In your time as a business owner you’ve probably heard the terms “margin” and “markup” used interchangeably. The truth is they’re two closely related but very different things. So how do you understand the difference and determine when it’s appropriate to use one or the other? Knowing how to calculate margin and markup is a good start.
Below, you will see how to do that while learning what they could mean for your business. To get you started, here’s some background about why business owners rely on margin and markup calculations to gauge profitability.
Margin vs. Markup: Views Into Profitability
Knowing how to calculate margin and markup is useful for business owners, CFOs, investors, and other stakeholders. That’s because they both offer their own views on profitability.
Margin and markup are not the same thing, despite the terms being used interchangeably at times. Some might think you only need to look at one or the other. On the contrary, both are vital ratios with a unique perspective on your company’s financial health and strategy.
To see a margin calculation or a markup formula, you first need to understand what they’re measuring. Here’s a quick primer on three important definitions.
Revenue is the money your company earns from selling products and services.
Cost of goods sold (COGS) is the total amount your company spends producing products and services. This includes labor, materials, overhead costs, and more.
Gross profit is your business’s revenue after subtracting the costs of producing the products you sell. To calculate gross profit, take your revenue figure and subtract the COGS amount.
Simple enough, right? It is, but as you know, accounting is never that easy.
What constitutes revenue and product costs in the real world is not that straightforward. And that’s where margin and markup come into play. These ratios give you differing high-level views of profit.
With all that in mind, let’s have a look at what profit margin is.
How to calculate margin
Profit margin is a ratio that determines how much your business makes on a product or service. In short, profit margin tells you how much of your sales revenue turns into profits. The sales margin formula is calculated by deducting your COGS from your sales.
From here, businesses can calculate a few useful metrics: net profit margin, operating expenses, operating profit margin, and gross profit margin. Out of all three, gross margin is the most commonly used. When finance professionals talk about “margin” or “profit margin,” they’re most likely talking about gross profit margin. (If you’re interested, the net profit margin is profit minus all of your company’s expenses, not just COGS.)
Gross Profit Percentage Formula
A gross margin definition is simply “the amount your business is able to retain after selling a product and paying the COGS.” Wondering how to calculate profit margin percentage? The gross profit margin formula is: Total Revenue minus COGS divided by Revenue.
To see this formula in action, imagine you’re selling widgets for $100, and it costs you $45 to produce each widget. In a month where you sold 10 widgets, your margin calculation would look like this:
|
Revenue minus COGS |
Revenue |
Gross margin |
|
($1,000 – $450) = $550 |
$1,000 |
0.55 = 55% |
After running the numbers through the gross profit percentage formula, you find that your gross margin on widgets for this month was 55%. For every $100 in widget revenue your company took in, you were able to keep $55. The other $45 went to all the costs associated with producing the widgets.
This metric offers insight into your company’s efficiency. A 55% gross margin would indicate that you’re doing great in the real world. A gross margin of this size gives you plenty of capital to reinvest in your business and promote future growth.
A low margin signals that your costs are too high and that some inefficiencies have crept into your company. Deciding which margins are too high or low is truly subjective—as long as you’re talking about positive numbers. You should never have a negative gross or net profit margin. That means your business is losing money.
For startups, no set margin qualifies as “high.” Getting a new and profitable business off the ground is always a challenge. You can find representative margins for your industry, but as a new business, your margins are likely to be lower than that.
So now that you have a solid understanding of margin and what it tells you, let’s take a look at markup.
How to Calculate Markup
While gross margin shows you how much profit you’re making, markup is meant to tell you how much you need to “mark up” a product to reach a desired profit level. That is, how much you need to add to your COGS to reach a price that produces an acceptable profit.
Learning how to calculate markup is essential for small businesses and startups. Setting initial pricing levels, so your company generates adequate profit, is critical to making your company a long-term success.
So that’s the markup meaning, and here’s how you put a markup formula into action. First, you will need your gross profit. Not the gross profit percentage formula you used earlier, but the actual gross profit in terms of dollars. This is found with the simple formula Revenue minus COGS = Gross profit.
Using the widgets example from before gives us these numbers:
|
Revenue |
COGS |
Gross profit |
|
$1,000 |
$450 |
$1,000 – $450 = $550 |
Markup Calculator
Now that you know your gross profit on the widgets for the month was $550, divide that figure by your COGS to arrive at the markup percentage:
|
Gross profit |
COGS |
Markup |
|
$550 |
$450 |
$550 / $450 = 1.22 = 122% |
Using this markup calculator, you now see that your markup on the widgets for the month was 122%. That means you marked up the widgets 122% from your cost.
Markup gives you an idea of what you should charge for other products. Assuming you’re happy with the 55% margin you make on widgets, you can apply a 122% markup to the COGS when pricing future products.
Of course, these are just examples to help illustrate how to calculate margin and markup. In the real world, arriving at these figures and ratios is more complicated.
Determining COGS is not a straightforward process, and pricing is heavily influenced by what customers in your market will actually pay for your widgets. You’ll depend on your accounting software to help you with margin and markup calculations.
When Do You Use Margin vs. Markup?
Even though calculating margin and markup for your business will be a more involved process, the important thing is that you understand the information they provide. The above examples should show you how both are useful for different aspects of your profitability picture.
The next thing to learn is when it’s the right time to know how to calculate margin or markup.
Margin is the best choice for calculating your company’s profits. It provides a better overall view into how profitable your products are.
Meanwhile, markup is more useful for setting initial prices. Markup also helps you identify potential roadblocks on your path to profitability. When you do find problems, examining your current markup is useful for determining the pricing levels that will help you address the issues.
Understanding the relationship between markup and margin is helpful in those times of evaluation. As you’ve seen so far, the two look at profitability from different but related viewpoints. It isn’t surprising to find out that markup can be calculated from the margin.
How to Calculate Markup From Margin
Just follow these steps:
- Convert a profit margin into a decimal by dividing the percentage by 100.
- Subtract this decimal from the number 1.
- Divide 1 by the number you came up with in the previous step.
- Subtract 1 from the figure you arrived at in the last step.
- This answer is the markup in decimal form; multiply by 100 to make it a percentage.
Following this multi-step formula with a few examples gives you an idea of how margin and markup work together. Once you’re dealing with larger numbers, it will make more sense to use a spreadsheet for your calculations.
Your accounting software may also have features that can do these margin-to-markup calculations for you, and vice versa. However you get these calculations done, use the results to aid your strategic planning.
Margin Calculation and Markup Formula: The Complete Picture
Every company has its own unique purpose. But all businesses share a common goal: to turn a profit. Margin and markup both fall into the category of profitability metrics. Together, they highlight your strengths and weaknesses and help you address issues before they become problematic.
Without the complete picture offered by margin and markup calculations, you can’t understand your company’s profitability. You also can’t do strategic pricing that returns the most gains to your company. That means you might unintentionally set prices customers won’t pay, making it impossible to generate enough revenue to cover your costs.
But when you utilize margin and markup together, you’re better able to set goals for the long-term health of your company. Margin and markup calculations should be part of your monthly financial metrics. Take action on the information you find, and over time your revenue, profits, and profit margin should fall in line with the representative margins in your industry.
inDinero Helps Get the Most From Your Metrics
Every business is unique. You’re creating your own path to success. At the same time, your books aren’t like anyone else’s either.
Your revenue and costs are yours alone. To see the big picture and understand your profitability, you need to know important metrics like your gross margin and markup percentage.
As a startup business, this can all feel overwhelming. How do you know if you’re collecting the right data and calculating it properly? A trusted team of experts can help you answer those questions—and keep your startup on the road to profitability.
inDinero has helped many businesses like yours with expert financial operation services. Our dedicated team of accountants, CPAs, CFOs, tax advisors, and more have guided those companies through gathering and understanding their metrics, driving profitability. To see how we can do the same for your startup, reach out to us today!
