The difference between Margin and Markup

Introduction: Due to the tough job market these days, many people are considering starting what will be their first business. This article falls into what I call “business 101”. It aims to help budding entrepreneurs avoid some of the mistakes that are so common to startups.

A quiz for you:

You just purchased an item for $1,000.00 that you will re-sell for $1,500.00. That’s $500.00 of profit and a nice sale. The pie chart to the left shows the breakdown. Hover over it to see how you will feel about that sale.

So, what was your margin?

A – 50%
B – 33.3%

Understanding the difference between Margin and Markup is extremely important to your bottom line. Many people confuse the two. I have seen this confusion kill businesses before they even get started because the business plan miscalculated margin. I have also seen businesses suffer significant losses because the sales team or a contractor did not understand the difference between margin and markup.

If you chose A, then you better read on. If you chose B, you are correct. Would everyone in your company have answered correctly? Do they know the difference between 50% markup and 33.33% margin?

Imagine that  someone on your sales team who does not know the actual cost is told that the item has a 50% markup. Believing that to mean 50% profit (or $750.00 of profit), they decide to give a healthy 25% discount and sell it for $1,125.00. Quick math tells you that you just lost the lion’s share of your profit. Instead of $500.00 in your coffers, you now have $125.00! The pie chart below, well, you get the picture.

 Let’s do some simple math based on the example just given.

Your Cost: $1,000.00
Markup: 50%
Selling Price: $1,500.00
Profit: $500.00

The equation to calculate selling price is:

(your cost X markup percentage) + (your cost) = selling price
($1,000.00 X 50%) + ($1,000.00) = $1,500.00

The equation to calculate profit is:

(selling price) – (your cost) = profit
($1,500.00) – ($1,000.00) = $500.00

So far so good? Now, let’s move onto margin using the same numbers, but adding one last equation to calculate the profit margin.

The equation to calculate profit margin is:

(selling price – your cost) / (selling price) = profit margin
($1,500.00 – $1,000.00 ) / ($1,500.00) = 33.33%

Or stated otherwise:

(profit) / (selling price) = profit margin
($500.00) / ($1,500.00) = 33.33%

Markup is what you use to set a selling price.

Margin is what you actually have left over after the sale.

Both have their uses, but as you have seen, it is paramount to understand the difference between the two.

There is one more critical point. Everything described in this article refers to “gross profit margin”. Gross profit margin is important on a per sale basis.  However, at the end of the day (or month, or year), the number you are most interested in is “net profit margin” which we will cover in the upcoming article titled “The Difference Between Gross Profit and Net Profit“.

 

© Gil Namur, 2009