As customers, we all know the frustration when we feel products have been priced substantially higher, creating a very expensive purchase price. What exactly is a mark-up in accounting terms and how does it differ from a profit margin?
Mark-ups and margins have sadly been used interchangeably without their true meanings being properly understood. However, it is extremely important that they be appreciated in their own right, as they are very different concepts that will dramatically affect the bottom line if not used correctly.
Mark-ups refer to the percentage extra that is added to the cost of a product (be it purchase or manufacture price). Since the base price may fluctuate and the mark-up is a percentage of the base price, the mark-up percentage may stay the same with the profit changing for different inventory items. Another important point to make is that the mark-up does not necessarily take into consideration company overheads as it only relates to the wholesale cost of the inventory stock.
Margins or profit margins refer to the amount of money the company wishes to make over and above the cost of goods sold (COGS). They will then add this to the COGS price to derive the selling price. The company can calculate the amount they wish to make in profit and incorporate it with the cost of overheads etc. to derive the gross margin. The margin stays constant, ensuring consistency of profit despite fluctuating COGS.
How mark-ups and margins relate
We will use a real example to highlight the difference between mark-ups and margins. If a stock item costs $50 and the company sells it for $100, the margin is the difference between the two, which is $50. Therefore, the profit margin as a percentage is 50%.
However, if the company chose to mark the product up by 50% to derive the selling price, the selling price would be $75 (50% x $50 mark-up). Therefore, the company would sell the product for $25 less using a mark-up technique rather than a profit margin technique. This would result in a loss of profit. To ensure the same profit or more is made using a mark-up, the mark-up would need to be equal to or greater than 100%.
Therefore, to ensure profits remain reasonable, the mark-up needs to be higher (in percent) than the margin percent. It is a very common occurrence to falsely price products when sale prices of inventory stock items are set by the sales department without a true understanding of the accounting dynamics. It is common to mistakenly think more profit will be made from using the mark-up method with albeit a higher mark-up percentage than the margin percentage, though not high enough. In fact, as illustrated, it can result in less profit for the company. In reality, using a gross margin to derive the sale prices of inventory stock, profitability can be more easily compared to other factors on the financial statement.
Understand what affects sales
Even though it is imperative to understand the difference between margins and mark-ups and which method would be the best for the company to maximise profits, it is equally important to understand the other factors which affect sales and subsequently profits.
The sale price should be a fine balance between optimising profit margins while still maintaining a competitive advantage over other companies. This is the highest price the customer is willing to pay while still being lower than competitors in the market. What the customer will pay for a product is partly affected by availability, seasonality, composition (such as sugar-free foods for example), or trade history (such as what ethical trade behaviours precede the sale of the item, for example Fair Trade chocolate or coffee).
To fully understand sales trends and adjust inventory stock and pricing accordingly there are inventory management software products available. These packages are designed to facilitate inventory control that relates to sales and demand and not only makes it clear what your profit margin should be to account for company and inventory stock overheads but also helps to get everything organised and efficient in the manufacturing or distribution process.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.