Pricing is important to business as it can mean the difference when it comes to customer satisfaction. Successful businesses want to maximise margins and markup. Unfortunately, businesses are increasingly using these terms as synonyms for the same concept – the difference between the price goods are sold for and the ‘cost of goods sold’.
What is a business’ margin?
A business’ margin is typically understood as the revenue earned through merchandise sales minus the cost of goods sold. Revenue does not take into account sales of noncurrent assets (such as a retail business selling a surplus point of sale system). The cost of goods sold refers to the direct costs to the business of the goods sold. As an example, if a brewery can sell 100 litres of beer for $400 and spends $220 on hops and grain, its margin is $180. Margin can also be expressed as a percentage of sales, in this case $180/$400 = 45%.
What is a business’ markup?
A business’ markup is best thought of as extra percentage in addition to the ordering cost which is passed on to consumers. Using the same brewery example, if costs are $220 the business must charge a $180 markup to reach a $400 price. Markup is typically stated as a percentage of product cost, in this example, the markup would be $180/$220 = 82%.
The relationship between margin and markup
While target margins are important to set and understand, markup is ultimately the number that you will use to set sustainable pricing within your business. If a given margin is desired (for example, 20%), it is imperative to set a markup which is (as a percentage) higher than the margin. This is because markup is a percentage of cost, while margin can be expressed as a percentage of revenue. Confusing the two is likely to impact negatively on business planning and inventory control, and result in prices that do not reflect a business’ costs.
How to determine the appropriate markup?
If you have a target margin and the cost of goods available to you, calculating the necessary markup is very simple. Markup is given by dividing the desired margin by the cost of goods. So, for example, if your brewery can produce a London Porter for $5 and a Pale Ale for $4 and wishes to make a $2.75 margin on each product, it must charge $7.75 for the Porter and $6.75 for the Pale Ale. This is a 55% markup on Porter and a 68.75% markup on Pale Ale. On the other hand, if you want to charge a consistent percentage margin between products, you can use this formula to determine the markup you should charge for each product: Markup = Margin ÷ (1-Margin)
So, for example, a 10% margin will require a 11.11% markup, a 25% margin will require a 33.33% markup and a 50% margin will require a 100% markup.
Providing sales teams with this formula makes it a lot easier for sales staff to work out their minimum price on the fly – if a prospective client suggests a given discount, it is useful if staff can check whether that price level would still meet your business’ target margin.