Are gross margins merely the same as markups? It’s tempting to say yes—after all, both of these values refer to the difference between the cost of goods and the selling price, right?
Well, sort of, but not really. In the interests of strategic business planning, retailers need to remember that markups and margins are two distinct entities, and as such, should be carefully compared, as opposed to being used interchangeably.
When sellers have a firm grasp on their markup vs. margin numbers and how to wield them, they can price their goods more determinatively and thus gain a much-needed competitive edge in today’s cutthroat retail market environment.
In this post, we’ll discuss the differences between markup vs. margin, when to use them, and how to calculate them.
What’s the Difference Between Markup and Margin?
In essence, a markup is a percentage added to a product’s cost to arrive at the retail price. A margin is a measure or ratio of a retailer’s profitability.
In other words, markup is equal to a product’s selling price minus the cost of goods (or, in some cases, minus marginal cost—more on that in a little bit). It can be expressed as a dollar amount or as a percentage of the selling price.
Typically, companies find expressing markup as a percentage of price has greater use-value than a dollar amount. Percentages can more easily be compared to other financial data, such as sales results for the previous year, price drops, and competitor data.
What’s the difference between markup on cost and markup on selling price?
We just defined markup as a function of the selling price, but note that it can also be expressed as a cost percentage. However, most retailers don’t bother calculating the markup on cost because most of the other financial data they rely on are defined as a percentage of the selling price.
Margin, on the other hand, is a term that can refer to several things but is most often used to indicate a firm’s sales profits. This figure is also known as a firm’s price-cost margin, gross margin, or contribution margin.
Businesses need their margins to be high enough to cover their operational expenses (i.e., the fees a retailer incurs besides the cost of goods, such as rent, payroll, insurance, utilities, etc.) and turn a justifiable profit.
What is the gross-margin percentage?
Similar to markups, margins are expressed as a percentage. The gross margin percentage is a measure of profitability calculated by dividing the gross margin by net sales (this is also known as the gross-margin return on sales.) A 60% gross margin would mean that a retailer earns 60 cents of gross-margin profit for each dollar of sales.
What is the net profit margin?
Another type of margin retailers need to calculate is the net profit margin, which is the ratio of post-tax net profit to net sales. While the gross profit margin shows the profit earned after subtracting the cost of goods sold, the net profit margin reflects the profit earned after deducting all expenses and taxes.
Because the net profit margin ratio is calculated only using data from a firm’s income or operating statement data, and does not reflect the business’s balance sheet, the figure isn’t necessarily an indicator of a retailer’s health, because it can’t effectively show how the retailer is using its profits.
What is the marginal cost?
One more “margin” term that retailers may encounter is marginal cost, which refers to the incremental cost of producing one more product.
Manufacturers tend to have much higher marginal costs (researchers have found manufacturers’ marginal costs tend to be about 2/3 of their wholesale price) than retailers. Service retailers have the lowest marginal costs.
Some last notes on margins:
Economists have shown that the largest firms in a retail market usually have the highest gross margins because economies of scale allow them to do business at a lower marginal cost.
Also, they can charge higher prices due to their sizeable market share. A small retailer could conceivably have an even higher gross margin than one of those fat-cat firms if its product is unique enough and there is sufficient consumer demand.
Technological differences between retailers can also dramatically impact their respective margins.
When Should Retailers Use Margin vs. Markup?
Sellers should use markup values when developing pricing strategies. (Note that projected or desired gross and net margin values can help calculate the markup—the two values do influence each other).
Retailers should use margin values when evaluating or forecasting the business’s overall profitability and setting a merchandise budget.
How to Calculate Markup
When it comes to calculating markup, the vast majority of retailers rely on cost-plus pricing, which involves calculating the cost of goods and then multiplying that figure by a predetermined fixed percentage (the markup) to arrive at the retail price.
The Harvard Business Review has called cost-plus pricing something akin to “the romance novel genre, in that it’s widely ridiculed yet tremendously popular.” It’s tremendously popular thanks to the ease and speed of applicability—but widely ridiculed among economists and market researchers because of how blunt of an instrument it is.
When calculating markup, retailers need to have some degree of flexibility and expansiveness in terms of how they account for the myriad factors, internal and external to the business, that influence pricing optimization.
One way to do this is to be mindful of the difference between initial markup and maintained markup.
Initial markup formula
Here’s the formula to arrive at a general ballpark for the initial markup when first introducing a new product to the market:
Initial markup percentage = (Operating expenses + Net profit + Markdowns + Stock shortages + Employee and customer discounts + Alteration costs – Cash discounts) / (Net sales + Markdowns + Stock shortages + Employee and customer discounts)
This can also be expressed more simply as:
Initial markup percentage = (Gross margin + Alterations costs – Cash discounts + Reductions) / Net sales + Reductions)
Pro-tip: Inventory management software tools like SkuVault can help retailers easily and speedily access the above numbers with a far greater degree of accuracy than any manual process.
This, in turn, can help generate a more precisely pitched optimal markup value.
Maintained markup formula
Retailers may change that initial markup (usually by lowering it) over time to:
- Balance demand with supply
- Make up for stock shortages due to clerical error and theft
- Make up for employee and customer discounts
- Make up for the cost of alterations to the product
- Reflect cash discounts given to the retailer by the vendor (such as for timely payment of invoices)
This second value is referred to as the maintained markup and can be expressed as follows:
Maintained markup = (Actual retail price – Cost) / Actual retail price
Tip: Retailers can avoid having to significantly reduce their maintained markup value by utilizing inventory management software like SkuVault to dramatically reduce the clerical errors that can lead to shortages, more precisely forecast demand, etc., thus reducing costs.
Factors influencing markup
Retailers shouldn’t just plug their costs into the above formulas and run with the number that results. Many variables impact pricing strategies, and they must all be accounted for. The above formulas are more of a guideline and should be adjusted to reflect factors such as:
- Product availability. The greater the number of retailers that offer a given product, the lower the markup; conversely, the rarer the product, the higher the markup.
- Handling and storage costs. These should be proportional to markup.
- Seasonality. Seasonal goods should have a higher markup earlier in the season.
- Demand elasticity. The less elastic demand is, the higher the markup
- Location. For brick-and-mortar retailers, proximity to other businesses or to consumers will also affect how high they can mark a product up.
- Additional services. Retailers that offer unique or customized customer services can charge higher markups.
- Retailer identity. Retailers should consider how they want to be seen by customers (i.e., as luxury purveyors or a scrappy spot for deep discounts) when considering how much to markup products.
- Business philosophy/orientation. Finally, the markup amount will also be influenced by the business’s philosophy and objectives: is the company pursuing profit-oriented objectives, sales-oriented objectives targeted at increasing market share, or “status-quo” objectives?
How to Calculate Margin
Once a seller has calculated their initial markup on their product, they can go ahead and calculate their planned gross margin, which is usually the last calculation done when putting together a merchandise budget.
This value is what allows the retailer to estimate profitability and thus make informed firm-wide decisions.
The calculation is quite simple:
Planned gross margin = Planned initial markup – Planned reductions
A quick rundown of margin and markup formulas
As we’ve seen, there are a fair number of calculations governing a retailer’s margins and markups. We’ve compiled all of the above formulas, plus a few bonus equations, into one handy cheat-sheet for easy reference and review.
Margin vs. Markup Chart
|Selling price formula||SP = C + M
Where C is the dollar cost of merchandise per unit, M is the dollar markup per unit; and SP is the selling price per unit
|Cost of goods sold prescription||Inventory at the beginning of the year + net purchases + cost of labor + materials and supplies + other costs) – inventory at the end of the year|
|Percentage of markup on selling price||Percentage of markup on selling price = (SP – C) / SP = M / SP||Gross margin formula||(Revenue – Cost of Goods Sold) / Revenue|
|Percentage of markup on cost||Percentage of markup on cost = (SP – C) / C = M / C||Gross margin percentage formula||(Gross margin / net sales) x 100|
|Initial markup formula||Initial markup = (Original retail price – Cost) / Original retail price||Net margin percentage formula||(Net income / total revenue) x 100|
|Maintained markup formula||Maintained markup = (Actual retail price – Cost) / Actual retail price||Marginal cost formula|
How Tech-based Solutions Can Help Calculate Markup and Margin
SkuVault’s inventory management software generates reports that provide retailers with the exact numbers they need to complete the above calculations.
Besides this, the software’s facilitation of inventory control, warehouse management, and shipping reduces operational costs. This translates into wider gross and net margins and, hence, greater price-setting flexibility for the business.
We’d love to show you firsthand how SkuVault can maximize your profitability and simplify these tough decisions for your organization. Contact our team today for a live demo.