A caller on The Dave Ramsey Show once left Dave laughing uncontrollably when she told him she wanted to start a home organization business. “I was thinking of [charging] probably like $100 to $200 per room,” she told him.
“Where’d you get that number?” he asked her.
The caller replied, “Uh – out of my [behind].”
This is a comical example of what can be “behind” the price of a good or service when it’s set by someone new to a market. But even industry retail veterans set prices that aren’t always clear.
Luxury brand Christian Dior sells a $2800 handbag that cost just $57 to produce – a seemingly shocking markup of 5000%. A Milan court investigation into Italian factory conditions found that LVMH (which owns Dior) and Giorgio Armani manufactured their goods in subpar working conditions to increase their profit margins.
The average retail markup (the difference between a product’s retail price and the production cost) is typically 50% or 60%, but this percentage varies due to many factors. For the LVMH group overall, for example, the average cost of manufacturing its products – handbags, clothes, accessories, cosmetics and other goods – amounted to 31% of sales in 2023. But margins on luxury handbags are typically the highest.
These findings raise questions about why prices for many retailers are higher than manufacturing costs. How does a product get from a manufacturer to a consumer? What accounts for additional increases along the way during production? The answer will help customers understand what’s behind the price sticker – and maybe avoid a shock.
Retailers vs. Wholesalers vs. Distributors
Manufacturers, retailers, wholesalers and distributors all play different roles in the supply chain.
The retail supply chain starts with manufacturers, who purchase raw materials to create physical products. But rarely do retailers purchase directly from the manufacturer. In the traditional supply chain, manufacturers sell their products to distributors, who sell to wholesalers which then sell to retailers.
Raw Materials → Manufacturer → Distributor → Wholesaler → Retailer → Consumer
The primary role of a distributor is to help a manufacturer reach its desired end market: getting into new territories and making connections with new wholesalers. Wholesalers have direct relationships with retailers (like department stores, online stores, supermarkets and brick and mortar shops), which then sell the products to customers.
Why don’t retailers buy directly from manufacturers?
Sometimes cutting out the middleman from the process is helpful for retailers. But most of the time, it isn’t in retailers’ best interest to buy directly from manufacturers. In some sectors, such as with alcoholic beverages, most states legally prohibit manufacturers from selling directly to retailers.
Manufacturers make and sell large quantities of products at once. Distributors and wholesalers buy products in bulk, which means they can get those products for a lower cost. This idea is known as “economies of scale.” To purchase directly from a manufacturer, retailers would have to purchase a large number of products at once, which may not be cost effective or efficient for some retailers’ businesses or storage capabilities.
Additionally, because raw materials and labor costs are sometimes lower abroad, many products are manufactured outside of the United States. Importing goods from abroad introduces a number of cross-border processes and logistics that wholesalers and distributors specialize in, but retailers may not want to deal with themselves.
What Accounts for Retail Markups?
The retail price of an item can be about two to four times the cost of producing that item. At each step of the supply chain, the cost of that item increases because distributors, wholesalers and retailers each need a product’s price to cover their own operational costs.
These costs include needs like rent, utilities, employee salaries and administrative expenses. For wholesalers and distributors that import goods from abroad, taxes and import duties also add to the final price of the product. For retailers, the cost of reaching consumers – marketing, advertising and sales – can be expensive as well.
Inflation also drives up the cost of goods by increasing the prices of raw materials, labor, transportation and energy. As suppliers face higher expenses, they pass these costs along the supply chain, leading to more expensive retail prices.
Taxes and Impact Pricing
Impact pricing refers to the practice of adjusting the price of goods or services based on external factors. These include logistics costs (the cost of shipping, warehousing and transportation); supply chain risks (companies may adjust prices upward to cover potential delays or shortages); and tariffs, quotas or sanctions imposed by governments.
To date, U.S. Customs and Border Protection has collected over $221 billion from U.S. importers for Section 301 tariffs on imports from China. The cost of tariffs and taxes is passed on to consumers, making imported goods more expensive. For example, a luggage seller interviewed by the National Retail Federation said that a suitcase that sold for $100 before those tariffs went into effect now retails for $160.
Regulatory Compliance
The cost of regulatory compliance in the current landscape is enormous and growing all over the world – particularly for small and medium-sized manufacturers, which drives up costs. Failure to meet U.S. regulatory standards can also result in expensive fines, so companies often invest heavily in compliance measures, which further raises costs.
The average U.S. company pays $9,991 per employee per year to comply with just federal regulations, but the average manufacturer in the United States pays nearly double that amount: $19,564 per employee per year. According to the National Association of Manufacturers, more than 63% of manufacturers report spending more than 2,000 hours per year complying with federal regulations, while more than 17% of manufacturers report spending more than 10,000 hours. These numbers again only account for federal regulations—not state, local or international rules.
Is This Model Changing?
In recent years, the lines of the retail supply chain have blurred. Many wholesalers, for example, now buy directly from manufacturers. And retailers buy directly from distributors.
These changes occur because it has become easier to reach the end consumer directly. Fashion and home goods retailer Quince, for example, partners with a select number of factories directly and manages every stage of its products’ creation, including packaging and transportation. Direct-to-consumer retailers like Quince rely on digital marketing and social media to reach potential customers. Not using distributors or wholesalers allows them to pass along more savings to the consumer.
According to KPMG, direct-to-consumer retail now accounts for 17% of online retail sales in the U.S. Other popular direct-to-consumer companies include the sock brand Bombas, the eyewear retailer Warby Parker, the mattress brand Casper, the skincare and makeup brand Glossier and the luggage retailer Away. Many direct-to-consumer retailers focus on a single type of item because they are able to partner directly with one manufacturer and closely monitor production and quality.
Conclusion
The future will likely include an evolved form of direct-to-consumer retail, with brands selling through their own online storefronts and appearing in marketplaces like Amazon and traditional retailers like department, big box and specialty stores. This trend is already happening, with brands like Glossier selling in Sephora and Dollar Shave Club and Casper selling on Amazon. Ultimately, consumers want low prices and choices in how they purchase items where they shop, without sacrificing quality. Thus, retailers adjust their strategies to provide the best products possible at the lowest price possible to customers.