Margin and mark-up have long since been a source of confusion and an improper understanding of the two can lead to some detrimental effects in terms of loss of income. So, delve in with us and learn about mark-ups and margins!
What’s in a word
Perhaps one of the keys to understanding these concepts is in the terminology: mark-up versus margin. Mark-up implies something over and above something else; you have added a finite amount to something and as a consequence you get a total that incorporates your starting value and the amount you added to get to the total. Whereas the word margin implies an extra amount that is a proportion of the initial number and therefore it will always remain the same as a proportion when the initial number fluctuates.
It is a perception issue: with a mark-up, we look at the initial number and choose to add a certain amount to it, we raise it, up it goes, to give us a new total which we take as it comes. The total is merely a consequence. With a margin, irrespective of the initial number, we want a percentage or margin extra. If the initial number is small, with a set margin, the total will be small. So, if we want to adjust the total, we adjust the margin.
Here’s a scenario
Perhaps we can look at it this way: we want to make juice by mixing a small amount of cordial with a larger amount of water, and in doing so we end up with juice of a certain concentration. If the water is our cost of goods sold (COGS) and the cordial is our profit, then the juice volume is the purchase price to the customer and the concentration of the juice is the proportion of our profit with respect to the COGS.
If we increase the amount of water but keep the amount of cordial the same, the juice volume goes up (the purchase price) and the concentration of the cordial is diluted (our profit with respect to COGS). Therefore, the cordial amount is decided irrespective of the water amount and the concentration decreases. This represents a mark-up.
However, if we increase the water amount and want to maintain a certain juice concentration regardless (and not dilute it out), then the cordial amount must increase proportionately to the water. The cordial amount (our profit) is then dependent on the water amount (COGS) and we will always maintain a certain concentration of juice (profit as a proportion of COGS) despite the total juice volume increasing (the purchase price to the customer). This represents a margin.
At the end of the day, we want to maximise both our profit and ensure it does not decrease as a proportion of our COGS.
To apply these rules to your manufacturing or distribution business, it is essential to understand your inventory stock and manufacturing process. This understanding relies on real numbers, which is possible with the help of downloadable inventory management software. These software packages will help you to isolate where adjustments can be made in your process to optimise inventory control and sales and thus have an accurate knowledge of how to adjust your pricing to maximise profits.
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.