Add the nominal Target Margin behind the % Markup and other percentages, ensuring a clear view of costs and a more accurate selling price

Why Markup reduces Profit

"BECAUSE BASED ON COST CREATES, BETWEEN THEM, A DIRECTLY PROPORTIONAL GREATNESS"

Directly proportional quantities are those where, when one increases, the other also increases, and when one decreases, the other also decreases. In other words, there is a direct proportional relationship between them.

"By reducing cost while maintaining the same or a similar markup percentage, you will also be reducing the profit."

And it is crucial to highlight that costs are being reduced exponentially, thanks to technology and the dedication of people. Therefore, the caution must be extreme and doubled!

Check the examples below to see how the profit margin can significantly decrease by reducing costs while maintaining the same markup percentage:

Below is an example illustrating the variation in markup, maintaining the same percentage but with different cost reduction scenarios and their respective profit margins. Observe the following examples:

• 0% cost reduction: profit margin of $100.
• 20% cost reduction: profit margin of $80 (a $20 reduction in profit).
• 40% cost reduction: profit margin of $60 (a $40 reduction in profit).
• 60% cost reduction: profit margin of $40 (a $60 reduction in profit).
• 80% cost reduction: profit margin of $20 (an $80 reduction in profit).

"The perception of a reduction in profit margin is similar to the quiet growth of a seed transforming into a tree. Day by day, progress goes unnoticed, but after a long period, we are surprised when we stop to 'measure' the accumulated impact." And remember: The markup was already 7,000% when the caravels were exploring the seas!

Be cautious, as maintaining (or even worse, reducing) the markup percentage is fatal.

Every cost reduction should lower the selling price and increase profit, or at least maintain it. In other words, the ratio between them should be inversely proportional.

"Technology has the power to reduce costs, while outdated pricing models end up limiting and shrinking unit profit margins. When you continue using old pricing methods, you're missing out on the efficiencies that new technologies offer, which can result in significantly lower profit margins. Innovation in pricing is essential to maximize profit potential, ensure return on investment, create more jobs, and increase wages (income, GDP)."

The market is becoming increasingly competitive every day. What should be a competition based on quality and services, governed by the law of supply and demand, often turns into a price war, driven by imprecise, blind intuition, and, in many cases, self-destructive behavior. In this scenario, it is essential to visualize the nominal target margin behind the markup percentage and other percentages used in determining the selling price. This strategic understanding is crucial for navigating with precision, staying on the right path, and ensuring sustainability in the market.

Check the following examples for the necessary adjustment in the markup percentage due to cost reductions, which becomes noticeable only in the long term, in order to maintain the same profit margin (excluding inflation):

It is important to emphasize that, to preserve the same profit margin, significant adjustments in the markup percentage must be made as costs are reduced over the long term.

Below are the following examples to preserve the same profit margin of $100:

• 0% cost reduction: 100% markup
• 20% cost reduction: 125% markup
• 40% cost reduction: 167% markup
• 60% cost reduction: 250% markup
• 80% cost reduction: 500% markup

It is not common to find in the market a +job-generating, income-boosting, GDP-increasing scenario where such an increase in the markup percentage is necessary.

In the fictional-financial market, we find much more robust markups. The question that arises is: are these professionals more aware that, with the emergence of money, everything became capital that transforms into goods and services? This strategic vision could be the key differentiator for transforming the market!

"I have been closely monitoring the supermarket segment, and surprisingly, I still see many establishments applying the average markup of 25%, a rate that dates back a decade, despite the ongoing impact of inflation. This reveals a resistance to adjusting pricing strategies to the new economic realities, which should start with the market leaders in each segment."

WHAT MAKES UP THE NOMINAL TARGET MARGIN?

Nominal Target Margin = Fixed Costs + Return on Invested Capital

Fixed costs are those that have not been allocated to products and services.

The return on invested capital represents the essential portion of profit, calculated based on a rate recommended by shareholders, aimed at ensuring a return on investments. This return is crucial for keeping shareholders engaged in financing companies, which in turn are responsible for generating jobs, income (wages), and GDP. If this return is unsatisfactory, shareholders may be attracted to the financial market, which often offers higher returns. And this is happening.

The leaders of each market hold the power to dictate the conditions of remuneration and the ideal rates of return, thus shaping a solid and healthy margin for each business. If this does not happen, it is at least essential to apply the maximum acceptable limit for each business segment.

In the Annual and Multi-Year Budget Plan (Budget), it is possible to break down the Nominal Target Margin into additional parts and across periods, according to the desired clients of each business, preferably using a model of identification and measurement based on genuine managerial accounting.

llustrative Example: Based on our work, without disclosing confidential data:

A company, with 3 distinct business areas, has adopted a single markup percentage of 51%, which, over the past three years, has remained virtually unchanged, with minimal variations based on intuition and comparisons with total results. This stability, although seemingly positive, suggests a rigid approach that may not be agile enough to respond to the dynamic changes in the market.

Your annual Nominal Target Margin was calculated at $51,000,000. Since it is a manufacturing sector company, this amount represents $25,000,000 in fixed costs and $26,000,000 in the ideal return on capital.

In the retail segment: This amount would be distributed approximately as $42,300,000 for fixed costs and $8,700,000 for the return on invested capital.        

In the service segment: This amount would be distributed around $30,000,000 for fixed costs and $21,000,000 for the return on invested capital.        

The managers of this organization did not concern themselves with calculating a profit that would guarantee the full return on invested capital, considering minimum return rates and risks. This is partly due to the fact that the cost of invested capital is still not recognized by official accounting, which creates the false impression that zero profit merely "breaks even" the results, when in reality, it only covers fixed costs while simultaneously eroding the invested capital through unadjusted depreciation. Instead of adopting a strategic and well-founded approach, they chose a simplistic practice based on the traditional market view: "ten fingers," meaning a 10% profit or multiples.

Based on the managerial identification and measurement model, we have separated the nominal target margin for each of the three business areas, providing a more accurate view of the required contribution margin, the nominal break-even point, and allowing for more effective sales direction:

• Nominal Target Margin Business 1 = Annual $30,000,000, Monthly $2,500,000, Markup 63.3%
• Nominal Target Margin Business 2 = Annual $12,000,000, Monthly $1,000,000, Markup 48%
• Nominal Target Margin Business 3 = Annual $9,000,000, Monthly $750,000, Markup 14%

KEY CONCLUSIONS:

• The company continues to use the markup percentage as a reference but now visualizes the nominal target margin by business area, providing a safer and more flexible approach.
• We adopted the cost-to-serve model, making the nominal target margin even more accurate, to be allocated or appropriated according to strategies aimed at selling more and better—not just by revenue percentage, weight, dozen, or other outdated drivers that don’t reflect market intelligence.
• Business Area 1 had been subsidized by the other areas, which compromised its competitiveness, particularly affecting the performance of Business Area 3 in the market.
• The internal cost committee, which we always create and train at the beginning of our work, approved these approaches, concluding that there was an evolution in the pricing strategy, making it more competitive. This will later be automated with a price simulation system, integrable with the ERP.

Based on a sampling I have analyzed for decades, consisting of the largest and medium-sized companies established in the country and some abroad, we have found that the exclusive use of markup in percentages (%) continues to be a widely adopted methodology for pricing. However, we can enhance this practice by incorporating the concept of the nominal target margin behind it, and further breaking it down into additional layers that truly reflect the desired customer base. The time to rethink and improve this approach is now, and the transformation begins with this more refined and market-aligned perspective!

Sincerely,

Carlos Roberto Kassai, CAiO

[email protected]

+55 11 9.9976.4848

Version of this Kassai News in Portuguese