factor is sure to leave you with many items that are priced incorrectly. Through all of this we have found multiple factors that should be considered in determining the selling price of each and every item in your shop. Determining the correct margin is definitely not third grade math.