To run a profitable business, a company must sell its products or services at a high-enough price to cover both its variable and fixed costs.
But to determine the optimal pricing structure, you must fully understand the relationship between price, margins, and costs. Once those dynamics are established, you can analyze price setting through the lens of profit margins and markups.
Both margin and markup are useful business analytics formulae that reveal different information, despite using the same inputs and analyzing the same transactions.
So what is the difference in margin vs. markup?
To answer that, we must first review the business practice of price setting.
The Value of Price Setting
The prices you set can significantly impact your business success. Particularly in markets with increased volume and price pressure, proper pricing is a vital strategy for remaining competitive. It ensures that you receive fair value for the goods or services rendered without pricing out your target audience. If executed correctly, the business should generate revenue—income earned from selling goods and services. So long as the cost of goods sold (COGS) is lower than the revenue, the business will have profits that can fund further growth.
But price setting is not just beneficial from an economic standpoint. It can also be a useful signaling mechanism to consumers.
As the Small Business Chronicle notes, savvy brands deploy price-setting strategies as a marketing positioning tool:
“The price you set sends a message to some consumers about your business, product or service, creating a perceived value. This affects your brand, image or position in the marketplace. For example, higher prices tell some consumers that you have higher quality, or you wouldn’t be able to charge those prices.”
How to Price Set—Margins and Markups
Price setting involves finding the sweet spot—the optimal price to charge for a good or service.
If you stray from this boundary by setting the price too high or too low, either action can result in lost sales and jeopardize the company’s market share. How, then, do you find that baseline range?
The answer to that involves margins vs. markups.
The margin is the percentage of profit earned on the total sale. It is the revenue left over after paying COGS. In this case, the basis for margins is revenue.
The formula for margins is:
Margins = (Selling Price – Cost of Goods Sold) ÷ Price
In other words, it’s the difference between the selling price and profit. These profits can be further distinguished into:
Gross profit – Measures businesses’ efficiency and financial performance in terms of the costs needed to generate revenue. By decreasing COGS value, you can drive profits.
Gross profit = (Total Sales – Cost of Goods Sold)
Net profit – Measures the profitability after accounting for all business operational expenses. If the business makes more than it spends, it is a net profit. If it makes less, that is a net loss. This calculation can help you determine where to invest or cut back.
Net profit = (Gross Profit – Operating Expenses and Taxes)
For example, if a company sells 1000 units of a product for $40, and their manufacturing cost is $15 per unit, the business would have a gross profit of $25,000. Expressed as a percentage of the selling price, the business would experience a 62.5% profit margin per item.
Markup is the percentage difference between the cost price and the selling price of your good or service. In other words, it is the extra percentage you can charge customers in addition to the cost.
The basis for the markup calculation is cost, and the formula is:
Markup = (Selling Price – Cost of Goods Sold) ÷ Cost
This formula helps you determine the price you would need to charge to ensure that revenue is earned for every sale.
Using the example above, the item that costs $15 to make was marked up by $25. To calculate the markup percentage, you would divide the margin by the cost of goods sold. So, a 166% markup percentage.
Although in dollar amounts, the margin and markup are both $25, by percentage, the markup percentage is lower than the margin percentage.
Using Desired Markups to Set Prices
Some businesses seek to predetermine their markups. To accomplish this, you must mark up your product or service by a percentage greater than the margin.
The formula for this would be:
Price = Cost + (Cost x Markup)
So, if the product costs $15 and you want to mark it up by 250%, the optimal price would be $52.50. Just remember to convert your markup percentage to a decimal—for this example, the value used for markup would be 2.5.
Using Desired Margins to Set Prices
Similarly, you could seek to achieve a specific profit margin, such as 25%.
The formula for this would be:
Markup percentage = Desired Margin ÷ Cost of Goods Sold
Applying this formula to the same product as above results in 16.66% = 25% $15.
To determine the final price, you will need to multiply 15 (i.e., COGS) by 1.1666 (i.e., 1 + Markup Percentage), which is $17.50.
When Is It Best to Use Markup vs. Margin?
The “right” answer to this is it depends on the situation. Both markup and margins have their uses.
For instance, if you want to set the optimal selling price to achieve a certain profit, you should use a markup percentage. However, if you analyze your books from a historical business performance perspective, you will want to consider margins in terms of previous sales.
Markup helps ensure that positive revenue is generated on each sale, which is especially useful in the early stages of a business. As the business matures, you can begin analyzing financial sales reports through the lens of margins to see how much profit you are making on each sale and where adjustments can provide a competitive advantage.
This guest blog post was provided by Justin Berg at CFO Hub, an outsourced Finance & Accounting agency. If you have interest in outsourcing your finance or accounting work to an experienced team, contact Justin at email@example.com or call 858-230-8956.