TV programs such as Shark Tank and Dragons’ Den have highlighted to entrepreneurs the fact that you should know your numbers before seeking finance for a startup business. This is the first in a series of posts designed to explain how those numbers are arrived at and what they mean.
The initial questions from the panel of potential investors usually revolve around the retail price, selling price, product cost, and gross margin percentage of the business.
What is the Retail Price?
This is the price at which the product will be sold to the end consumer in the shops. While the investor will be interested to know the retail price as it helps define where the product can be positioned in the marketplace, unless you are a retailer, this will not necessarily be the price at which you sell your product.
What is Your Selling Price?
This is the unit price you will be selling at. If you are a retailer it will be the same as the retail price referred to above, if you are further down the chain and selling to a wholesaler or distributor it will be a lower price. For example, the retail price in the shops might be 60, but your selling price to a wholesaler might be 27.
What is Your Product Cost?
The unit product cost is the amount it costs you to either purchase or manufacture the product. The costs to include are those necessary to bring the product to its present state and condition prior to sale. They do not include selling expenses, distribution costs, marketing etc, such costs are termed costs of selling or selling costs or sales and marketing costs.
For a manufacturing, business the product cost refers to the physical product and the costs of bringing it to the point of sale. This might include direct material costs, direct labor costs, factory production overhead and freight inwards (that is the costs of transporting the product to your place of manufacture or distribution warehouse).
For a retailer or wholesaler the product cost is usually the cost of purchasing the product from a supplier, freight inwards, and other sundry costs necessary to get the product to the point at which is can be sold.
In a services business, the product cost is more likely to be wages and salaries costs of staff delivering the service, or perhaps subcontracting costs. It might include items such as costs of research, photocopying, and production of presentations and reports.
What is Your Gross Margin Percentage?
Having defined the selling price and the product cost, you will most likely be asked what the gross margin percentage of the product is. The gross margin percentage is simply the gross margin (sometimes referred to as the gross profit) of the product expressed as a percentage of your selling price.
Since the gross margin is the difference between the selling price and the product cost, the product gross margin percentage is given by the formula below.
Suppose for example, a business has a product costing 18.90 which is sells to wholesalers for 27.00. The business does not sell directly to the retail market, but the retail price in the shops is 60.00.
The gross margin percentage is calculated as follows:
Retail price = 60.00 Selling price = 27.00 Product cost = 18.90 Gross margin % = (Selling price - Product Cost) / Selling price Gross margin % = (27.00 - 18.90) / 27.00 Gross margin % = 30%
What this is effectively saying is that each time you sell a product for 27.00, the business makes a gross profit of 8.10 (27.00 – 18.90), which is 30% of the selling price.
The information is summarized in the table below:
|Gross margin %||30%|
Check the Retailers Gross Margin %
In this example your business is selling to wholesalers and the retail price of 60.00 was not part of the calculation of your gross margin percentage. However, the investors will be looking to see that the retail price you are quoting makes sense, and therefore it is important that you also calculate the retailers gross margin percentage to see whether it is reasonable. In this example, the retailer will buy from you at 27.00 and sell at 60.00, their gross margin percentage will be as follows:
Selling price = 60.00 Product cost = 27.00 Gross margin % = (Selling price - Product Cost) / Selling price Gross margin % = (60.00 - 27.00) / 60.00 Gross margin % = 55%
The panel of investors will be looking to see that you know your numbers and that the information provided is consistent with the standards in the industry in which your business operates. Eyebrows will be raised if you specify a retail price, selling price, product cost or gross margin percentage way above or below the industry norms, so it is important to do your research and find out what your nearest competitors are charging and what the industry standards are.
If you need help with the calculations referred to above, our product gross margin percentage calculator is available for download, and allows you to enter the selling price, and details of your product costs, and then calculates the gross margin percentage for you.
This post is intended to be the first in a series of posts entitled know your numbers for dragons’ den and shark tank. The next post in this series deals with the income statement and in particular the revenue, gross profit, and net profit numbers you need to know, and sets out to show how this information can be found from our financial projections template.
Other Posts in This Series
- Income statement numbers, revenue, gross profit and net income
- Balance sheet numbers, assets, liabilities and equity.
- Startup valuation.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.