Margin vs Markup Explained
I cannot count the number of times I have heard someone use the words markup and margin interchangeably.
Many business owners do not know that there is a difference between the two terms, and unfortunately, the confusion between the two terms can negatively affect the bottom line of your business.
The confusion between the meaning of the two terms stems from the fact that the same inputs are used to calculate both markup and margin, and the two of them provide information about the same transaction.
However, margin and markup are totally different things.
They show different information and are accounted differently.
In this article, we are going to explain the difference between margin and mark up and explain why it is important to tell each apart from the other.
Before we go into the differences between margin and markup, it is important to first understand three terms which will come in handy when calculating both the margin and the markup. These terms are:
- Revenue: This refers to the income earned after products or services are sold. Revenue reflects to all the money earned from the sale before any deductions have been made. Revenue is usually the top line in an income statement.
- Cost of goods sold (COGS): This refers to all the expenses that the business incurs while making products and delivering services. During the calculation of cost of goods sold, only variable costs are considered. Variable costs are those that are directly incurred in the production of goods and those that may vary depending on the amount of goods being produced. Examples of variable costs that are calculated as part of COGS include the cost of raw materials, manufacturing costs, product packaging, direct labor, freight, and any other costs that can be directly attributed to making and selling the product. Fixed costs are not considered part of the cost of goods sold. Examples of fixed costs include rent, office expenses such as utilities, supplies, internet, telephone, and so on, the salaries of office staff who are not directly involved in production, professional fees, insurance, advertising, promotional and other sales expenses, payroll taxes and employee benefits, etc.
- Gross profit: This is the part of the revenue that remains after the expenses of manufacturing your products or delivering your products have been deducted. Gross profit is the difference between revenue and COGS.
Keep these three terms in mind since we will use all of them to calculate margin and markup.
WHAT IS MARGIN?
The margin, also referred to as gross margin, is a figure that shows the amount of revenue earned after the COGS has been deducted.
Margin can be expressed in dollar value or as a percentage. Margin is calculated by dividing the gross profit by the revenue.
Below is the formula for calculating margin:
To make the margin formula easier to understand, let’s use an example to illustrate how it works.
Let’s assume a pair of headphones is sold at $400 and costs the company $200 to make.
The margin on a pair of headphones would be:
Alternatively, you can express the margin as a percentage as by multiplying the figure above by 100.
In our example above, the margin for a pair of headphones is 50%.
This means that 50% of the total revenue is kept by the company, while the other 50% of revenue covers the cost of producing the headphones.
From this, we can say that margin is a measure of how much of every dollar earned in revenue is kept by the company after deducting expenses.
In our example, for every dollar made in sales, the company retains $0.50.
The higher the margin, the greater the portion of revenue the company keeps after making a sale.
The gross margin is a very important metric when evaluating the financial performance of a company because it tells whether the company is making or losing money on sales, which is a very crucial aspect of business, since a business that is not making money on sales is failing.
In addition, the gross margin is a useful indicator of how efficient the management of the company is in using supplies and labor in the production process.
For a company that has a very low gross margin, there are two major approaches for improving this key metric.
The first one is by increasing the price of products or services, while the second is by reducing the cost of production. None of these two approaches is easy.
A price increase in a bid to increase the profit margin can result in a reduction in sales.
If the sales become too few, the business might be unable to bring in enough revenue to cover operating costs.
Therefore, before increasing the price, the business needs to consider factors such as supply and demand for the product, completion from other businesses, inflation rates, and so on.
The second option for companies that want to increase their gross margin is to reduce the variable costs associated with producing their product.
For this to happen, the company needs to either reduce the cost of acquiring materials or make the production process more efficient.
A great way of cutting costs on materials is to take advantage of volume discounts.
By buying more material from a supplier at a go, you are more likely to receive discounts.
Alternatively, you might opt to look for a less costly supplier.
You should be careful when doing this since low prices on materials might mean lower quality materials.
If you decide to reduce your production cost by making your production process more efficient, you should also take care to ensure that the quality of goods is not compromised.
WHAT IS MARKUP?
Just like margin, markup also analyzes the profit made after making a sale.
However, markup looks at gross profit as a function of the cost of goods sold, rather than revenue.
In other words, whereas you divide the gross profit by revenue to calculate margin, you have to divide the gross profit by the COGS to determine the markup.
You can think of markup as the extra percentage on top of the cost of production that you charge your customers.
Markup can be calculated using the following formula:
Once again, let’s use the example from above where it takes $200 to produce a pair of headphones, which are then sold at a price of $400. Here is how we would calculate the markup.
Alternatively, you can express the markup as a percentage as by multiplying the figure above by 100.
The markup in this case is 100%, which means that the headphones were sold for 100% more than what it cost to produce them. In other words, the selling price is double the cost of production.
Markup is a measure of how much more you sell a product compared to what it cost you to produce the product.
Just like margin, the higher the markup, the greater the portion of revenue the company keeps after making a sale.
Markup can also be described as the factor by which you multiply the cost of production to come up with a selling price. This can be expressed as:
THE DIFFERENCE BETWEEN MARGIN AND MARKUP
As you might have realized by now, margin and markup are like the two sides of a coin.
They describe the same thing, but they provide different perspectives.
The margin shows the relationship between gross profit and revenue, while markup shows the relationship between profit and the cost of goods sold.
Aside from showing different perspectives, there are some other key differences between margin and markup, which include:
- Having a markup on your products ensures that your business is making a profit with each sale and provides a way of quantifying that profit.
- Markup is a great tool in the initial stages of a business since it helps you to better understand how cash flows into and out of your business. This can be very usefully in helping you locate efficient points and bottlenecks within your business.
- Margin, on the other hand, is a precise and reliable tool for calculating profits and provides a clear picture of how sales are impacting your company’s bottom line.
MARGIN VS. MARKUP CHART
While the margin and markup offer different perspectives of the same thing, it is important to understand how each behaves in relation to the other, since confusing the two can impact your profitability.
Considering that the reference for calculating markup is cost of goods sold, which is a lesser value, the markup will always be bigger than markup, which is calculated based on revenue.
Generally, a profit making business should have a markup percentage that is higher than the margin percentage.
If your markup is lower than the margin, this means that your business is making losses.
The relationship between markup and margin is not an arbitrary one.
Generally, the relationship between margin and markup can be expressed using the following formula.
For instance, in our headphones example above, we saw that the margin was 50% while the markup was 100%.
Let’s confirm if our formula above will get the same thing.
Alternatively, we can use a specific margin to determine what markup is required to achieve the margin. In this case, we use the following formula:
Once again, going with our previous example, we know that a 50% margin will give you a 100% markup. Plugin this into our formula confirms this.
Using the above two formulas, we can accurately predict how margin and markup interact with each other.
A specific markup will always produce a specific margin.
To easily determine what markup will produce what margin, a margin vs. markup chart is used.
Below is an example of a margin vs. markup chart:
PRICING YOUR PRODUCTS BASED ON MARGIN
Setting the right price for your products is very crucial, and can be the difference between attracting customers by the loads and your business going under.
One of the most common ways of pricing products is to adjust the cost of goods sold by the target profit margin.
This way, as a business owner, you can always be sure that a specified percentage of each dollar made from sales represents profit over the COGS.
For instance, if you adjust your COGS by a target margin of 30% to come up with a selling price, 30 cents of every dollar earned from sales will be a profit.
To come up with a selling price based on the margin, you should start by diving your target gross margin by 100 to convert it from a percentage into a decimal.
For instance, if you have a target margin of 30%, divide 30 by 100 to get 0.30.
Once you have your target margin as decimal, subtract it from 1 to determine what portion of your selling price will represent the cost of goods sold. In this case, the cost of goods sold would be represented by
Once you determine the portion the cost of goods sold represents, divide the cost of goods sold by this figure to come up with the selling price.
For instance, if manufacturing your product costs $14, then the price in this case would be:
In this case, you would sell the product at $20.
When coming up with your target margin, it is always advisable to include other costs besides what goes directly into the making of the product, such as overhead.
This will ensure that your selling price is enough to cover all the costs of doing business.
When setting the price, you should also keep in mind that there are several other factors other than the cost of making the product that will affect the price.
For instance, the price that the market can bear will also have an impact on your price.
Setting a price based on a specific target margin will not be effective if customers are not willing to pay that price.
Therefore, in as much as you want to achieve a specific target margin for every sale, you should also make sure that your price allows your product to maintain a competitive advantage.
PRICING YOUR PRODUCTS BASED ON MARKUP
Some entrepreneurs may also choose to set up their price based on markup.
When using markup as the basis for selling price, the markup must be big enough to cover all the expenses and reductions that are part of business, such as markdowns, customer discounts, and so on, while at the same time ensuring that the business earns a significant profit.
Therefore, if you want to use markup as a basis for pricing your products, you should make sure that you are well informed about all aspects of your business, such as total operating expenses, including costs such as labor, materials, and overhead costs, as well as things such as sales figures.
When setting price based on markup, all you need to do is figure out all the costs associated with producing and selling a product and then multiply this by the markup to come up with the price.
Below is the formula for calculating a markup-based price:
Going by our earlier example, if the cost of manufacturing a pair of headphones is $200, and the company wants a markup of 100% on the headphones, then the price of the headphones would be calculated as follows:
There are some factors that you need to keep in mind before deciding the markup you will use on your products or services.
The two most important factors to consider are the costs associated with producing the product and the market demand for your product.
Aside from these factors, you should also consider the industry in which you are operating.
In most cases, you will find that there is standard markup within certain industries, and it might be wise to stick to the standard in order to maintain your products’ competitive edge.
One of the greatest advantages of using markup as a basis for your product pricing is that it guarantees that your business generates a proportional amount of revenue for each sale.
The revenue will remain proportional even when your cost of goods sold increases or decreases.
However, this does not mean that a business owner should blindly stamp a flat markup percentage on all of the business’ products and services.
This is not a very effective strategy. Instead, you should consider using different markups based on the characteristics of your products.
For instance, if you are an electronics retailer, you might have different markups for different products, such as TV sets, home theater systems, fridges, cookers, and so on.
The markup should also depend on factors such as the products’ turnover.
For instance, products that have a very high turnover might have a lower markup compared to those with lower turnover.
This is because the high sales might be enough to cover operating expenses, despite the lower markup.
To explain how this works, let’s assume that two companies, company X and company Y are in the same industry and sell similar products.
It costs both companies $10 to make the product. However, company X places a 50% markup on the product, while company Y places a 30% markup on the product.
This will result in a price disparity between company X and company Y, with company Y’s products being more competitively priced. This difference in price can result in company Y selling two or three times more than company X and making more profits than company X, despite company X having a higher markup on their products.
This is based on the law of demand, which states that the price of a product is inversely proportional to demand.
An increase in price leads to reduced demand, while a decrease in price leads to increased demand for the product.
MARGIN VS. MARKUP – WHICH SHOULD YOU USE?
At the start of this article, I mentioned that confusing between margin and markup can be hurtful for your business.
So, which of the two should you use? Generally, most small businesses, and especially retailers, depend on markup to set prices for their products.
However, when it comes to recording financial information about your business, you accountant, bookkeeper or accounting software will be more interested in the margin rather than the markup.
If you use markup in the place of margin, you will end up with bungled accounting numbers, which might make you think that your business is making more money than it is actually making.
Therefore, while both can be used to determine how to price your products, you should stick to the gross margin when it comes to accounting, because it is a more accurate representation of the profit your business is making.
Understanding the relationship between margin as well as the difference between the two is very important for every business owner.
Confusing between the two messes up your accounting and may even result in your business losing money without your knowledge.
On the other hand, knowing the difference between the two terms and how they related to each other helps in setting the right goals for your business and implementing short and long term strategies for your business.
Understanding margin and markup also helps you to properly price your products.
It allows you to competitively price your products while ensuring that you are not leaving any revenue on the table.
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