One of the most important aspects of your business is product pricing. You want to price your products so you can earn a profit but not too high that the number turns buyers away. Prices should allow for coverage of costs as well as a cut of profit to everyone involved in the process. To determine how to price an item, business owners can turn to either markup or margins.
While these two terms are often used interchangeably, they actually differ quite a bit. Markups and margins both play key roles in pricing your products, and they can each be helpful in different situations.
Before We Begin
Before you can start talking about margin vs. markup, there are a few key terms you should understand: gross profit, revenue, and cost of goods sold (COGS).
Gross profit is the revenue you have remaining once you’ve paid the expenses associated with making your products or providing your services. This figure is calculated by subtracting the cost of goods sold from your revenue.
Revenue is the income that your products and services bring in. This figure reflects your earnings before any deductions are taken out.
Cost of goods sold (COGS) is the amount of expenses you have to incur when making your products or providing your services. This figure can consist of material costs, labour costs, and more.
What is Margin?
Gross margin, also simply referred to as “margin,” refers to the amount of sales minus the cost of goods sold (COGS). Let’s say that you’re selling a product for $50. The product in question costs $30 to manufacture. Subtract your COGS from your revenue, and you wind up with a gross profit of $20. Then, divide this gross profit by the revenue.
$20 gross profit / $50 revenue = 0.40 margin
You can then multiply this number by 100 to convert it to a percentage. In this example, a margin of 40% means that you keep 40% of your total revenue from your sale. The other 60% of that revenue is spent on manufacturing the product or providing the service.
What is Markup?
Markup refers to the amount that the cost product of an item is being raised in order to determine the selling price. Essentially, markup shows how much extra your product is selling for than what it initially cost you. Let’s return to the example above and say you have a product with a cost price of $50 that costs $30 to manufacture. You’ll need your gross profit first, which we’ve already calculated to be $20 (revenue – COGS).
Now we need to determine the percentage of your COGS that is gross profit. You can do this by dividing the gross profit by the COGS:
$20 gross profit / $30 COGS = 0.67 markup
Again, you can multiply this number by 100 to get your percentage, which is 67% in this case. So here, you’ve sold your product for 67% more than what you paid for it. This is an easy enough figure to calculate on your own, but you can also use a markup percentage calculator to make the process faster.
How Should I Use Margin and Markup?
Now that we’ve settled the issue about markup vs. margin, how do you know when to use each figure? The answer is actually surprisingly simple. When you’re initially determining your selling price for an item, refer to the markup. Each member of your supply chain will typically have a set standard for their figures, which can help you determine the best markup amount for your products. Not to mention, markup is usually easier for new businesses to wrap their heads around.
Once you’ve reached the end of the year and are looking at year-end performance metrics, or once you’re a bit more experienced and know what to expect with your sales, you’ll usually want to use margins. However, take care to differentiate between gross margins, which is what we’re discussing here, and net margins, which account for additional operating costs.
In DEAR, Average Cost is used to estimate the % Margin of your sales. Average Cost in DEAR is calculated as Value on Hand/Quantity on Hand for every given product. It is calculated from the average purchase price paid for the products including any landed costs. All historical costs of an item are used by the system to compute the Average Cost. The selling price is not taken into account with this calculation. It is recalculated automatically whenever any inventory movement (buy, sell, etc.) happens to the product – specifically when the purchase invoice or sale invoice is authorised.
Can I Convert Markup to Margin?
You might run into a situation where you know your markup and want to figure out your margin. Alternatively, you might know your margin and want to calculate your makeup. Luckily, these conversions are simple.
To convert your markup to margin, use the formula Margin = [Markup / (1 + Markup)] x 100.
Let’s say you want a markup of 40% and need to know the margin. Your formula would be:
Margin = [0.40 / (1 + 0.40)] x 100 = 29%
On the other hand, if you’re looking to convert your margin to markup, you’ll use the formula Markup = [Margin / (1 – Margin)] x 100.
In this example, let’s say you want a 40% margin and need to calculate your markup. Your formula would be:
Markup + [0.40 / (1 – 0.40)] x 100 = 67%
Margin vs. Markup Chart
In general, your business should aim for a markup percentage that’s greater than your margin percentage. This situation indicates that your company is profitable, whereas the opposite scenario means that your business is losing money.
Luckily, margin and markup interact with each other in a predictable way, so you can use a margin vs. markup chart to keep track of your conversions. Here are a few quick figures to keep in mind:
- 15% markup = 13% margin
- 20% markup = 16.7% margin
- 25% markup = 20% margin
- 30% markup = 23% margin
- 40% markup = 28.6% margin
- 50% markup = 33% margin
- 75% markup = 42.9% margin
- 100% markup = 50% margin
Pricing Items Based on Margin
If you choose to price your items based on your ideal profit margin, you’ll start by dividing your target gross margin by 100 to convert the figure into a decimal. So, if you’re looking for a 40% margin, your decimal figure is 0.40.
Subtract this figure from 1 to determine what portion of your asking price will represent your cost of goods sold (COGS). In this example, 1 – 0.40 = 0.60, meaning 60% of your price will cover COGS.
Finally, divide your COGS by the figure you just calculated. Let’s say your product costs $25 to manufacture. Your formula would be:
25 / 0.60 = 41.67
This calculation gives you a selling price of roughly $42.
Pricing Items Based on Markup
If, on the other hand, you choose to price your items based on markup, you’ll need to start by making sure you’re aware of every single aspect of production and how much they cost. Once you have all your figures, multiple this number by the markup to come up with your selling price. In short, your formula is COGS + (COGS x Markup) = Asking Price.
Let’s use our previous example with a COGS of $25. In this case, let’s say you want to place a markup of 50% on your product (which is a markup of 0.50 when converted to a decimal). Your calculation should look like this:
25 + (25 x 0.50) = 37.5
This calculation gives you a selling price of roughly $37.5.
How Much Should I Markup My Items?
Don’t fall into the trap of thinking you can markup items as high as you like. If you go too high with your price, customers simply won’t purchase. You want your markup to cover all the costs associated with your item at every step of your supply chain.
Additionally, your markup should leave you with a reasonable profit once you’ve made all the necessary payments. Finally, your markup should still leave your product at a competitive price when compared to similar items on the market.
How Can I Improve My Margin?
The gross margin can be a helpful figure when determining the financial performance of your company. It indicates whether your business is making or losing money on sales, and it can also help you determine whether your management is being efficient in its use of supplies and labour.
One major way to improve your gross margin is by increasing the price of your products or services. As we’ve mentioned, though, be wary not to raise your prices too high, or you run the risk of no longer remaining competitive in your industry and losing business to your lower-priced competitors.
You can also improve your gross margin by decreasing the costs of your production. Your company might consider how to obtain cheaper materials or make your production process more efficient in order to reduce costs. Speak to your vendors about potential volume discounts, which can help lower the cost per unit, or start searching for less costly materials altogether. Whatever you do, strive to maintain the quality level that your customers have come to expect from you.
Navigate the Complexities of Sales with DEAR
Using markup and margin in your pricing model can be complicated, but DEAR is here to help. DEAR Systems provides Cloud ERP software that helps evolve every aspect of your business, from POS to warehouse management, manufacturing, inventory management, and more. Contact DEAR Systems today to start your 14-day free trial.