Trade Margins and Selling Prices

Understanding Trade Margins

Trade margins, also referred to as channel margins, are the differences between prices and costs at each level of the distribution channel. Consider the simple example illustrated in Figure 1. This example assumes a traditional channel of distribution consisting of a manufacturer selling through a single wholesaler and retailer to reach the consumer buyer.

Figure 1. Illustration of Trade Margins in a Traditional Channel of Distribution

Assuming the consumer will pay $100 for the product, that is also the price charged by the retailer. If the retailer pays the wholesaler $75 for each unit (the retailers cost) then the retailers margin is $100 - $75 = $25. Similarly, working backwards in Figure 1, the margins for the wholesaler and manufacturer are $15 and $10, respectively.

Channel margins illustrated in Figure 1 are often called markups. For the remainder of this discussion, we will employ markup terminology since this terminology is more commonly encountered in practical application. Markups can be expressed in both dollar and percent formats. In the above example, the dollar markup for the retailer is $25 while the percentage markup is expressed as a percent of the selling price to the consumer:

(1)

Similarly, the percent markups for the wholesaler and manufacturer are $15$75 =.20 (or 20%) and $10$60=.1667 (or 16.67%), respectively.

Percent markups can be expressed in terms of the selling price to the next channel member, or the percent markup can be based on cost. The previous discussion and examples all illustrate expressing percent markup based on selling price. When the percent markup is based on cost, the denominator in the formula (Equation (1) above) becomes the channel members cost instead of his or her selling price. For example, using the data from Figure 1, the retailers markup based on cost is given by:

(2)

Figure 2 compares the computations of percent markup based on cost with the percent markup based on selling price for each member of our hypothetical channel of distribution. Note that for a given dollar markup, the percent markup based on cost is always larger than the percent markup based on selling price.

Figure 2. Markups Based on Selling Price and Based on Cost

Markups and Price Setting

The distinction between markup based on selling price and markup based on cost becomes crucial when setting prices. Assume you are the manufacturer in our last example, but lets change the example a bit. Your costs are $100 per unit and you normally require a 20% markup to cover your fixed costs and allow for profit. What should your price be to the wholesaler? The answer depends on which form of percentage markup you are to employ. If the manufacturers markup is based on selling price, then the price should be $125. Twenty percent of $125 is $25, which is the dollar amount added to the manufacturers costs of $100 to yield the $125 selling price. In contrast, if the percent markup is based on cost, the resulting selling price will be: $100 + (.2 x $100) = $120, a lower projected selling price. Which one to use? Usually, a percent markup based on selling price is employed. But is doesnt really matter as long as you are consistent with expected pricing practices in your Firm and industry.

Price Setting Formulae

The following formulae solidify the distinction between using markup based on costs versus markup based on selling price when setting prices through the channel. Equation (3) employs markup based on cost:

(3)

To compute selling price to the next channel member simply multiply your cost by one plus the desired markup percent (expressed as a fraction). For example, given that a product costs the wholesaler $50 and a 25% markup based on cost is desired, the selling price will be:

(4)

Equation 3 presents the formula for computing selling price when markup based on selling price is employed:

(5)

Using the same cost and markup data from the last example, the selling price when cost is $50 and a 25% markup based on selling price will be:

(6)

Pricing Through the Channel

Manufacturers often are interested determining a suggested retail price for their products that may even be preprinted on packages. You already know how this is done. The manufacturer simply begins with its own costs and required margins and works forward through the distribution channel computing price at each level given the margins required by each intermediary. This is exactly the example developed in Figure 2. But lets modify the example a bit to further show the effects of whether of markup based on cost or markup based on selling price is employed. The manufacturer faces costs of $50 and requires a 20% margin. The wholesaler needs a 15% margin and the retailer demands a 40% margin. What suggested retail selling price (price to the consumer) will provide all channel members with their desired margins? Figure 3 illustrates the logic and provides the computations when the margin is operationalized as either markup based on selling price or markup based on cost. The top half of Figure 3 illustrates markup based on cost. The end result is a suggested selling price to consumers of $96.60. The bottom part of Figure 3 projects a suggested selling price of $122.55 when markup based on selling price is used.

Figure 3. Forward Chain Markup Pricing

This process of applying markups through the channel to determine a final selling price is referred to as forward chain markup pricing. Similarly, marketers can work backwards through the channel using intermediaries required margins. This is often done when manufactures or other middlemen try to determine a reasonable cost for a product that can be sold to consumers at some predetermined price. Assume a retailer of mens clothing knows consumers in its target market expect a price no higher than $75 for a pair of its private label designer slacks. The retailer is negotiating with a number of manufacturers to produce its private label brand. The retailer normally demands at least a 50% margin on its private label clothing items. If the retailer is buying direct from the manufacturer, what is the maximum possible price from the manufacturer that it should be willing to accept in the negotiation process? The answer is quite simple. The maximum possible price (retailer's cost) is simply $75 (.5 x $75) = $37.50. We assume here that the margin is expressed as a markup based on the $75 selling price. The retailer should not accept any contract that bids out at more than $37.50 per pair of slacks.

QUESTION 3

Shannons craft beers are sold via a three tier distribution channel, consisting of its brewery, a distributor (Miller Distributing) and the retailer. At the retail level, a six pack of its craft beer sells for about $12.00. If the typical retailer demands a 50% markup based on selling price and the distributor also wants a 39% markup based on selling price, what will be the maximum that Shannons can charge the distributor for a six pack? Compute your answer to the nearest penny.