You can’t calculate margin without first establishing your mark-up
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.
* 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.
Profit Margin % x Cost Price ≠ Selling Price
Setting your price involves totalling-up all of your costs (both direct and indirect) and then adding an extra bit on top of your total to give you 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 (in this case the ingredients) are usually quite easy to total-up and allocate out on a piece by piece basis. But accurately predicting, and then allocating the value of your overheads (indirect costs) across each one of your products can prove very difficult, and is extra difficult where you offer a service instead of products.
Consequently often Mark-up is often calculated by starting with Direct Costs only – then including a “guestimate” portion that is hopefully sufficient to cover the rest of the costs, plus adding an extra bit for profit, on a per unit basis – see the Cake example below.
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: