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Markup and its Role in a Basic Business Model

Markup and its Role in a Basic Business Model. Ted Mitchell. We have looked at 4 performance rates dealing with profit. 1) ROS = Return on Sales = the amount of profit being returned on the sales revenue 2) ROI = Return on Investment = the amount of profit being returned on the investment

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Markup and its Role in a Basic Business Model

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  1. Markup and its Role in a Basic Business Model Ted Mitchell

  2. We have looked at 4 performance rates dealing with profit • 1) ROS = Return on Sales = the amount of profit being returned on the sales revenue • 2) ROI = Return on Investment = the amount of profit being returned on the investment • 3) ROA = Return on Assets = the amount of profit being returned on the assets • 4) ROME = Return on Marketing Expense = the amount of profit being returned on the Marketing Expenditures

  3. Every Performance Ratio is part of a simple business model • Return on Sales (ROS) • Is part of the business model in which an increase in sales revenue, R, will increase your profits, Z • Revenue x ROS = Profits • R x ROS = Z • ∆R x ROS = ∆Z

  4. Every Performance Ratio is part of a simple business model • Return on Assets (ROA) • Is part of the business model in which an increase in the assets, A, will increase your profits, Z • Assets x ROA = Profits • A x ROA = Z • ∆A x ROA = ∆Z

  5. Every Performance Ratio is part of a simple business model • Return on Inventory (ROI) • Is part of the business model in which an increase in the inventory, I, will increase your profits, Z • Inventory x ROI = Profits • I x ROI = Z • ∆I x ROI = ∆Z

  6. Every Performance Ratio is part of a simple business model • Return on Marketing Expenditure (ROME) • Is part of the business model in which an increase in the marketing expenditures, E, will increase your profits, Z • Expenditures x ROME = Profits • E x ROME = Z • ∆E x ROME = ∆Z

  7. The primary Goal of managers is to increase profits by increasing the performance rate in the business model they are responsible for. • You are given assets to work with. • If you increase the performance rate (the efficiency) of the business model you will generate more profit

  8. Four Simple Business Models • R x ROS = ZAn increase in efficiency is an increase in profit • R x ∆ROS = ∆Z • I x ROI = ZAn increase in efficiency is an increase in profit • I x ∆ROI = ∆Z • A x ROA = ZAn increase in efficiency is an increase in profit • A x ∆A = ∆Z • E x ROME = ZAn increase in efficiency is an increase in profit • E x ∆ROME = ∆Z

  9. The performance ratios are aggregate measures of performance • It is easy to think of ways of improving the efficiency of business models when using highly aggregated performance ratios such as • ROS • ROA • ROI • ROME

  10. Some Performance Rates can be linked together into systems for understanding performance changes • ROA = ROS x Asset Turnover Rate • ROS = ROME x Spending Rate • and therefore • ROA = ROME x Spending Rate x Asset Turnover Rate

  11. The Fifth Performance RateGross Return on Sales, GROS • GROS = Gross Return On Sales = the gross profit being returned on total sales revenue • The simple business model isSales Revenue x GROS = Gross ProfitR x GROS = G • More Sales Revenue implies More Gross Profit∆R x GROS = ∆G • A Better operations manager should be able to improve our efficiency rate, GROS for more profitR x ∆GROS = ∆G

  12. Markup on Cost and Markup on Price • Both are rates of performance and efficiency • Markup on Price, Mp = (Profit from each unit sold)/( Selling Price) • Mp = (P-V)/P • Markup on Cost, Mv =(Profit from each unit sold)/(cost of each unit) • Mv = (P-V)/V

  13. Markup on Cost is associated with a simple business model Markup on Cost, Mv Cost per Unit x Mv = Profit per Unit • V x Mv = Profit per Unit • cut the cost per unit and increase the profit∆V x Mv = ∆Profit per Unit

  14. Both Markup on Price is associated with a simple business model • Markup on Price, Mp • Selling Price per Unit x Mp = Profit per Unit • P x Mp = Profit per Unit • Increase the selling price and increase the profit∆P x Mp = ∆Profit Per Unit

  15. There is a link between GROS and Markup on Price • Business Model for Markup on Price • Price x Mp = Profit Per Unit • Increase Gross Profits by selling more units, Q • (Price x Q) x Markup = (Profit per Unit) x Q • Revenue x Markup = Gross profit

  16. Markup Rates are elementary or primitive rates of performance • Markup Rates are primitive performance measures and not the aggregate measures of performance like ROS, ROA, ROI, ROME • A primitive performance rate can not be decomposed into more elementary elements on the income statement • Price per unit and variable cost per unit are primitive elements in the income statement • A primitive or elementary rate of performance is a ratio that can not be changed except by changing the denominator or numerator of the performance ratio

  17. Example • How to improve the markup on cost? • Change Price, P, or Cost Per Unit, V, • Mv = (Unit profit)/(Cost per unit) • Mv = (P-V)/V = P/V – V/V • Mv = (P/V) – 1 • You have to change one of the two variables that are in the denominator and/or the numerator

  18. Because Markup on Price, Mp • Mp is closely linked to GROS measure of efficiency and Mp uses the primitive financial elements of selling price per unit and variable cost per unit • Therefore • Mp is used in a lot of different marketing calculations

  19. 10 Uses of Markup Formula • 1 The calculation of Breakeven Revenue, R* • 2 Setting Target Markup when retailers negotiate with manufacturers regarding the necessary discount off list • 3 Setting a price using Markup pricing • 4 Estimating the change in quantity that is needed to maintain the current total contribution given a change in price.

  20. 10 Uses of Markup Formula • 5 Determining the optimal stocking rule • 6 Calculating the Breakeven or Lowest Possible Discount Price • 7 Channel Efficiency • 8 Store Markdowns and Add-Ons

  21. 10 Uses of Markup Formula • 9 Calculating the price that maximizes profit OPM = 1/Mp + |Eqp| • 10 Comparing brands and allocating budgets between them using the Marketing IdentityMROS = ROME x Spending rate x Markup

  22. For our First Exam • We have be able do use the business model of the markup on price to calculate • 1) What is the markup percentage given the selling price and the cost per unit? • 2) What is the unit cost given the price and the percentage markup? • 3) What is the selling price given the unit cost and the percentage markup? • 4) How to convert from Markup on Cost to Markup on Price • 5) How to calculate a chain of markups or discounts

  23. Sample exam Questions

  24. 1 Markup Problem • A boy buys an apple for V = $2 and sells it for P = $5. What is his dollar markup or unit contribution (M) to Fixed costs and Profits? • P - V = M • $5 - $2 = M • $3 = M = Unit per Unit Sold

  25. 2 Markup Problem • A boy buys an apple for V = $2 and sells it for P = $5. What is his Markup on Price (Mp)? • (P - V) / P = Mp • ($5 - $2) / $5 = Mp • $3/$5 = 0.6 = 60% =Mp

  26. 3 Discount Off List • A store pays an apple distributor V = $2 per dollars per apple and sells it the suggested list price P = $5. What is the store’s Discount Off List or Markup (Mp)? • (P - V) / P = Mp • ($5 - $2) / $5 = Mp • $3/$5 = 0.6 = 60% =Discount off list price

  27. 4 Commission Rate A store gives their salesmen a 60% commission on the sale of an apple. The selling price is $5 per apple and the cost of each apple to the store is $2. How many dollars does the salesperson earn every time he sells an apple? • (P - V) / P = Mp • ($5 - $2) / $5 = 60% commission • Salesmen’s profit = P x Mp = $5 x 60% = $3

  28. 5 Discount Off List to Cost • An apple distributor gives a store a 60% discount off the suggested list price of P = $5 per apple (i.e., Mp = 60%). What is the store’s cost per apple (V)? • (P - V) / P = Mp • (5 - V) / 5 = 0.6 • 5 - V = 0.6(5) = 2 • 2 = V or the cost per apple = $2

  29. 6 Given Markup on Price and Cost • A boy buys an apple for V = $2 and sells it with a markup on price of 60% (i.e., Mp = 60%). What is the selling price of the apple? • (P - V) / P = Mp • (P - 2) / P= 0.6 • P - 2 = 0.6P • P -0.6P = 2 • P = 2/.4 = 5 or the price per apple = $5

  30. Many students simply memorize • Cost based pricing equation to set a selling price using markup and variable cost is • Price = (variable cost per unit)/(1-Mp) • P = V/(1 - Mp) • P = $2/(1-60%) • P = $2/(1-0.6) • P = $2/0.4 = $5

  31. 7Markup on Cost • A boy buys an apple for V = $2 and sells it for P = $5. What is the Markup on Cost (Mv)? • (P - V) / V = Mv • (5 - 2) / 2= Mv • 3/2 = 1.50 = 150% = Mv • Markup on cost = Mv = 150%

  32. 8 Convert Markup on Cost to Markup on Price • You are told that a product has a markup on cost of 25% What is the product’s markup on price? • (1/Mp) - (1/Mv) = 1 • 1/Mp– 1/0.25= 1 • 1/Mp = 1 + 1/0.25 • 1/Mp = 1 + 4 = 5 • Mp = 1/5 = 0.20 or 20%

  33. 8 Convert Markup on Cost to Markup on Price • You are told that a product has a markup on cost of 25% What is the product’s markup on price? • Make 25% into a fraction • Mp = 25% = 25/100 • “add the top part to the bottom part”25/(25+100) • And solve for Mp = 25/125 • Mp = 25/125 = 0.20 or 20%

  34. 9 Chain Markdowns & Markups • You marked down your selling price of $10 in the store by 10% two weeks ago, followed by a 20% markdown last week. This week you marked the price up by 15%. What is your current price? • Current price = $10 x (1 - markdown #1) x (1 - markdown #2) x (1 + markup) • Current price = $10 x (1-10%) x (1-20%) x (1+15%) • Current price = $10 x 0.9 x 0.8 x 1.15 = $8.28

  35. 9 Chain Markdowns & Markups • You marked down your original selling price of $10 in the store by 10% two weeks ago, followed by a 20% markdown last week. What is the size of the total percentage markdown or discount over the two events? • Current price = $10 x (1-markdown #1) x (1-markdown #2) • Current price = $10 x (1-10%) x (1-20%) • Current price = $10 x 0.9 x 0.8 = $7.20 • Total Markdown % = (Current price – Original Price)/(Original price) • Total Markdown = ($10 -7.20)/$10 = -$2.80/$10 • Total Markdown or Discount = -2.80/10 = -0.28 or -28%

  36. 9 Chain Markdowns & Markups • You marked down your original selling price of $10 in the store by 10% two weeks ago, followed by a 20% markdown last week. What is the size of the total percentage markdown or discount? • To solve directly • Total discount = Discount 1 + Discount 2 + (Discount 1 x Discount 2) • Total discount = D1 + D2 + (D1 x D2) • Total discount = (-0.10) + (-0.20) + (-0.10 x -0.20) • Total discount = -0.30 + 0.02 = -0.28 or -28%

  37. 9 Markups in a Channel of Distribution • A retailer sells wagons at a list price $800 each and receives a 40% markup on price. • His distributor gets a 20% markup on the price he sells the wagon for to the retailer • The manufacturer get a 30% markup on the price he sells the wagon for to the distributor • What is the dollar cost that the manufacturer pays to make each wagon? • Manufacturer’s cost to make each wagon=$800 x (1-0.4) x (1-0.2) x (1-0.3) = $268.80

  38. 10 More Markups in a channel of distribution • The manufacturer builds wagons for $228.80 each and sells them to a distributor with a markup on price of 60%. • The distributor sells the wagons to a retailer. • The retailer sells the wagons to the final consumer for $800 each and receives a 30% discount off the $800 suggested retail price. • What dollar profit does the distributor make on each sale?

  39. 9 Markups in a Channel of Distribution • A retailer sells wagons at a list price $800 each and receives a 40% markup on price.Pays the distributor 0.6 of $800 = $480 • His distributor gets a 20% markup on the price he sells the wagon for to the retailerThe distributor keeps 20% of the price he’s paid0.2 x $480 = $96and pays the manufacturer $480 – $96 = $384 • The manufacturer get a 30% markup on the price he sells the wagon for to the distributor • What is the dollar profit that the manufacturer makes on the sale of each wagon? • Manufacturer’s profit per sale is 30% of the $384 price he is paid0.3 x $384 = $115.20His cost per wagon = $384 -$115.20 = $268.80

  40. Markup problems are simple but you have think about them carefully • If you rush, you can get them wrong.

  41. Any Questions on Markup?

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