Marginal Profit

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Marginal profit is how much profit you would make if you sold one more of an item. It can also be how much profit a new product line will add to your business.

It is such a simple, but extremely valuable concept.

Expenses are either 'fixed expenses' or 'variable expenses'.

The starting point for figuring marginal profit is to classify your expenses as 'fixed expenses' or 'variable expenses'.

A variable expense increases if sales increase. Cost of merchandise and freight bills are variable expenses.

A fixed expense is one that does not change with sales. Rent is a fixed expense. If your sales increase or decrease, your rent does not change. Other fixed expenses would be utilities, accounting fees, maintenance costs, basic phone bill, etc. Fixed costs are NOT considered when looking at marginal profits.

Fixed expenses are only fixed in a certain range. An increase of 5% in sales might not change your fixed expenses. However, if you sales increased by 50% you might need more space, another phone line, etc., so that many of the fixed expenses become variable expenses.

Labor can be especially hard to classify. If there is extra time available, or if the product does not require any customer support, then the marginal labor cost is minimal. On the other hand, some products require a lot of labor; in these cases the marginal labor cost can be quite high.

Marginal profit is the added profit from selling 1 more item.

Marginal profit = (selling price) - (total variable costs for 1 unit)

Marginal profit is also the added profit from adding a new product or product line.

Marginal profit = (sales of the new product) - (total variable costs of the new product)

[numbers used in examples are NOT real life amounts]

Example: You have an item that has a total marginal cost (cost of the item plus the variable expenses) of $30. You sell it for $50. Your marginal profit is $20 per unit sold. Remember that the fixed expenses like rents, etc. are ignored.

OK. That is it. That is how you calculate marginal profits. Easy to figure (on paper, at least). Now what do you do with it?

What Happens If I Lower My Selling Price?

You want to increase sales of the item shown in the example above, so you decide to lower the price 10% (new selling price becomes $45). At the old price you were selling 10 units a month. Your marginal profit for that item was 10 x $20 = $200 per month. At the new selling price of $45 your new marginal profit for this item becomes $45 - $30 = $15. To make the same $200 marginal profit you need to sell $200 / $15 = 13.3 units. In other words, lowering your price 10 requires you to sell 33% more just to make the same profit.

What Happens If I Advertise More?

There is a new group of potential customers for this same product. To sell to them, you put a $25 ad in the group's newsletter. You sell 2 units to members of this group. What happens to profits?

You continue to sell the 10 units per month to your existing customers at $50 each, so the $200 profit is unchanged. The additional 2 units cost an additional $25 to sell. Your marginal cost for each of these 2 units (not the original 10 units) increased to $30 + ($25/2)= $42.50. The marginal profit for these 2 units was $50-$42.50=$7.50. Selling these 2 additional units added $15 to your profits (2 x $7.50). Your total profits is now $200 +$15 =  $215

Keeping A Poor Selling Product Line

For a $500 investment you added a new product line. Your marginal profit is $5 on each unit you sell. You sell 10 units a month. Your marginal profits are $50 a month ($5 x10). At $50 per month you will get your $500 investment back in 10 months. Sounds good? Maybe...

IF you have unused room in your store this is a good investment. HOWEVER, if you do not have unused display space, then you may have fallen into a trap.

Suppose the display takes up 20 square feet of display space that was previously devoted to other products. This might be 2% of your usable display area. The true variable cost for the line is the normal variable costs PLUS 2% of the fixed costs of rent, utilities, labor, etc. When these costs are considered, the new product line may be actually loosing money. Say your fixed expenses are $3,000 per month (rent, utilities, payroll, etc). $3,000 x .02 = $60. In this case, this product line is costing you $10 a month.

If your store has unused display space, adding additional inventory can be an inexpensive way to increase profits. If floor space is tight, than rearranging or replacing product lines that take up a lot of floor space should be considered.

Do Not Worry About 'Product Turnover'

It is common for an accountant or banker to advise you that you need to 'turn over your inventory' a certain number of times a year. Turnover (or 'turns') measures how fast you sell your merchandise. Say you have $50,000 inventory valued at retail price. You sell $100,000 in a year. Your product turnover is 2  ($100,000/$50,000).

Looking at turnover is popular because it is easy to calculate. Unfortunately, it is easy to see that it is has little meaning. If a store sold everything for the same price they paid for it, it would not matter what their turnover was, they would still loose money. Concentrate on profits, not turnover.