I want to show you some simple math that you can use in your shop to help make you more profitable.
By Jim Rickoff
Admittedly, the headline of this column is pretty bold, coming from a guy who was a national sales manager for 15 years. However, in this article I want to show you some simple math that you can use in your shop to help make you more profitable.
Having a mother who taught math for over 30 years has probably given me a greater appreciation for math than most people. But you don’t have to have a strong math background to understand profit margin and how it relates to sales. Let me explain.
Cutting prices to increase sales is probably the worst business practice a shop owner could do. In fact, cutting prices or charging too little could have a disastrous affect on any business.
For ease of example let’s use some simple numbers. Let’s suppose you sell 100 items a month at $1 each and this product costs you fifty-five cents each. Your gross profit margin would be $45 or 45 percent.
Gross Profit Margin (GPM)
GPM = Sales - Cost
Gross Profit Margin Percentage (GPM%)
GPM% = (Sales-Cost)/Sales
For review, remember that gross profit margin (GPM) equals sales minus cost. The gross profit margin percentage (GPM%) equals sales minus cost divided by sales (see the formulas below for hopefully a clearer picture).
Now, let’s say you wanted to cut your price by 15 percent to increase sales, but your unit volume stayed the same. Your sales would drop to $85, your gross profit to $30 or 30 percent. We understand you wanted to cut prices to increase sales enough to make more money. However, notice how much of an increase in sales it takes after a price cut just to make the same amount of profit. The mathematical formula to determine these results goes like this:
GPM% ÷ (GPM% +/- price change %) – 1 =
Unit Volume % Change.
Stay with me – it’s not that difficult. Putting this formula into our example would look like this:
.45 ÷ (.45 – .15) – 1 = .50
Remember your math here – in the above example the percentage is changed to a decimal.
What this example shows us is that by discounting your original price by 15 percent, you would have to increase your sales volume by 50 percent. You would have to sell 150 units just to make the same amount of money you used to make selling 100 units. These numbers don’t lie. Mathematics is a precise science. Cutting prices to make more money doesn’t make sense!
Raising your price actually makes more sense. Instead of lowering your price 15 percent, let’s raise it 15 percent. Let’s still assume our unit volume stayed the same. Using the same formula, you’ll see that your sales would go up to $115 and your gross profit margin to 60 percent.
Let’s figure out how much your sales would have to fall off before your gross profit dollars would drop below the original $45. You would use the same formula, but this time you add, rather than subtract, the price change percentage. Our formula would look like this example:
.45 ÷ (.45 + .15) – 1 = .25
You would interpret the results from the formula like this: Before, you were selling 100 units, and now with a 15 percent price increase, as long as your unit volume does not go below 75 units (25 percent less volume), you are making more money. The price increase would improve your gross profit in dollars from the original $45 even with a sales drop. This math proves that you can sell less and still make more money.
Let me clarify one thing: I really do care about sales volume. Without sales we don’t have a business. However, I care more about the profit margin we make from sales. Sales volume is often used for bragging rights, but companies with half the sales volume can have larger profits. And who cares about bragging rights anyway? Work smarter not harder. Hopefully you see that profit margin is the name of the game.
Jim Rickoff is vice president of marketing with the Engine Rebuilders Association (AERA). For information on monthly technical mailings, telephone technical support and other member services and benefits offered by the association, contact AERA toll-free at 888-326-2372 or email firstname.lastname@example.org.