The biggest struggle in maintaining or improving profitability often comes down to pricing. Two of the most common methods companies use to price their products are margin and markup. Unfortunately, many people think they’re pricing their products based upon a desired margin, but they’re really using markup. There is a major difference between the two methods and their impact on your bottom line.
Markup is commonly used to find the price of retail products which are somewhat of a commodity; costs are fixed and the market dictates purchasing price. Let’s explore what happens when you use markup as your primary reference for pricing.
Markup Percentage is the percentage difference between the actual cost and the selling price.
The formula for markup = selling price – cost.
The formula for markup percentage = markup amount/cost.
Let’s say I owned a t-shirt company, and the unit cost of a t-shirt is $8. I want to sell it for $12. The retail markup would then be $4 because:
The retail markup percentage is 50%, because
$4/$8 = .50
Markup is the difference between the actual cost and the selling price. Since it is generally market-driven, it often fails to take into account a lot of the indirect costs associated with the product. Setting prices in terms of a particular markup can be dangerous unless the markup has been calculated in a way to consider all product costs – direct and indirect.
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With our clients, we recommend using gross margin (or profit) percentage for a number of reasons. It is more reliable and accurate, and we can easily see the impact on the bottom line.
As mentioned before, gross margin is:
Sales – Cost of Goods Sold (COGS).
We then find the gross margin percentage, which is:
(Gross Margin/Sales Price) X 100.
Based on these calculations, how do we determine the selling price given a desired gross margin? It’s all in the inverse (of the gross margin formula, that is). By simply dividing the cost of the product or service by the inverse of the gross margin equation, you will arrive at the selling price needed to achieve the desired gross margin percentage.
For example, Steve charges a 20% markup on all projects for his computer and software company which specializes in office setup. Steve has just taken a job with a company that wants to set up a large office space. The total cost needed to set up the space with computer and the respective software is $18,000. With a markup of 20% the selling price will be $21,600 (see how to calculate markup above). The margin percentage can be calculated as follows:
Margin Percentage = (21,600 – 18,000)/21,600 = 16.67%
As you can see from the above example, a 20% markup will not yield a 20% margin. Failing to understand the difference between the financial impact of using margin vs. markup to set prices can lead to serious financial consequences. In the example above, if Steve were to assume his 20% markup would yield a 20% margin, his net income would actually be 3.3% less than expected. While a 3.3% difference in net income may not seem like much, to many low-profit-margin businesses it can mean the difference between solvency or bankruptcy.
Additionally, using margin to set your prices makes it easier to predict profitability. Using markup, you cannot target the bottom line effectively because it does not include all the costs associated with making that product.
15% Markup = 13.0% Gross Profit
20% Markup = 16.7% Gross Profit
25% Markup = 20.0% Gross Profit
30% Markup = 23.0% Gross Profit
33.3% Markup = 25.0% Gross Profit
40% Markup = 28.6% Gross Profit
43% Markup = 30.0% Gross Profit
50% Markup = 33.0% Gross Profit
75% Markup = 42.9% Gross Profit
100% Markup = 50.0% Gross Profit
To sum things up, markup percentage is the percentage difference between the actual cost and the selling price, while gross margin percentage is the percentage difference between the selling price and the profit. Markup is not as effective as gross margin when it comes to pricing your product. Not only should you take into account how much it costs to acquire the product, but you also need to take into account the indirect costs associated with your product in order to ensure you’re selling your products at a price that will result in profit.
If you’re still uncertain about how to price your product or service to be profitable, download the free Pricing For Profit Inspection Guide. This ultimate guide allows you to easily discover whether you have a pricing problem and gives you steps to fix it.
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