Return on Investment is a useful tool to understand, analyze, and compare different investment opportunities. ROI measures the efficiency of a specific investment by revealing how net earnings recover the cost of the original investment. Have you ever wondered if the result of your investment was really worth the cost? Well, a return on investment model looks at the inputs and assumptions of the ROI equation to determine if the benefits of the investment are worth the costs. Following are the ROI model tools you need to analyze ROI and improve ROI so that you can determine the value of your investment:

The first step is to identify and analyze overall benefits from the investment. For different financial situations, the percentage of returns may vary according to what the decision-makers consider to be gains or losses from the investment. As long as you are consistent with how you classify benefits of the investment, you should be able to effectively use your calculations for analysis and comparisons. Focus on benefits which are measurable and attainable. Tangible benefits can be measured and evaluated to improve ROI percentages.

If the benefits appear significant, the next step is to identify and analyze associated costs of the investment. Costs are simpler to identify than benefits. Make a list of costs and then breakdown the costs into groups to better categorize the origination of costs. This will enable you to understand where the majority of costs are coming from. Are there any costs that appear inflated? Can you easily reduce some costs? Are there costs that could be eliminated completely? These questions will help you analyze expenses of the investment. Keep in mind that the cost of an investment includes not only the start-up cost, but also the maintenance and improvement of the investment over time.

To improve the return on your investment, business managers and directors should develop comprehensive and realistic projections for both revenues and expenses. Effective planning will account for unexpected expenses and underperforming sales revenue. By analyzing projections, you should be able to develop strategies to reduce costs and increase sales.

Working capital, also known as net working capital, indicates the total amount of liquid assets a company has available to run its business. In general, the more working capital, the less financial difficulties a company has.

Example: a company has $10,000 in current assets and $8,000 in current liabilities.

Working capital = 10,000 – 8,000 = 2,000

Applications

Working capital measures a company’s operation efficiency and short-term financial health. Positive working capital shows that a company has enough funds to meet its short-term liabilities. Negative working capital shows that a company has trouble in meeting its short-term liabilities with its current assets.

Working capital provides very important information about the financial condition of a company for both investors and managements. For investors, it helps them gauge the ability for a company to get through difficult financial periods. For management members, it helps them foresee any financial difficulties that may arise. It is very important for a company to keep enough working capital to handle any unpredictable difficulties.

Max owns a retail store called Retailco. Retailco sells clothing as well as other items common to department stores. Max’s company has just opened their doors and is still finding a place in the market. As a result, some of the essential financial ratios have not been calculated yet. Max would like to calculate his retail markup for his various selling items so that his new business can determine the retail actual retail price of the products that they are selling. These markups will serve as benchmarks for the rest of the business team in an effort to show the company’s likelihood of success. The way these efforts are achieved is by estimating the total amount of profits by comparing the retail price of the products with the overall spending and costs of the company.

(NOTE: Want the Pricing for Profit Inspection Guide? It walks you through a step-by-step process to maximizing your profits on each sale. Get it here!)

Recently, the amount of profit made on the average pair of women’s jeans has come into question. Max, from working in the industry for years, has an intuition that he is making a profit on these products. Still, he needs to prove this to the rest of his company. Personally, he also wonders what is standard retail markup for a department store just like his.

Max initially searches Yahoo for the term “retail markup calculator”. Though he does not find a function to provide his calculation, he does find a formula which will serve the purpose. The formula which Max will utilize is known as the retail markup formula. This formula takes the retail price of the cost to produce a unit of product and subtracts that price from the retail price of the product. What is left is a retail markup price.

Max sells the average pair of jeans for $15. His cost of goods sold on each unit is $10. Max uses the retail markup formula to calculate the retail markup average on his pair of jeans:

$15 – $10 = $5

Knowing his retail markups will help him to build confidence and courage in his team. He resolves to find retail markups for all of his products. He later finds that this amount is standard with industry expectations.

Additionally, the retail markup percentage is calculated by taking the retail markup and dividing the value by the unit cost of the product. The fraction that remains after the calculation is known as the retail markup percentage.

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Bill is the founder and CEO of a retail store called Shopco. Shopco recently took a loan. Shopco has experienced a dip in sales, because of the recession, and wants to make sure they can keep net operating profit margin ratio above the limit in their loan agreement. If not, Shopco may have their loan revoked. Shopco decides to prepare for this scenario by looking at their books and finding all relevant numbers. Bill then performs the calculation below.

Shopco was required by the bank to maintain an operating profit margin about 10%. After performing the calculation Bill now knows that his operating profit margin ratio calculation is above this. Bill is very relieved and has the confidence to make it through his time of difficulty.

Operating Profit Margin Meaning The meaning of operating profit margin varies slightly, although the basics stay the same across all industries. This makes it a common and important metric. Operating profit margin ratio analysis measures a company’s operating efficiency and pricing efficiency with its successful cost controlling. The higher the ratio, the better a company is. A higher operating profit margin means that a company has lower fixed cost and a better gross margin or increasing sales faster than costs, which gives management more flexibility in determining prices. It also provides useful information for investors to determine the quality of a company when looking at the trend in operating margin over time and to compare with industry peers. There are many ways for a company to artificially enhance this ratio by excluding certain expenses or improperly recording inventory. Revenues may also be falsified by recording unshipped products, recording sales into a different period than they actually occurred, or more. Usually, it serves more as a general measurement than a concrete value.

The markup percentage can best be defined as the increase on the original selling price. The markup sales are expressed as a percentage increase as to try and ensure that a company can receive the proper amount of gross or profit margin. Markups are normally used in retail or wholesale business as it is an easy way to price items when a store contains several different goods.

By definition, the markup percentage calculation is cost X markup percentage, and then add that to the original unit cost to arrive at the sales price. The markup equation or markup formula is given below in several different formats. For example, if a product costs $100, the selling price with a 25% markup would be $125.

Sales Price = Cost X Markup Percentage + Cost = $100 X 25% + $100 = $125.

One of the pitfalls in using the markup percentage to calculate your prices is that it is difficult to ensure that you have taken into consideration all of your costs. By using a simple rule of thumb calculation, you often miss out on indirect costs.

(NOTE: Want the Pricing for Profit Inspection Guide?It walks you through a step-by-step process to maximizing your profits on each sale. Get it here!)

Markup Percentage Example

Glen works has started a company that specializes in the setup of office computers and software. Glen has decided that he would like to earn a markup percentage of 20% over the cost of the computers to ensure that he makes the proper amount of profit. Glen has recently received a job to set up a large office space. He estimates that he will need 25 computers at a cost of $600 a piece. Plus, Glen will need to set up the company software in the building. The cost of the software to run all the computers is around $2,000. If Glen wants to earn the desired 20% markup percentage for the job what will he need to charge the company?

(Looking for more examples of markup? Click here to access a retail markup example.)

Step 1

Glen must calculate the total cost of the project which is equal to the cost of software plus the cost of the computers.

$2,000 + ($600*25) = $17,000 Step 2

Glen must find his selling price by using his desired markup of 20% and the cost just calculated for the project.The formula to find the sales price is:

This means that to earn the return desired Glen must charge the company $20,400. This is the equivalent of a profit margin of 16.7%. For a list of markup percentages and their profit margin equivalents scroll down to the bottom of the Margin vs Markup page, or they can be found using the above markup formula.

Using what you’ve learned from how to calculate your markup percentage, the next step is to download the free Pricing for Profit Inspection Guide. Easily discover if your company has a pricing problem and fix it.

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Gross margin defined is Gross Profit/Sales Price. All items needed to calculate the gross margin percentage can be found on the income statement. The margin percentage often refers to sales or profitability which may help lead to several key understandings about the company’s business model as well as how successful the company is at maintaining its cost structure to gain the proper amount of sales. Analysis of margins within a business is often useful in controlling the price in which you need to sale as well as a control on the cost associated to make the sale.

(NOTE: Want the Pricing for Profit Inspection Guide? It walks you through a step-by-step process to maximizing your profits on each sale. Get it here!)

How to Calculate Margin Percentage

In this example, the gross margin is $25. This results in a 20% gross margin percentage:

Gross Margin Percentage = (Gross Profit/Sales Price) X 100 = ($25/$125) X 100 = 20%.

Not quite the “margin percentage” we were looking for. So, how do we determine the selling price given a desired gross margin? It’s all in the inverse…of the gross margin formula, that is. By simply dividing the cost of the product or service by the inverse of the gross margin equation, you will arrive at the selling price needed to achieve the desired gross margin percentage.

For example, if a 25% gross margin percentage is desired, the selling price would be $133.33 and the markup rate would be 33.3%:

Glen charges a 20% markup on all projects for his computer and software company which specializes in office setup. Glen has just taken a job with a company that wants to set up a large office space. The total cost needed to set up the space with computer and the respective software is $17,000. With a markup of 20% the selling price will be $20,400(see markup calculation for details). The margin percentage can be calculated as follows:

Using what you’ve learned from how to calculate your margin percentage, the next step is to download the free Pricing for Profit Inspection Guide. Easily discover if your company has a pricing problem and fix it.

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The gross profit margin ratio, also known as gross margin, is the ratio of gross margin expressed as a percentage of sales. Gross margin, alone, indicates how much profit a company makes after paying off its Cost of Goods sold. It is a measure of the efficiency of a company using its raw materials and labor during the production process. The value of gross profit margin varies from company and industry. The higher the profit margin, the more efficient a company is. Gross profit margin can be assigned to single products or an entire company.

Gross Profit Margin Ratio Formula

Gross profit margin = Gross profit ÷ Total revenue

Or = (Revenue – cost of goods sold) ÷ Total revenue

(NOTE: Want the Pricing for Profit Inspection Guide? It walks you through a step-by-step process to maximizing your profits on each sale. Get it here!)

Gross Profit Margin Ratio Example

Joe is a plumber in Houston, Texas. He has recently started his company and has a lot to learn. Joe thinks he may be able to cut back on raw materials by changing his construction process. Essentially, he is wondering what is his gross profit margin rate is. He evaluates his company financials for relevant information. Once the proper numbers are found uses the gross profit margin ratio calculator on his Texas Instruments BA II. His results are shown below.

Gross Profit Margin Ratio Calculation

The gross profit margin ratio would be calculated using:

Gross profit = revenue – cost of goods sold

Example: A company has $15,000 in sales and $10,000 in cost of goods sold.

It would be expressed as a percentage of sales by:

This means for every dollar generated in sales, the company has 33 cents left over to cover basic operating costs and profit.

Gross Profit Margin Ratio Analysis

The gross profit margin ratio is an indicator of a company’s financial health. It tells investors how much gross profit every dollar of revenue a company is earning. Compared with industry average, a lower margin could indicate a company is under-pricing. A higher gross profit margin indicates that a company can make a reasonable profit on sales, as long as it keeps overhead costs in control. Investors tend to pay more for a company with higher gross profit.

Gross Profit Margin Disadvantages

Many see gross profit margin disadvantages despite the common use of gross profit margin ratios. The issue is that certain production costs are not entirely variable. Some believe that only direct materials should be included as they are the only variable to change in proportion to revenue. When applied, this new gross profit margin causes all other related costs to be transferred to operational and administrative cost categories. This tends to cause a higher gross margin percentage than originally. It is applied by certain industries and businesses instead of the more common application. This formula is:

Gross Profit Margin = (Revenue – Direct Materials) / Revenue

Easily discover if your company has a pricing problem. As you analyze your gross profit margin, it’s an opportune time to take a look at you pricing. Download the free Pricing for Profit Inspection Guide to learn how to price profitably.

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Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

Click here to access your Execution Plan. Not a Lab Member?