Retail is a service industry, and retail stores make money by providing the service of making merchandise available for customers to buy conveniently.
Retailers do not have to be manufacturing the goods themselves, although some retailers do design and sell their own private label merchandise.
Read Also: What is Retail?
The Business Model: How Retail & Ecommerce Stores Make Money?
To understand how retail stores make money, let’s have a look at the main business model for retail businesses and then discuss some variations to this model.
Buy at wholesale price —> Add markup —-> Sell at retail price —-> Gross Profit Margin
This was the main business model.
However; a lot of retailers also work on consignment basis. In this case they provide area in their stores for merchants to display their products and only when these products are sold the retailer gets a commission that is usually around 40%
The consignment business model will look like this:
Display products —-> Sell to customers —-> get % commission of retail price (Gross Profit Margin)
Read More: Consignment: How It Really Works?
Factors Affecting How Retail Stores Make Money
Now that we have seen the main business models used in retail & ecommerce, let’s have a look on different factors that affect retailers’ profitability.
1. Gross Profit Margins
In oder for retail stores to make money they first have to source the products that they sell at a significantly lower price than what they are going to sell to the end customer. This is called the wholesale price and is usually between 40% to 60% of the end retail price. For grocery stores and convenience stores this gross margin is lower (more in the 20s) and they capitalize on the high volume they sell and their high inventory turnover rate.
We have compiled different benchmarks by retail segment in our Retail Benchmarks page.
However; retailers usually don’t sell at the original retail price all the time. Throughout the year, they will be running sales & promotions to achieve their sales targets and clear out the merchandise they bought.
This is why anyone getting into the retail or ecommerce business and wanting to make money out of their retail store should be able to differentiate between intake margin vs. realized margin. Failing to make this differentiation will result in wrong planning and possibly failing to make money due to having a realized margin that is not sufficient to pay the retail overheads.
Read our article on Gross Margin Types for more details.
While sourcing their products, retailers have to try and get the highest intake margin from suppliers and then figure out the final realized margins after running all their promotions for the year to see if they will produce enough gross margin to support their operational costs. This realized margin is the one that will show in the P&L/income statement.
Use our markdown planning tool to forecast your final realized margins.
2. Retail Overheads
In order to provide the service to their customers, retail stores will have certain overheads to pay for.
This will include store rent, employee costs, admin fees, warehousing costs and sales & marketing expenses.
For more details read our free guide on P&L Management
This is why the initial gross margin has to be high enough to pay for all those overheads and at the end return a net profit out of the retail or ecommerce operation.
3. Product sourcing or Buying
You must have noticed that the money a retail store will make at the end is a function of sales or revenue.
In order to be able to make good sales, the retailer needs to source products that are in demand and sell well. These products should also be sold at a high enough gross margin as discussed before.
In fact, sourcing the wrong products does not only affect sales, but it also affects the margins of the business. This is because if these products are not sold, they will have to be discounted and this will result in lower realized margins.
Another factor to consider while buying is also the amount of inventory you buy.
If your inventory level is too low, you will miss sales opportunities and will not deliver your sales budget, and hence also will not make the budgeted money out of your retail or ecommerce store.
On the other hand, if your inventory level is too high, your storage costs will increase and you will eventually need to discount your products to clear the excess inventory.
Read more on Inventory Management
The process to accurately calculate the amount of inventory you need for your retail or ecommerce store is called Open to Buy.
We explain this process in details in our free guide: Open to Buy: How Much Inventory Do You Need?
How Much Profit Do Retail Stores Make?
The amount of money made (Net Profit) at the end of the year is a function of the sales/revenue delivered throughout the year.
Pre-tax profit for retailers in the U.S is usually around 3% to 5% of revenue. Some retailers perform better and some deliver lower profits, and it varies widely between the different types of retail segments. We have noticed that specialty retailers tend to deliver higher profit margins.
Read Also: What is Retail?
Retail Margins by Category
We have compiled a list of Retail Benchmarks by retail segment for reference and here is a snapshot for gross margins and pre-tax profit by category.
|Category||Gross Margin||Pre-tax Profit|
This is why maximizing sales is a primary goal for every retailer, since the end profits will be a % of this revenue number. However; as we have shown here, if those sales come at lower gross margins by excessive discounting, then this will affect the net profit and can even result in loss.
Read Also: Types of Sales Reports
Retailers always try to strike a balance between increasing their sales, while giving aways less margins in the process. They usually do this by running tactical sales promotions. If the sales promotions don’t work or drive extra sales, then it is better to stop that promotion, so that you won’t be losing sales and margins at the same time.
With retail net profit margins being so low, it is very critical that retail & ecommerce owners focus on all the numbers that affect their final profitability.
They should start with a proper sales budget, which affect all the planning process afterwards, from buying to end P&L budget.
We have combined all the knowledge and tools needed to master your retail & ecommerce financials in our membership plans, feel free to check them out.
Retail is one of the most important sectors in the economy and one that provides a lot of value to its customers, employees and store owners.
Retailers make money by providing their service at reasonable gross margins. These gross margins then pay for the retail overheads and deliver a final net profit to the retail or ecommerce business owners.
Due to the slim profit margins that characterize this industry, it is very important for retail owners and managers to know their numbers and watch them carefully throughout the year, and take corrective actions if necessary.
Read more on Retail Financials
Retailer & Founder of Retail Dogma, Inc.
Rasha has 14 years of retail & ecommerce experience. She has started an ecommerce business in 2008, and later worked at H&M, Bath & Body Works, Victoria’s Secret and Landmark Group. She’s lived in 4 different countries, speaks 3 different languages and holds a BSc in Pharmaceutical Sciences and an MBA in Strategic Management & Marketing.