Many small businesses — particularly those in the retail sector — set their selling prices using a cost-plus pricing strategy. The popularity of cost-plus pricing strategy is mainly attributed to the concept’s ease of use.

Although it is the most commonly used price-setting method, it does have some drawbacks. In particular, cost-plus pricing does not take into consideration the price customers are willing to pay for the good or service. For this reason, small business managers should consider each product’s mark-up on a case-by-case basis.

A cost-plus pricing example

To provide an example of cost-plus pricing, let’s pretend that we are operating in the sporting goods retail market. We’ll also presume we know from our direct involvement in this industry, that our suppliers, including Adidas and Nike, suggest a mark-up of 80 per cent.

Next, let’s say we’ve decided to buy a new line of Adidas runners, which we intend selling in our sports store. The Adidas representative confirms our purchase price for this product is $55 including GST.

Knowing our industry typically operates on 80 per cent mark-up, we add this percentage to our purchase price. We then arrive at our recommended retail price (RRP) of $99. In accounting terms, this is the cost of goods sold (COGS). Here’s what the formula looks like:

$55.00 + 80% = $99.00

Is mark-up and gross margin the same?

No, definitely not. Many small business managers confuse mark-up with gross profit margin (GPM). In fact, they’re completely different terms. Under the next heading, I’ll do my best to clear up the confusion.

Gross profit margin (GPM) demystified

If we look at our Adidas footwear example, above, we can see how we arrive at our recommended retail price. And we have done so simply by using a cost-plus price setting method. But our gross profit isn’t, unfortunately, 80 per cent. Actually, it’s only 44.44 per cent. Or expressed in monetary terms, $44 per pair.

Calculating gross profit margin in percentage terms

As I have just explained, there is a distinct difference between mark-up and gross margin. It is important for all managers — regardless of business size — to understand this. Lack of understanding here, can mean the difference between showing a profit (or) recording a loss.

To explain the calculation process, let’s continue with our footwear example.

In order to calculate our gross profit (measured in percentage terms), we now need to write down our gross profit (measured in dollars). We get this figure by subtracting our purchase price of ($55.00) from our selling price of ($99.00). In our example, the result of which equals ($44.00) gross profit.

Our next task is to divide the sale’s gross profit ($44.00) by the item’s selling price ($99.00). We then multiply the result by 100. The sum of which gives us our gross profit, expressed in percentage terms, as shown below.

Gross profit: $44.00 / Selling price: $99.00 = 0.4444 * 100 = 44.44% GPM

Want a free Cost-plus pricing calculator?

We have created a handy Excel cost-plus pricing calculator, which is free of charge and yours to download. Simply change the two grey shaded cells (numbers 1 and 3) and the mark-up and gross profit margin calculations will take care of themselves.