The Math Of Rising Prices

Let me preface this blog by telling you that all of the numbers that I am using here today are made up to prove a point.

Anyone following me lately should know good and well that fabric prices are on the rise along with most other stuff that we buy due to inflation. With that, I wanted to walk you through some mathematics to show you how and why prices jump like they do when prices rise.

The first thing I am going to do is walk you through an example of pricing prior to factoring in newly implemented price increases that we are currently incurring from the fabric print mills that we use.

Let’s say the fabric costs $1/yard to buy from one of the mills we use. Using the $1 cost, we have to pay a 7% duty on that for $.07/yard. Then we have to double and roll the fabric for $.15/yard. On top of that, we have to pay to ship the goods to our warehouse and there are a few other miscellaneous costs. Let’s say those additional miscellaneous costs add up to another $.10/yard. Here’s the math:

$1.00 (fabric cost) + $.07 (duty) + $.15 (d/r) + $.10 (misc.) = $1.32/yard

Now let’s say that we are selling these fabrics to quilt shops for $3.00/yard. We can’t forget about royalties for designers and commissions for sales reps because as the selling price rises, those numbers rise too. Let’s say that the designer makes 4% per yard ($3.00 x .04= $.12) and the sales rep makes a 7% commission per yard ($3.00 x .07= $.21). I then take the $3 selling price and reduce it by the royalty and commission ($.12 + $.21 = $.33). So $3.00 -$.33 is $2.67. That is the net amount of money we would take in after paying the sales rep and designer.

Now, the final calculation is to take the $2.67 and subtract the cost of $1.32 to figure out how much money we make per yard. That ends up being $1.35/yard. To figure out the profit margin, I take the $1.35/yard and divide it by $2.67 and that turns out to be a 50.5% margin.

That 50.5% margin sounds very high and great, but don’t forget that there are a lot of other costs we have to cover to manage the business i.e. rent, salaries, equipment, computers, travel, etc. Unfortunately, that profit margin number drops precipitously when you factor in all the costs incurred to run a business.

One other thing to mention is that a quilt shop owner who buys this fabric for $3/yard will have to sell it at twice the cost plus another $.25 for the cost of freight. With that, the shop owner will be selling for $6.25/yard. A shop owner would have a gross margin of 52% ($6.25 selling price -$3.00 cost divided by $6.25/yard). It’s a gross number because we know the shop owner paid $.25 for freight and they also have other costs to factor in like anyone else who runs a business including salaries, rent, supplies, etc. All those extra costs need to be factored in to figure out the net margin of the business.

Now, let’s fast forward to today and talk about what happens with the numbers when prices rise and how that impacts all the calculations. Let’s say the $1.00 fabric cost goes up by $.20/yard. Now the new calculation is this:

$1.20 + .084 (7% duty) + .15 (d/r) + $.10 (misc.) = $1.534 rounded to $1.54

If we sell at $3/yard again and net out $2.67/yard after we pay royalty and commissions, we then need to calculate the new margin. $2.67-$1.54 = $1.13 Now, we are making $1.13 on a $2.67 sale for a new margin of 42.5%. Now you can see that with a $.20 price increase that the margin goes down by 8%. As you can imagine, we don’t want to lose 8% so we now need to increase the selling price of the fabrics to make up for the decrease in margin. The goal is to maintain the margin although that isn’t always feasible because if the price gets too high, that could cause a huge reduction in sales in which case nothing would matter because sales are absolutely necessary.

Let’s say now that we raise our selling price to quilt shops to $3.50/yard and see what happens. We need to reduce that $3.50 selling price by 4% for royalty and 7% for commissions for let’s call that a $.39 reduction. Our selling price of $3.50 less the $.39 for royalty and commissions nets us out $3.11. If you take the $3.11 and subtract $1.54 for new the cost of the fabric based on the $.20 increase, the profit ends up being $1.57. When we divide $1.57 by $3.11, we get back to right around our 50.5% margin that we got to prior to raising prices.

So you might be asking, what’s the point? The point is that we needed to raise our selling price by $.50/yard to cover and maintain our margins of 50.5% based on a $.20 increase in the fabric. The bigger point is that the reason for having to make such a big raise to maintain the margin is that, with the increase in price, there is an exponential increase in the duty, commission and royalty to consider. It would be awesome if we only needed to raise our prices by $.20 to keep our margins the same with a $.20 increase. No such luck!

Ok, I know your head is spinning now especially if you aren’t a math person, but I need to close the loop by talking about the impact on quilt shop pricing.

If the fabric is now $3.50/yard and the shop is going to sell at double the cost plus $.25 for the freight, that $.20 raise in our cost resulted in the shop having to raise up to $7.25. That in effect required the shop to raise their price by $1.00. Long story short, a $.20 raise in the first cost to the supplier (my company) is forcing the shop owner to raise prices by a $1 to the end consumer and that is mainly the result of the increase in the duty, royalty and commission on top of the fabric cost increase.

To wrap it all up, let’s see what happens to the shop owner’s gross margin when they have to sell at $7.25/yard. Using the selling price of $7.25 less the cost of $3.50 results in a $3.75 profit before expenses. Divide $3.75 by $7.25 and the gross margin is slightly below the original gross margin of 52%. If the shop doesn’t want their gross margin of 52% to go down at all, they may have to raise prices by another $.05 or $.10.

I am sorry to say it, but this is what your future looks like for just about everything you buy including fabric! Don’t say I didn’t warn you.