Markup is just plain gross, not Gross Margin

An anonymous commenter on my previous post wrote,

maybe you need a refresher in the most basic tenets of finance and accounting because gross margin is a percentage, not an absolute dollar figure. you’re referring to GROSS PROFIT, but calling it gross margin.

First correction on this comment is – Gross Margin can be expressed as either absolute dollar value or as percentage. In most situations it is understood by context – especially by the practitioners. Gross Profit and Gross Margin are used interchangeably as well. See for example Apple’s earnings release

apple-gross-marginBut when Google Finance shows Apple’s financials they refer to it as Gross Profit.

Sometimes we see Gross Margin Percentage explicitly used to indicate percentage margin. Again practitioners are not confused by any of the terms even when two of them are used interchangeably.

What is Gross Margin? (or Gross Profit)

Expressed as dollar value it  revenue less cost of goods sold. Expressed as a percentage it is this difference divided by revenue.

The anonymous commenter (who seem to have inexplicably routed his IP traffic through Fool.com, because I know MotleyFool is not afraid of making comments) added,

gross margin is the percentage that a company nets on the sale of a good after dividing it by its cost of goods sold.

That is not true. What this person is confusing with is  Markup. While Gross Margin (etc.) are financial accounting terms Markup is not. Its origins are in cost based pricing. You compute the cost to make a widget, add your preset margin you want to extract and call it the price.

Which you, my right tail readers, know is simply gross way to set prices. It would serve us all well if we banish the  “Mark Brothers” – Mark Up and Mark Down.

Another note on Gross Margin – it is a financial accounting term used for financial reporting purposes. The intended audience are investors and regulators. Since competitors can also see this companies do not want to signal their exact cost structure. So they  confound this number with a share of fixed cost allocation from manufacturing.

If you as a product manager or marketer going to worry about margin, worry about customer margin.

What does store design have to do with price increases?

In a WSJ interview  Wal-Mart’s chief of U.S operations says this about Wal-Mart’s attempt to re-design its stores,

WSJ: Is Wal-Mart as focused as it needs to be on offering the lowest possible prices?

Mr. Simon: A lot of things have distracted us from our pricing mission. We got enamored with presentation as an example. We walked people through our [remodeled] stores and they were gorgeous.

But they cost more. And if you spend more on your building, your prices can’t be as low as you want them to be.

“Every Day Low Price” can’t come from the supplier because they have to make money too. “Every Day Low Price” has to come from every day low cost, which means we have to operate for less.

Sustainability and some of these other initiatives can be distracting if they don’t add to every day low cost.

There are two claims made here that I believe the interviewer should have pushed Mr.Simon on but did not.

  1. If you spend more on your building, your prices can’t be as low as you want them to be.
  2. Sustainability and some of these other initiatives can be distracting if they don’t add to every day low cost.

I will discuss the first point in this article and defer the second for a future article.

Better design and presentation does not mean the sourcing costs (what Wal-Mart pays to suppliers) go up.  So why should the customers offset that cost in the form of higher prices?

If the design changes are already made and if there are no recurring costs to keep-up the design, the costs are sunk. So why do they matter?

Unless of course Mr.Simon is looking at an accountant’s definition of Cost Of Goods Sold (COGS) which includes in it a share of all fixed costs. To an accountant preparing the company’s financial statements, ever bar of soap and bottle of shampoo must be assigned its share of the building cost, employee cost, utility cost etc.

It is due to the quirky accounting rule of how costs are matched with inventories and how inventories are moved into expenses as Cost of Goods Sold.

But the accountants do not run businesses, set prices or make business decisions. They report on the business’ performance with just enough clarity and obfuscation at the same time.

A business cannot spend more on a building and expect to pass on the costs to customers in the form of price increases. Before spending money to improve the aisles, they should have estimated whether the improvements will nudge their customers’ willingness to pay higher and whether they can  generate enough profit to justify the costs.

Incremental profit need not come in the form of higher prices,  it can be in the form of increase in sales from new customers. Better design could bring in new customers who otherwise would not have stepped into the store.

To say, “If you spend more on your building, your prices can’t be as low as you want them to be” is neither true nor relevant here.

As an important side point, when a store spruces up and improves its design and shopping experience will the willingness to pay of its customers go up?

The answer will take us through the path set forth by Thaler on Mental Accounting and Consumer Choice.  It starts with the  story of you relaxing in beach and thirsty for an ice cold drink.

To be covered in a later article.