Markup vs Margin Differences
Is there a difference? Absolutely. More and more in today’s environment, these two terms are being used interchangeably to mean gross margin, but that misunderstanding may be the menace of the bottom line. Markup and profit are not the same! Also, the accounting for margin and mark-up are different! A clear understanding and application of the two within a pricing model can have a drastic impact on the bottom line. Terminology speaking, 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.
So, who rules when seeking effective ways to optimize profitability?. Many mistakenly believe that if a product or service is marked up, say 25%, the result will be a 25% gross margin on the income statement. However, a 25% markup rate produces a gross margin percentage of only 20%.
How to calculate markup percentage
By definition, the markup percentage calculation is cost X markup percentage, and then add that to the original unit cost to arrive at the sales price.
For example, if a product costs $100, the selling price with a 25% markup would be $125:
Gross Profit Margin = Sales Price - Unit Cost = $125 - $100 = $25.
Markup Percentage = Gross Profit Margin/Unit Cost = $25/$100 = 25%.
Sales Price = Cost X Markup Percentage + Cost = $100 X 25% + $100 = $125.
How to calculate gross margin percentage
Gross margin defined is Gross Profit/Sales Price. In this example, the gross margin is $25. This results in a 20% gross margin percentage:
Gross Margin Percentage = Gross Profit/Sales Price = $25/$125 = 20%.
Not quite the “margin percentage” we were looking for. So, 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, if a 25% gross margin percentage is desired, the selling price would be $133.33 and the markup rate would be 33.3%:
Sales Price = Unit Cost/(1 - Gross Margin Percentage) = $100/(1 - .25) = $133.33
Markup Percentage = (Sales Price - Unit Cost)/Unit Cost = ($133.33 - $100)/$100 = 33.3%
Reprinted with permission from WikiCFO.com.