Markups and margins explained

**** PSA **** If you're a visual learner, I'll be going live on LinkedIn later this month to explain margins and markups. Here's the link to the event and what we'll be covering ****

Margins and markups are often confused by non-finance managers, as they both play roles in sales, pricing, and assessing productivity. However, it's crucial to you know the difference between margin and markup to ensure pricing strategies that yield profits.

Before diving in, it's essential we recap three concepts we've touched on in a previous edition:

1. Revenue: The income generated from selling products and services. This is the top line of your Profit and Loss (P&L) statement.
2. Cost of goods sold (COGS): The expenses associated with producing goods or delivering services. COGS would also include materials and direct labor costs. Some companies refer to COGS as COS (cost of sales).
3. Gross profit: The revenue remaining after covering the expenses of production and service provision. It's calculated by subtracting COGS from revenue.

If you need to improve your understanding of a P&L, check out this previous edition on 'Understanding a P&L'

While both margin and markup involve these three elements, they interact in different ways, shaping pricing decisions and profit margins.

What is margin?

Margin, also known as gross profit margin, indicates the revenue you retain after covering the cost of goods sold (COGS). Essentially, your margin represents the difference between what you've earned and the expenses incurred to earn it.

To calculate the gross profit margin, begin with your gross profit, which is the difference between revenue and COGS. Then, determine the percentage of revenue that comprises your gross profit. To do this, you need to divide your gross profit by revenue, and then multiply the result by 100 to obtain the margin percentage.

Here's the formula in action:

Margin (Gross profit margin) = [(Revenue – COGS) / Revenue] X 100

OR

Margin = (Gross Profit / Revenue) X 100

This formula tells us how much of each dollar in revenue you retain after covering expenses. A higher margin means you're retaining a larger percentage of revenue from each sale.

Example of margin calculation: Consider this scenario: You sell shoes for $200 each, and each pair of shoes costs $150 to produce. What's your margin?

Apply the numbers to the formula:

Margin = [($200 – $150) / $200] X 100

Start by finding the gross profit by subtracting the COGS ($150) from the revenue ($200), yielding $50 ($200 – $150). Then, divide this total ($50) by the revenue ($200) to get 0.25. Multiply 0.25 by 100 to convert it into a percentage (25%).

Margin = 25%

This implies that you retain 25% of your total revenue, while the remaining 75% covers shoe production costs.

What is markup?

Similarly to margin, markup involves revenue and COGS. However, it demonstrates the extent to which your selling price exceeds the item's cost.

To calculate the markup, commence with your gross profit (Revenue – COGS). Then, ascertain the percentage of COGS represented by the gross profit by dividing your gross profit by COGS, not revenue.

Here's the markup formula:

Markup = [(Revenue – COGS) / COGS] X 100

OR

Markup = (Gross Profit / COGS) X 100

This formula assesses the difference between the selling price and the production cost. A higher markup indicates a greater revenue retention per sale.

Example of markup calculation: Let's revisit the shoe example: You sell shoes for $200 each, and each pair of shoes costs $150 to manufacture. What's your markup?

Utilize the markup formula:

Markup = [($200 – $150) / $150] X 100

Start by finding the gross profit ($50) by subtracting the COGS ($150) from the revenue ($200). Then, divide this total ($50) by the COGS ($150) to get 0.33. Multiply 0.33 by 100 to convert it into a percentage (33%).

Markup = 33%

This indicates that you sell your shoes for 33% more than the cost of production.

Why margins and markups are important

Understanding the difference between margins and markups is crucial for goal-setting. By discerning how much profit you aim to achieve, you can adjust your pricing strategies effectively using the formulas for margin and markup.

Failure to grasp your margins and markups might lead to incorrect pricing of your products or services, potentially resulting in missed revenue opportunities. Alternatively, you might set prices that exceed what your target customers are willing to pay.

Regularly assessing your margins and markups ensures that your pricing strategies are optimized for maximum returns, allowing you to capitalize on strategic pricing decisions.

If you or your non-finance teams need a deeper understanding of margins and markups, be sure to attend my LinkedIn live event later this month.

That's all for now.

Have a great week ahead.

Best,

Mark

www.accountingmadeeasy.co

Whenever you're ready, there are 3 ways I can help you:

1. Finance for non-finance Managers – Fundamentals - This course is delivered virtually in three 2.5 hour modules. Our expert finance facilitators use our interactive finance game to help non-finance staff understand financial jargon, make sense of P&L’s and make better financial decisions.
2. Finance for non-finance Managers – Customized - This course is a customized follow-up to the fundamentals course. We prepare case studies using your P&L’s and business numbers to help your non-finance staff with commercial acumen and apply what they have learnt in a practical and real way.
3. Finance for Sales Teams – This course helps sales teams drive profitability by giving them the financial skills to protect and improve their margins.