Margin Math – Don’t Be Tricked

The difference between 90% gross margin and 50% gross margin is not what you think.  Be careful.

Let’s assume your company finds 50% gross margin “acceptable” but you have some products with 90% gross margin.  First, congratulations!  This demonstrates you are pricing to what the market is willing to pay, not just cost plus.  Now assume your sales or marketing or pricing team wants to bring the price of the high margin product down to 50% margin to rapidly increase sales.

Here’s an example.  You have a product that sells for $10 at 90% margin.  Your sales team says “Margins are too high.  We need to bring the price down.”  What is the new price if you bring it down to the acceptable level of 50%?

It seems like you have drop your price almost in half to get there.  If you believe that, you’d be wrong.  You have to drop your price 80% to get there.  The new price would be $2.  You have to give up $8 of profit to get to 50% margin.   Ouch!

Here is a quick chart of prices and margins for a product with a $1 cost.
Price    Margin
$1.00    0%
$1.50    33%
$2.00    50%
$3.00    66%
$4.00    75%
$5.00    80%
$10.00    90%
$20.00    95%
$100.00    99%

Margin math is counter intuitive.  It’s confusing because margins can never go over 100%. However, our brains aren’t wired to think this way.  We think in straight lines.  My suggestion is to monitor your margins with an eye toward increasing the average margin for a product, product line, or company; but when it comes to pricing and especially discounting, think in dollars or percentage discounts, not in gross margin.

Dollar discounts and percentage discounts are straight line concepts that are easily interpreted by our brains.  Use them when evaluating transactions or price changes.  Don’t be tricked by using margins.

 

Mark Stiving, Ph.D. – Pricing expert, speaker, author

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