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Markups

Nov 10, 1998 2:17 PM   By Martin Rapaport
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The markup, or gross profit margin, is the amount of money one adds on to the cost of an item in order to turn a profit. While the concept of markups appears very simple and elementary for the operation of any business; how markups work and how they influence the marketplace is a highly complex matter. All too often people simply focus on the statistical level of markups without really understanding what the numbers mean and how shifts in the level of markups alter the distribution system.

Information about markups come from a variety of sources and in many formats. Often surveys are used to obtain direct information from the trade. In other instances, empirical price information is gathered by comparing the retail sales prices of specific products to wholesale costs prices. Finally, financial information generated by firms produce figures for gross profit margins. To some degree all information is useful, however one must be very careful how one applies average markup information to specific products or segments of the industry.

An analysis of first hand survey data provides a fascinating insight into the broad range of responses to questions about markup. At first glance it looks as if the numbers don’t make sense because of their great variance. Clearly the level of markup is not consistent throughout the trade and is highly dependent on who is selling, what type of product in which market.

While overall average markup data is interesting and provides general guidelines, we must recognize that in order for markup data to be really useful, it must be categorized into type of seller, type of product, value of product, and in some instances geographic location.

Name Brand Markups

Markups vary for a variety of reasons. Obviously, a brand name store, such as Tiffany, in an exclusive location can charge a significantly higher markup than a normal retailer. This is true even if the jewelry being sold is a generic item such as a 4/4 H VS2 in a standard four-prong setting. The justification for the higher markup is the added value derived from the name brand. In fact, it can be argued that a ring with a Tiffany stamp is a wholly different product than the same quality generic item from another source. High-end name brand retailers don’t just sell the diamond, they sell customer assurance and satisfaction.

Interestingly, higher margins do not necessarily assure higher profits. Firms seeking to differentiate themselves can always attempt to climb the “quality name” ladder through advertising and more expensive locations even if they do not adopt the full-blown “name brand” approach. A jeweler that invests in a $1 million advertising campaign and a high class premises will be able to charge a higher markup than a “normal” jeweler. Whether or not the higher markup will be enough to cover the higher costs is another matter. Our industry is littered with firms whose costs are too high relative to margin. In many cases the “cost” of increasing the markup is greater than the markup.

It should be clear that high markups do not necessarily translate into high profits. Markup is, after all, only gross profit (i.e. profit before costs). The only real measure of profitability is net profits (i.e. profits after costs). Amazingly, many in our industry are addicted to the relentless pursuit of higher markups, even if these higher markups are unattainable due to increased competition and high raw material costs. What some of these firms should really be doing, is drastically cutting costs to increase profits and reduce markups to gain market share.

In fact, a number of retailers have discovered the low markup (margin) method to increased profits. These firms have evolved a low cost, low markup strategy that enables them to sell a broad range of products. Interestingly, the low markup strategy has taken hold in the high end of the industry with an increasing number of innovative firms taking on a greater share of the cert business.

Positioning with Markup

Since retailers can control their costs they can decide the markup necessary to generate adequate profits. In other words, a retailer can decide to be low cost/low markup, high cost/high markup or anywhere in-between. The kind of store you have dictates the kind of markup you can charge.

The secret to understanding the markup game is to understand that markup is the way that a firm positions itself in the marketplace. Since there are consumers at every level of the spectrum, there are all kinds of retailers to serve them. For many firms, the secret to success is to be able to position themselves at the right markup level for their target markets and to be able to provide an attractive and competitive basket of products and services at their given markup level.

Over time, successful firms adapt their bundle of goods and services to their markets. Firms that are unable to fine-tune their position in relation to shifting market conditions run the risk of going out of business. While the strategic decision regarding the proper “type of store” and markup is of the greatest importance to new firms, the ability to adapt to market conditions is ultimately the real test of a successful firm.

Markup By Product

While the overall level of markup reflects the store’s positioning, markups are also highly product sensitive. Different products have different markup levels. To some degree, the level of markup is defined by the scarcity and resultant level of competition in the product’s markets. Another factor is the level of expertise necessary to discover the quality and value of a product. Items that are difficult to evaluate (grade) and valuate (discover price) tend to have higher profit margins. Items that are easy to evaluate and valuate tend towards commoditization and have lower levels of markup.

For example, markups for colored stones are significantly higher than markups for Rolex watches. Since few people really know what a colored stone is worth, retailers can charge a price based on the customers ability to pay, or perception of value rather than the market value of the item. On the other hand, Rolex watches are a known item with known market prices. Consumers can easily shop and compare different retailers. The ability of consumers to comparative shop is a key factor increasing competition among sellers and lowering potential markup.

Interestingly, given the example of Rolex watches, we can observe that name branding does not ensure a higher level of markup. In the case of Rolex watches, the brand name is so strong that it has standardized and commoditized the product. Consumers shopping for a Rolex watch can easily compare values from different retailers and negotiate the best price. In fact, the only thing enforcing any level of markup for Rolex watches is the ability of the manufacturer to restrict sales to firms that discount the “suggested retail price” or resell the watches on the grey market.

It is important to recognize that while brand-name companies increase the markup potential, name brand products often decrease the markup potential.

Brand name companies are able to maintain larger markups for their products due to the enhanced value their name, reputation and reliability bring to products. The best case of added markup value is when a brand name company sells a nonbrand name product that consumers are afraid to buy because they do not understand the item. A consumer buying a blind item, such as an expensive ruby, will pay more for a stone from Tiffany because they know that Tiffany’s quality control will assure a fine quality stone. On the other hand, few consumers need to pay Tiffany a high markup for a Rolex watch. They know that the same quality Rolex watch is available at any other retailer.

Obviously, there is a lesson for De Beers here. If De Beers sells direct, its name will increase margins for the diamonds it sells. On the other hand, if De Beers merely brands the product, then retailers will compete with each other selling De Beers diamonds and the brand name will actually help commoditize the diamonds and lower margins.

While De Beers brandname diamonds might be worth more and cost more than other diamonds, the retail markup for such diamonds will probably be rather tight as retailers compete to sell the stones.

The GIA and other grading labs are good examples of product branding for diamonds. One of the primary reasons that retail margins are low for lab graded diamonds is that consumers don’t need to pay retailers to tell them, or assure them of what they have. Educated consumers can read the certs and have even begun to learn all about cut grades based on data in the grading report.

Price Point Markups

Price points also have a definite impact on markups. In general, the higher the price of an item, the lower its markup. To some degree this is based on the expectation of buyers who expect a better price for a more expensive item. Another factor is the inability of retailers to let a big customer walk. When it comes to expensive items, retailers don’t think in terms of percentages, but rather dollars. Retailers just can’t stand the thought that they will lose hundreds, or thousands of dollars, if the customer walks.

Next month we will discuss the impact of memo, competition and cost pricing on markups. We also plan to present the first installment of our data results from the Rapaport Markup Survey.

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Tags: Consumers, De Beers, GIA, Jewelry, Labs, Martin Rapaport, Tiffany
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