Margin and markup are terms used in the derivation of product costs and profits. The two terms have different meanings, which can lead to considerable confusion when setting product and service prices and determining profit levels. A mistake in the usage of these two terms can lead to price setting that is substantially too high or low, resulting in lost sales or lost profits, respectively. There can also be an inadvertent impact on market share. Explanations of the two concepts follow.
- Margin (also known as gross margin) is sales minus the cost of goods sold. For example, if a profit sells for $100 and costs $70 to manufacture, its margin is $30. Or, stated as a percentage, the margin percentage is 30% (calculated as the margin divided by sales).
- Markup is the amount by which the cost of a product is increased in order to derive the selling price. To use the preceding example, a markup of $30 from the $70 cost yields the $100 price. Or, stated as a percentage, the markup percentage is 42.9% (calculated as the markup amount divided by the product cost).
It is easy to see where a person could get into trouble deriving prices if there is confusion about the meaning of margins and markups. Essentially, if you want to derive a certain margin, you have to markup a product cost by a percentage greater than the amount of the margin, since the basis for the markup calculation is cost, rather than revenue; since the cost figure should be lower than the revenue figure, the markup percentage must be higher than the margin percentage.
The markup calculation is more likely to result in pricing changes over time than a margin-based price, because the cost upon which the markup figure is based may vary over time, or its calculation may vary, resulting in different costs which therefore lead to different prices.
The following bullet points note the differences between the margin and markup percentages at discrete intervals:
- To arrive at a 10% margin, the markup percentage is 11.1%
- To arrive at a 20% margin, the markup percentage is 25.0%
- To arrive at a 30% margin, the markup percentage is 42.9%
- To arrive at a 40% margin, the markup percentage is 80.0%
- To arrive at a 50% margin, the markup percentage is 100.0%
To derive other markup percentages, the calculation is:
Desired margin / Cost of goods
For example, if you know that the cost of a product is $7 and you want to earn a margin of $5 on it, the calculation of the markup percentage is:
$5 Margin / $7 Cost = 71.4%
If we multiply the $7 cost by 1.714, we arrive at a price of $12. The difference between the $12 price and the $7 cost is the desired margin of $5.
Consider having the internal audit staff review prices for a sample of sale transactions, to see if the margin and markup concepts were confused. If so, determine the amount of profit lost (if any) as a result of this issue, and report it to management if the amount is significant.
If the difference between the two concepts continues to cause trouble for the sales staff, consider printing cards that show the markup percentages to use at various price points, and distributing the cards to the staff. The cards should also define the difference between the margin and markup terms, and show examples of how margin and markup calculations are derived.