Understanding the difference between Gross Profit and Mark-Up will change the way you price your jobs forever.
Your approach to pricing work is a crucial element to a profitable and fun to owning a trades business. There are many ways to price including quoted work, tenders, charge-up (time and materials) or even having a set price book. If you do not understand the difference between gross profit margin and mark-up, you’ll cost yourself plenty with whatever approach you use.
When you price your jobs, if you get all the costs and then put a 15%, 20% or 30% mark-up on top of the cost price, odds are you are not clear on the difference between gross profit margin and mark-up.
Here’s an example to demonstrate how it works
Firstly, when you do a project you've got the cost of doing the project. We call that “the cost of sales.” Cost of Sales includes the labour, materials and any other job specific costs such as sub-contractors or equipment hire. For this example, let’s say we’re doing a small bathroom alteration and the cost is $10,000.
Next you have the quoted price (or the charge-up price) that the client pays. Let's say that's $13,000. To calculate the gross profit, we subtract the cost of sales from the sale price. In this case it would be $13,000 - $10,000. We are left with a gross profit of $3,000. Gross profit is the profit from doing the job.
So how does this then translate into mark-up versus gross profit margin?
Mark-up is calculated by using this formula:
Gross profit divided by cost of sales i.e. ($3,000 / $10,000) x 100 = 30%.
But is that our profit margin? No it’s not.
Your gross profit margin is the profit you make from your jobs. The formula for gross profit margin is gross profit divided by sales ($3,000 / $13,000 x 100) = 23%. Now 23% is what we get to keep, not the 30% we thought we were getting with our mark-up.
The difference between mark-up and gross profit margin explains why when you price jobs you think there's enough fat in the job, but when you actually do the job, the money's just not there in the bank account.
Now the relationship between mark-up and gross profit margin is a mathematical one. Your mark-up is always going to be higher than your gross profit margin. So a 30% mark-up will give you a 23% gross margin, a 43% mark-up will give you a 30% gross margin and 100% mark-up would give you a 50% gross margin. I have included a chart showing the relationship between mark-up and gross profit margin.
Now the key is when you use gross profit margin for pricing it can actually completely change the profitability of your business and indeed your life.
So how do you implement gross margin versus mark-up?
The first thing is to set a target gross profit margin when you're pricing and invoicing your jobs. For instance, you may aim for 55% or better gross profit margin for maintenance and servicing work. Second, back-cost all the jobs you complete and analyse what gross profit margin you achieved. Third, compare the result with your target and analyse why there may be a difference. Labour overruns are a common cause which may be caused by poor estimating or low productivity. Use the information gathered to adjust your pricing for the next project or job.
If you want more information about pricing and margins, including what target margins to aim for, I have a free report titled “The 3 Steps of Pricing To Make Profit”. Click here to get a copy now.