All too often Mark-up is used interchangeably for Profit Margin
Knowing the difference will improve your PROFITS
How to avoid setting your mark-up so you lose money and have a negative margin!
Quick Definitions to help you clear this up once and for all!
Margin and mark-up are rooted in the same concept – both are ways of expressing what you get to take home at the end of the day; both can be expressed as either Dollar Values or Percentages. Their difference is the basis used for calculations:
* Mark-up – the amount added on top of production and purchase costs to create your selling price – the basis of this calculation are your expenses.
* Profit Margin – the proportion of the selling price that is profit – the basis of this calculation are your selling prices.
You can’t calculate margin without first establishing your mark-up
Profit Margins and Mark-ups
The easiest way to explain this is with an example – using something pretty basic… Let’s decide to run a cake stall at the local market – selling 10 cakes each weekend. OK so it wont make us millionaires, but it will help out the local school…
INDIRECT COSTS: Plus we need to add some tiny portion of our rent and electricity (by taking a guess of the cost), a small charge for our time baking selling and organising, and we want to print a few flyers that will cost $10 – we reckon all this costs about $50 in total each week so you work out this is $5.00 of overheads per cake…
TOTAL COSTS: That takes the total costs up to $10.50 per cake.
We then agree to sell our cakes at $15 each so:
* There is a $4.50 mark-up ($10.50 cost + $4.50 mark-up= $15.00 sales price) which is a mark up of 43% ($4.50 mark-up ÷ $10.50 cost price = 43% mark-up)
* There is a $4.50 profit margin ($15.00 sales price – $10.50 cost = $4.50 profit margin) which is a 30% profit margin ($4.50 mark-up ÷ $15.00 sales price = 30% profit margin)
So in this example if we stick to looking at the dollar values both the margin and the markup are $4.50 – the same and annoyingly confusing!
But the calculation of the Percentages differ because one is based on cost and one is based on profit. Using percentages is really important if you have several product lines and are making a change, or adding new products/services – don’t get caught out.
Profit Margin % x Cost Price ≠ Selling Price
In this example that exact calculation will only give a markup $3.15 instead of the $4.50
(ie $10.50 x 30% = $3.15, and $10.50 + $3.15 = $13.65 – not $15.00)
This is why it is so important to understand the difference between markup and margin; mix them up and you may rip yourself off!
Setting your price involves working out all of your costs and then adding an amount on top to ensure you make a profit, this is called your mark-up.
Knowing how much mark-up to add is a matter of researching conventions and industry standards, and then tailoring these numbers to your company’s specific circumstances. Your mark-up should probably differ from your competitors because your costs will be slightly different, and if your price doesn’t reflect all the cost differences your profit may be eroded.
The direct costs, ingredients are usually quite easy to allocate on a piece by piece basis. But predicting, and then allocating the value of your overheads (indirect costs) across your products very accurately can prove difficult, and is also difficult where you offer a service instead of products. Consequently often Mark-up is calculated on Direct Costs only (using a guestimate that is hopefully sufficient to cover the rest of the costs, plus enough for some profit, like we did for the cakes above):
For more info on where these figures can be found in your P&L see the three-part series Understanding your Income Statement
Both Profit Margins and mark-ups can be positive and negative: when the profit margin is negative the selling price is insufficient to cover the costs of production. So let’s quickly look at a few other ways these calculations can go haywire:
A mark-down is the amount a product is reduced below cost to establish a selling price, this may be necessary to clear a backlog of slow-moving stock especially in the case where regaining a portion of costs is preferable to simply discarding the products at -100% mark-down (or zero sales value).
In the cake example above this may mean selling yesterday’s cakes at $5.00 which would be a mark-down of $5.50 ($10.50 net cost price – $5.50 markdown = $5.00 selling price).
Negative Profit Margins can be caused by an informed decision (usually involving a mark-down or discount to move older stock) or unintentionally which always rapidly leads to a business crisis. Negative Profit margins most commonly arise when the mark-up is calculated on only Cost of Goods Sold and not Total Costs. ie the Gross Margin is the driver rather than the Net Margin.
NOTE: your profit isn’t your salary: if you work in your own business you are entitled to both take home pay for the work you do and a profit, for the risk you take in running a business. Many SME and micro-business owners omit to add in their own time as part of their product cost before adding a profit margin. BOTH should form part of the equation in any owner operated enterprise.
Remember it is possible to set your mark-up so you lose money and have a negative margin
The process of setting a mark-up and establishing the profit margin is also ongoing – it is important to regularly re-evaluate whether these are sufficient to cover all the business expenses (they will be negative profit margins if your costs are not covered), PLUS give you a good return for the risk you are taking for owning the business.
Check your mark-up supports the profit margin you are wanting!
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