Why does markup vs margin matter? Because muddling up the two can lead to your business struggling and, ultimately, failing.
If you don’t know your markup from your margin or rely on percentages rather than raw data, you are not running your business properly. Here, I’ll show you why markup vs margin is important, what the difference is, and how you can ensure you aren’t storing up problems for your company.
Definitions
I’ll start by defining some of the terms you will likely encounter. If you aren’t sure what a phrase on an accountant or bookkeeper’s report means, don’t just ignore it and hope for the best. Find out, educate yourself, and take ownership of your leadership position.
The ‘cost of sales’ is how much whatever you sell costs you. That could be parts or produce you buy in to create your product or the cost of your team’s time providing a service to clients and customers.
‘Direct costs’ refers to the expenses of achieving that sale, for example, postal charges. Other costs are overheads.
Margin is the difference between the cost of sales and the sales of the items or services you deliver.
Your gross profit percentage is margin divided by sales.
Markup vs Margin
You’ll notice I didn’t define markup. Essentially, the term, that many people talk about, is the profit figure you add to the cost of a service or product to arrive at your sales price.
We get into problems when we confuse markup with margin, and that’s why the markup vs margin explanation matters.
Perhaps an example will simplify the difference. If the cost of sales of your product or service is £5 and you sell for £7.50, you have a markup of £2.50 and a 33.3% gross profit.
Where people get confused is that they see £2.50 markup as being 50% of the cost of sales and assume a 50% profit. In fact, £2.50 markup on a £7.50 item is only a gross profit of 33.3%.
When people choose to look at headline percentages, they lose sight of the true numbers. Raw data is valuable, because it stops you from making assumptions that don’t actually add up.
Completing the example started above, if you believe your markup equates to a 50% profit, rather than the actual 33% gross profit it represents, your balance sheet will show a loss once other costs are factored in, rather than the profit for which you hoped.
Percentages can help convey information quickly, especially if you know what they mean, but they aren’t the only source of information you need. Yes, you employ an accountant to take care of the numbers, but as a business leader, you have a responsibility to be across the bottom line.
Don’t treat simplistic percentage values as the only data you need. Look at the actual numbers. In order to ensure you make a profit, you need to avoid the markup vs margin muddle.
How to Price
As many of us in business understand only too well, you don’t always get what you want – especially when it comes to profit. We’d all love a gross profit margin of 50%, but few will get there. In rationalising our expectations and settling on a lower margin, we still need to ensure that the profit makes doing the work worthwhile.
You need to know how to work out a price that will sell and still make you money.
I’m afraid we must go back to some definitions before moving on.
Costs
You must know the difference between variable costs and a fixed cost.
It’s relatively simple. As the name suggests, a fixed cost doesn’t change if you increase or decrease activity, such as the rent for your premises (unless you are so successful that you expand to a larger site!). Generally, this is a cost you pay at regular intervals at exactly the same amount. You need a margin on sales big enough to cover this liability.
As the name again suggests, costs that vary with your activity are variable costs. These can include sales-related commissions, expenses, and so on.
Because this value isn’t fixed, you must keep variable costs at the forefront of your mind when deciding on margins and setting sales prices.
If you understand how variable costs will move as activity levels vary, you’ll have an understanding of the cost impact of selling more. The variable cost cuts into your margin, so knowing this helps you have a clearer picture of how to set a price that ensures a profit regardless of fixed and variable costs.
Incorporating sufficient ‘wiggle room’ to accommodate activity related variable costs means that while the margin you have set may not be fully achieved, you can still cover costs and make some profit.
To help illustrate the situation, picture this. An item you sell has a sale cost of £10. It has costs of sales of £5 and variable costs of £1. That means each unit you sell brings you £4 to cover fixed overheads and your profit.
Assuming you have a grip on the fixed overheads you must meet, you now know how much you could discount a product, to encourage sales, while still making money.
In simple markup vs margin terms, if you put a 100% markup on an item, your gross profit will be 50%. A 50% markup equates to 33.3% gross profit, and a 25% markup gives you a 20% margin. If your margin is coming in lower than that, you need to question why you are providing that product or service. Is the margin really worthwhile?
Markup vs Margin – Stay Smart
To make money, you just need to pay attention, look at the data, and avoid common mistakes whenever possible.
As I mentioned earlier, the worst outcome of the markup vs margin confusion is that you end up selling your products or services at a loss because you’ve failed to understand the difference.
Your bookkeeping system can sometimes be an early warning system for a problem. If things don’t look right, ask questions.
If you are still unsure and want to discuss the implications of increasing or decreasing sales price, it may be worth speaking to an expert external accountant.
Listen to Experience
While I don’t have all the answers, I have experienced success and failure in my long career, learning lessons from both along the way. I have made mistakes, including when it comes to pricing for profit, and I’d much rather you learn from my experience than go through it yourself.
That’s why I write these articles, to share the lessons. If you think your business could benefit from more of my insight, in consultation or training for directors or individual teams, I’m here to help.
