How to calculate margin vs. markup
If you’ve been wondering about the differences between Margin and Markup and how to calculate those figures, this is the article for you! We’ll explore the relationship between cost, price, markup, and margins.
Margin vs. markup. Whats the difference? How do we calculate both?
Well, it starts with deciding on how to price your products (which is a big deal!). How you price your goods will depend on whether you buy your products in bulk, or if you buy them from different vendors at differing prices. However, in most instances, once you have a system in place to figure out the cost (a.k.a. cost of goods sold or your purchase price), you can use cost to help derive your price.
This is where the concept of markup comes in. Depending on where you search, you can get differing answers for what markup is, and what it has to do with something called margin (or gross profit margin).
If you’re wondering how to untangle that web of M-words and learn what the difference is between margin vs markup, you’ve come to the right place.
Let’s get started, shall we?
What is the markup formula?
You can think of markup like this: the extra percentage on top of your cost that you end up charging your customers.
The markup formula looks like this:
An example of using the markup formula
Now let’s make the example a little more concrete. Let’s say the cost for one of Archon Optical’s products, Zealot sunglasses, is set at $18. This is how much it costs Archon Optical to create a single pair of the Zealot. They will then turn around and sell each Zealot for the price of $36.
If we run through that calculation, we arrive at a markup of 100%:
Pricing products based on markup
However, some businesses might set their prices based on a certain markup in mind already. They’d have the costs ready and have particular markup percentages in mind to help them calculate a price.
How would we express the markup formula in this case? Let’s write this out:
Given a markup of 100% on the Zealot, the price would be $36.00:
Expressing markup as a percentage is useful because you can guarantee that you are generating a proportional amount of revenue for each item you sell, even as your cost fluctuates or increases. This means that the markups you set up at the beginning should scale well as your business grows. We’ll discuss this more when you’ve scrolled a bit more down this page.
What about margin vs. markup?
Now that we’ve defined markup and how it helps you decide on a price, we should discuss the other other big M-Word: margin. The type of margin we’re discussing in this case is gross profit margin, which describes the profit that you earn on a product as a percentage of the selling price.
What is the margin formula?
Margin is often expressed as a specific amount in currency, or a percentage (similar to markup). However, margin uses price as the divisor. If we want to calculate the margin on the Zealot sunglasses, we would lay things out like this:
Based on that formula, let’s apply the numbers we have for the Zealot:
The Gross Profit margin on Zealot sunglasses $18 ($36 price – $18 cost), or you could say the margin is 50%.
Expressed in this way, margin and markup are two different perspectives on the relationship between price and cost. Just like you could say: Thomas is taller than John, or John is shorter than Thomas.
When should I use margin? When should I use markup?
The question then arises: if these two M-Words are so similar, how do we know which one to express or use at a given time?
Markup is perfect for helping ensure that revenue is being generated on each sale. Markup is good for getting started because, as you are getting things set up, you are keenly aware of the costs for your business, and you’re still learning about the kind of revenue you can bring in through sales.
As you get to know your business better and you start to look at reports on your sales, margin can be helpful for examining how much actual profit you’re making on each sale.
Fixed markup as percentage or dollar amount
The world is always changing, and so the cost of manufacturing the Zealot may not always stay at $18 (actually, it definitely won’t!). Should those dark days come to pass, Archon Optical will want to make sure that their prices are always adjusted to reflect the increases in cost.
This where the concept of fixed markup really comes in handy, because it can help you to automatically adjust your prices based on changed in cost. You could have cost and price as separate numbers that you input into your spreadsheet or inventory management software, but it’s much easier in the long run to have them linked.
Defining your markup as a percentage above cost ensures that you continue to earn revenue on sales as costs increase, but it also means that you don’t have to keep automatically going back to adjust your pricing. Manually adjusting your prices based on cost is plausible for a smaller business, but this quickly becomes untenable as your inventory expands to include hundreds of items.
If the Zealot becomes more expensive to produce over time, the price will have to go up, and gaining a markup of $18 on a $36 item is very different a markup of $18 on an item priced at $55. A fixed markup percentage would ensure that the earnings are always proportional to the price.
The thing to watch out for with Fixed markup percentages is that you’ll have to balance this convenience with your customers’ happiness. If your prices vary too wildly over time, it will be difficult for your customers to budget for your products. For products whose costs can go wildly up and down, you may want to consider a markup that’s expressed in dollar values above your cost.
Other factors that affect markup
We’ve described markup very simply thus far, because we’re assuming a scenario where Archon Optical makes the Zealot for a set cost and sells it at a set price, and that’s all there is to it. Of course, real life is a little more complicated than that.
For each order of the Zealot, someone will have to be there to package and sell it. That’s a labor cost.
If you ship Zealot to customers in boxes or send them in trucks to stores around the city, you’ll also have to factor the cost of freight.
Since the Zealot is a product that Archon Optical had to develop over time (it didn’t just come pre-designed, believe it or not!), they need to account for all of the time and expertise that went into making sure that the Zealot was as as cool, aesthetically pleasing, and blocked as many of the sun’s harsh rays as possible. This is product development as part of cost.
These are things to consider and aggregate as part of cost as your business grows. If you use an inventory management system like inFlow Inventory, there are different fields in Work Orders and Purchase Orders to help you account for those extra expenditures in purchasing or creating your products.