Margin and markup are not synonymous, although many businesses confuse the two terms. In this article we’ll discuss how they are the same, how they are different, and when and how to use them. Both terms apply to any business that sells products. In some cases they could also apply to a service business, but they’re mostly useful for tangible goods. Both markup and margin can be used to determine a selling price. However, markup vs margin use different math.
An important distinction is that margin, aka gross margin, is a fundamental accounting term. Gross margin is a key number on income & expense statements, reporting gross profit across all products. This gives margin greater weight than markup. A metric that relates directly to accounting removes any translation that could cause a business to miscalculate its profitability.
What Is Markup vs Margin?
In a nutshell: markup is based on unit cost, margin is based on selling price. Markup determines an item’s selling price by taking unit cost and adding a certain multiple of that cost, for example 25%. Markup sets a profitable selling price for an item. Example: the unit cost for a widget is $8 and you want a 25% markup. 25% of $8 is $2, so your selling price is $10.
Gross margin is part of the company’s accounting rules. Gross margin is also called gross profit. It is determined by sales minus cost of goods sold. If a company’s quarterly sales were $100,000 and COGS were $80,000, that’s a margin of $20,000. The gross margin ratio (or percentage) is based on gross sales, not gross cost. Therefore, $20,000 margin against $100,000 in sales is a 20% ratio. Later in this article we’ll explain how to use margin to establish selling price.
Who Uses Markup vs Margin?
For markup vs margin, it might be fair to say that sales teams could think in terms of markup for products. Meanwhile, accounting teams think in terms of margin for the entire business. In the above section, we’ve seen that an $8 cost and a $10 selling price is a 25% markup, whereas $80,000 COGS and $100,000 sales results in a 20% margin. The 8-to-10 ratios are the same, but the percentages are different.
This is why markup needs to derive from margin. The value for gross margin is a business decision that company management makes. The company financial team and executive leadership crunches the numbers to determine what gross margin needs to be profitable. Gross margin needs to cover all operating expenses. This includes debt service, cash management and all other considerations.
How to Determine Gross Margin and Markup
Determining gross margin can be a delicate balance between profitable operation and competitive pricing. The detailed process is not in scope for this article. However, it’s basically a matter of setting a threshold sales dollar figure to break even. That dollar figure spreads across expected sales and compared against gross cost of goods sold. The resulting ratio is your break-even margin percentage. Add a desired profit percentage and the result is your desired gross margin ratio.
Markup can be reverse engineered from this desired gross margin ratio. Selling price for any given product should be set to achieve your desired gross margin ration. However you cannot simply add the margin percentage to the cost.
Here’s a simple formula for deriving markup from gross margin:
- SUBTRACT gross margin % from 100; e.g. for 25% margin, 100-25 = 75%;
- Express as a DECIMAL … e.g. 75% = .75 (it will always be less than 1);
- DIVIDE unit cost by this decimal. In Excel, express it as “=cost/.75”.
Basically, if gross margin is 25%, you’re asking “my cost is 75% of WHAT?” The above steps solve for that answer.
5 Ways to Improve Gross Margin/ Profitability
However you use markup vs margin in your business, here are five ways you can improve profitability:
1. Price Breaks on Larger Wholesale Quantities
Whenever possible, work with suppliers to get price breaks for larger orders.
- If your business is retail and you’re ordering finished goods for resale, go for higher volume discounts whenever you can.
- If your business is manufacturing / assembly / prepared food etc., you can cut finished unit costs by lowering component / ingredient costs when you place larger orders.
2. Minimize Debt
Debt service can have a substantial impact on your bottom line. Minimize debt, eliminate debt or negotiate lower interest rates as much as possible. This doesn’t directly impact markup on any given item. But it can impact gross margin by lowering overall expenses.
Setting prices for your product line involves a holistic understanding of your business. So, lower debt has benefits across your organization.
3 Adopt a Top-Quality Business Model and Branding Strategy
People pay more for quality. Top-tier products can sell for much more than average and cheap goods. Also, that can lead to bigger margins and more profitability. Margins for cheap products tend to be razor thin.
Caveat: A top-quality approach only works if you mean it. This requires patience, commitment and vision, and it needs to be practiced from the CEO down to the front-line new hires.
4. Maximize Operational Efficiency
Look at ways that you can reduce expenses. Be creative. In the internet age, specialized outsourcing can help with efficient staffing solutions for accounting, customer service / technical support, marketing, IT, HR, legal and just about any other key function.
No one wants to think about layoffs. But when the time comes for new staffing, testing the waters with some outsourcing could really help lower expenses.
5. Great Customer Services
Make a commitment to keeping your customers happy. Satisfied customers are repeat customers. So, few single factors have a more beneficial impact on a successful business than customer loyalty.
The cost of acquisition is at least 5 times the cost of retention, and that has a huge indirect impact on margin.
Markup vs margin is a simple enough distinction. If you follow our guide above, you’ll know how to use them properly to set profitable, competitive prices. Just remember that your desired gross margin is the benchmark number that dictates markup.
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