Does your business make a profit? Do its gross margins and product markups position it for profitability over the long haul? These are fundamental questions whose answers can make or break a business – but far too many business owners and managers take them for granted.
Generating profit begins with properly pricing your product and understanding its direct and indirect costs. Sounds simple, but poor pricing is one of the reasons that startup businesses can fail. Business leaders who understand the concepts of gross profit margin and product markup, and how to apply them to product pricing strategy, are in a better position to keep their company financially healthy. Read on to make sure you’re one of them.
What Is Margin?
Margin can mean many things depending on the context, but when it comes to managing a business’s profitability, it usually refers to gross margin. Also known as gross profit margin, this calculation is a key financial metric that shows whether a business makes money on product sales and, if so, how much. Specifically, gross profit compares the price of a product with the direct costs to make the product, resulting in a “gross” amount of profit or loss. Gross profit becomes gross profit margin when it is divided by the price so it can be shown as a percentage.
In product pricing exercises, margin focuses on market values, while markup hinges on the direct costs to make the product.
Gross profit margin is a very narrow look at profitability, since it only includes direct costs of the product, such as raw materials, labor, and direct overhead, otherwise known as “cost of goods sold” (COGS). This narrow view shows the percentage of the sale price that is left after paying for direct costs and, therefore, becomes available to cover other business costs like selling, marketing, distribution, taxes, and administrative expenses.
Gross profit can be found on a company’s income statement, showing at a high level whether the revenue-less-COGS for all its products yields a profit. It’s the first subtotal on a multistep income statement, such as the hypothetical KMR Industries income statement shown below. Subsequent levels on the statement go on to calculate the company’s operating margin and, ultimately, net profit (or net income). The statement shows KMR Industries gross profit margin is 43%.
KMR Industries |
|||||
Income Statement |
|||||
For the year ended December 31, 2022 |
|||||
Sales |
$ 5,000,000 |
||||
Cost of Goods Sold |
|||||
Materials |
$ 2,000,000 |
||||
Labor |
$ 600,000 |
||||
Manufacturing Overhead |
$ 250,000 |
$ 2,850,000 |
|||
Gross Profit and Margin |
$ 2,150,000 |
43% |
|||
Operating Expenses |
|||||
Selling |
$ 400,000 |
||||
Administrative |
$ 180,000 |
||||
Depreciation |
$ 150,000 |
$ 730,000 |
|||
Operating Income and Margin |
$ 1,420,000 |
28% |
|||
Income taxes |
$ 900,000 |
||||
Net Income and Margin |
$ 520,000 |
10% |
|||
How to Calculate Margin
Gross profit margin can also be calculated at the product level. For example, if the hypothetical KMR Industries generated all $5 million of its sales by selling a million units of the same product, that would translate into a $5 selling price for each unit and $2.85 in COGS per unit. Plug those numbers into this formula to determine each unit’s gross profit margin:
(Sales Price – COGS) / Sales Price = Unit Gross Profit Margin
Substituting KMR Industries’ product price and COGS, that would be:
($5 – $2.85) / $5 = 43%
In this hypothetical example both the product-level gross margin and the company-level gross margin are the same because the company sells only one product. A company with many products would conduct both analyses to better understand which products contributed more – or less – to its total profitability.
What Is Markup?
Markup is another way to look at the profitability of a product and is a commonly used method for setting product prices. The markup is the amount added to the cost of an item – COGS – to determine its selling price. Sometimes companies set their markup as a fixed, predetermined dollar value and sometimes as a percentage of the product’s cost. In either case, markup represents the amount of money the seller expects to get from selling the item after paying for its production.
Marketplace factors play an important role in determining a product’s markup, which is an important reason why markups vary widely across industries and even within an industry. As a rule of thumb, high-value brands tend to have larger markups, while economy brands tend to have smaller ones. A markup that is too high can cause a product’s selling price to be out of line with the industry norm, putting the product at a competitive disadvantage. Markups that are too low may help the product sell more due to its lower total price, but that may not always translate into enough increased dollar volume to cover all of a company’s costs.
How to Calculate Markup
The formula to calculate an item’s markup in dollar terms simply subtracts cost from sales price:
Markup = Sales Price – COGS
Going back to KMR Industries’ single product, the markup would be $2.15 ($5 – $2.85).
To convert the markup to a percentage, divide by COGS:
Markup % = (Sales Price – COGS) / COGS
KMR Industries’ markup percentage is ($5 – $2.85) / $2.85, or 75%, which means that the selling price is 75% more than the cost to make the product.
Markup vs Margin: Understanding the Difference
At the product level, markup and margin can be thought of as two sides of the same coin. Both formulas use the same two variables: selling price and cost. Margin measures profitability through the lens of sales price, whereas markup does it through costs. When trying to decide a product’s price, margin is a top-down view that starts with determining what the market will bear and then offsets costs against it. Markup is a bottom-up approach since it begins with the cost of the product and adds a desired amount of profit to determine the selling price.
Markup vs Margin: Which Formula Is Best for Your Business?
Markup and margin are both ways to evaluate profitability and to set prices for a company’s products. In both cases, a company is better off with a higher metric – higher gross profit margin means more money is left over after paying for costs, and a higher markup means that the seller makes more money on each item it sells.
When evaluating the overall profitability of a business, margin gives a more holistic view. A positive margin shows that, on average, the company’s products are more than covering their direct costs, while a negative margin can be an early warning of an unsustainable business model. Gross profit margin is also a good starting point to determine if a business is profitable overall because it can be easily compared with indirect costs.
Markup is helpful when first establishing an item’s price as it ensures that direct costs are covered. It’s also an easy approach to reevaluating and resetting prices, especially if costs fluctuate. Where markup falls short is that it doesn’t tell you whether the additional amount will be enough to sustain a company when considering all the costs of running the business.
The Takeaway
Markup and margin are two different ways to analyze profitability and to help set prices. While their formulas are similar, they have distinct differences in practice. Margin is revenue minus costs, expressed as a percentage of revenue. Markup is the amount added to a product’s cost to determine its selling price. In product pricing exercises, margin focuses on market values, while markup hinges on the direct costs to make the product. Savvy business managers will monitor both when evaluating products and thinking through how to maximize profitability.
