If you are a business that sells products, or a business that invests more than just time in the delivery of their services, then this question should be a big deal for you. As the owner, you want to earn as much profit margin as possible, yet still remain competitive in your space. What I have recently discovered is that many businesses don’t truly understand the different in Markup vs Margin, how they are calculated, and what does this mean for your profits?
Before I get into the explanation, there are a few key terms related to this topic that you must understand in order to truly grasp the overall concept.
Revenue is the income you earn by selling your goods or services. It is the top line of your income statement and reflects earnings before deductions. How you PRICE your products contributes to this number. If you sell 10 widgets for $10 each, your revenue is $100.
Cost of Goods Sold (COGS) is the expenses incurred during the making, procurement of, and delivery of your products or services. It will include expenses like materials, direct labor costs, and contractors.
Gross Profit is the revenue left over after you pay your COGS expenses. Gross Profit is Revenue – COGS
I see many business owners that are taking a product that costs them $10 to produce, and say well I want to have a 35% profit, so I will sell it for 13.50. There, I have set a 35% profit margin on this product, right? WRONG!! Unfortunately, that price does NOT result in a 35% profit margin, that is simply a 35% markup.
I am not saying that the calculation is incorrect, the calculation is fine IF you desire to see what your markup is. If you want to get to your margin, or profit margin, you would need a different calculation. Profit Margin is not a direct reflection of your pricing. Instead, it is a calculation that provides your rate of return on the sale of your products and services. To calculate margin, you start with your Gross Profit (Revenue – COGS), then divide that number by revenue.
For example, in the problem statement I provide above, if you sell one widget at $13,50, and a cost of $10.00, then you make $3.50 gross profit on that widget. To find the margin, we take the gross profit ($3.50) and divide by the revenue ($13.50) and that give us 25.93% margin. You get to keep 25.93% of what you bring in (not counting overhead, fixed costs, etc). That’s a little way off from the 35% profit margin that we wanted.
If you know your cost and want to price to get a 35% profit margin, you would take your COGS and divide that by 1 – profit margin. In this example, the formula would be:
10.00. / (1 – .35) = 15.39
So to make 35% profit on a $10.00 COGS, you would need to price the product at $15.39
Markup represents how much more your selling price is than the amount the item costs you (COGS). It does not represent how much money you get to keep as profit.
To find the markup in the example above, you sell your item for $13.50 and it costs you $10.00. First find the gross profit:
$13.50 – $10.00 = $3.50
To find out what percentage the cost was marked up, divide the gross profit by the COGS.
$3.50 / $10.00 = 0.35 markup or 35%
That simply means you sold the widget for 35% more than it cost you to make it. But at that price, you are only making 25.93% profit.
Here is a little table that I created that shows the margin that each markup will produce.
When you find that your profits aren’t working out where they should be, check your pricing first. Often, your COGS, or cost to produce the item, have increased and your pricing doesn’t account for that. Bottom line is you are taking a direct hit to your bottom line, your salary, on the increase in COGS. Also be positive that you are truly factoring all of the costs (labor, purchase price, fees, shipping, etc) associated with selling the product in your COGS calculation?
In our next installment, we’ll discuss why discounting is not the bright star you think it is!