“If I want a 40% margin then how much of a markup do I need?”
This may be a simple answer to some but for others the answer may not be as clear. In today’s environment, markup and margin are often used interchangeably or confused to mean gross margin. Misunderstanding these two very different financial terms can have a significant impact on a company’s bottom line.
Understanding the difference
The difference between margin and markup is that margin is sales minus the cost of goods sold, while markup is the amount the cost of a product is increased in order to determine the selling price. Confusing the two can result in setting prices that are too low or too high, resulting in either a loss of sales or profits. It can also inadvertently impact market share by pricing yourself out of the market when compared to the competition.
Margin (or gross margin) is sales minus the cost of goods sold. If a product is sold for $100 and costs $70 to produce, then the margin or profit from the sale is $30 or 30%. To calculate the percentage, use:
(sales - cost of goods sold) / sales = margin %
Markup is amount the cost of a product is increased to arrive at the selling price. Using the same example as before, if you want to make a margin or profit of $30 and the product costs $70, the you need to sell it for $100. In this case, the markup percentage is 42.9%. To calculate the percentage, use:
(sales - cost of goods sold) / cost of goods sold = markup %
If they’re so different, why do they get confused?
When you look at the formulas above, you may notice that they’re pretty similar. The formulas use the same inputs, just with different placement, and both result in percentages. As Investopedia puts it, they’re telling different sides of the same story. Profit margin is addressing the profit as it relates to the selling price, whereas the markup addresses profit as it relates to cost price. The truth is, it’s really easy to confuse these numbers.
A few years ago, I was working with a company who had been mistaking margin and markup for years. They wanted to make a 40% margin or profit so they were marking-up their prices by 40%. They didn’t realize anything was wrong until they had a difficult year financially. That's when I was brought in to help them fix things. The company was struggling because while they thought they were making 40% margins they were actually making 28.5% margins. To actually make a 40% margin, they would have had to have a 67% markup.
Another problem for the company was that they weren’t benchmarking themselves against the industry. Once we did that, it was discovered that were making well below industry averages. Now this wasn’t a small company either, they were one of the leaders in their industry and had a brand name to support premium prices but they weren’t charging them.
When the misuse of margin and markup was corrected, people in the company were worried that the market wouldn’t be receptive to their new prices and rightfully so. But the company had been underpricing themselves for years, they lost profits and market share, and when prices increased they continued to get business because they were still charging an appropriate amount for the industry.
As you can see, it’s relatively easy for people to have trouble setting their prices if they confuse margin and markup. A simple way to look at it is that your markup percentage needs to be greater than your desired margin percentage. Margin vs. Markup, by the numbers:
To make a 10% margin, the markup percentage is 11.1%
To make a 20% margin, the markup percentage is 25.0%
To make a 30% margin, the markup percentage is 42.9%
To make a 40% margin, the markup percentage is 80.0%
To make a 50% margin, the markup percentage is 100.0%
Looking at the bigger picture
If you’re having trouble with markup and margin, take a step back to look at the bigger picture. Are you making the amount of money you should be? Are your prices competitive in the market? Could you be making more?
After asking yourself these questions, you’ll likely notice that something is off. Look at whether your markup is more than your desired margins and then bring it back to basics. Use the formula’s above to achieve the right margins for your business.
It can be tough to look critically at your business, especially when things aren’t going well. Instead of dwelling on what you may have missed out on, focus on how you can improve things today. What happened in the past is in the past, so move forward with excitement over the new potential of your business. Embrace the discomfort that comes with change and go succeed.