Every business owner might have a unique vision in mind for their business. But whatever that may be, one thing is certain: they all want to be profitable. A business’s profitability is key to ensuring the business can continue its operations, support its growth, and drive the business toward its financial goals.
There are many proven ways to monitor overall business performance, and Key Performance Indicators (KPIs) are one of them. There are several KPIs you should be tracking such as cash flow, revenue, costs, and staff turnover. To ensure the business is on track with its objectives, KPIs are laid out and measured over time.
One important key performance indicator is your profitability. However, most businesses fail to optimise their profitability due to poor pricing of their products and services. To avoid potentially costly pricing mistakes and cash flow issues, you must first understand the distinction between your margin and your markup, and how to use them to establish appropriate pricing.
Confusing profit margins with markup is a common problem among business owners. This is understandable given that they both deal with sales, pricing, and costs.
Both profit margin and markup are important concepts and can be used to help you price your products effectively. But it is crucial that you understand the major difference between the two.
Let’s dive into these a little deeper.
Profit margin (or margin) is the percentage difference between the sales price and the profit. Or in other words, revenue minus cost of goods. This tells you how much you earn after your direct costs are paid. Here is an example to help you understand how the margin is calculated.
Let’s say you are offering a service at $1600 and your direct cost is $700, your margin is then 0.56 or 56%.
To get technical, the equation is:
Margin = (sales price – direct cost) / sales price = ($1600 – $700) / $1600 = 0.56 or 56%
On the other hand, markup is how much the cost of your product or service is increased in order to get to the selling price. Markup is the percentage difference between the direct cost associated with delivering a service or purchasing/producing a product and the sales price. This tells you how much more your selling price should be and is calculated relative to costs.
So, if you offer a service at $1600 and your direct cost is $700, your markup is 1.29 or 129%.
Markup = (sales price – direct cost) / direct cost = ($1600 – $700) / $700 = 1.29 or 129%
How to Use Margin and Markup to Set the Right Price
Both the margin and the markup are essential to guide your pricing strategy so as to avoid overpricing or underpricing your products or services, minimise any cash flow crisis, and ensure you are achieving optimal profitability.
Determine your profit margin
Generally, you need to determine what you want your profit margin to be before you can calculate a markup percentage on your selling price. This is why margin and markup go hand in hand with each other.
Determining your profit margin doesn’t need to be guesswork. It’s helpful to understand what others in your industry are charging and the level of service that comes with price setting when developing your markups. For example, if you plan to achieve higher margins, and therefore need to charge more than competitors, you must take this extra cost seriously as your customers will expect a higher quality service.
Don’t get caught in undercharging leading to lost profit. This can do real damage to your business. Calculate all your direct costs and how they affect your gross profit. Direct costs are the actual expenses attributed to providing the service or selling the product. For example, direct costs for trades businesses typically include the cost of the labour (including contractors), and the materials required to complete the job. Keeping records of all the costs in a given timeframe to understand what you’re spending is a great way to calculate your gross profit, giving you the ability to more accurately determine your markup percentage.
Convert your margin to markup percentage
Your markup percentage must always be higher than your margin percentage if you want to reach a particular profit margin. To set a selling price for your product or service with a markup that will generate optimal cash flow performance and profitability, you must convert your desired margin, which you already have worked out, into a markup percentage on your selling price.
For example, if your desired margin is $500 on a particular service and your costs are $1200, you need to price the service at a 42% markup, giving you a selling price of $1700. This selling price covers the direct costs of doing the job as well as making your desired margin.
It’s important to keep in mind that your markup is not a set and forget. With rates on the rise in Australia, it’s important to revisit your pricing and ensure your markup percentage is delivering on the desired margin. As an example, for tradies, this means taking into account your direct costs that are increasing such as timber, materials, petrol, etc., and indirect costs such as company vehicles and insurance costs.
It is essential that you understand the difference between the margin and the markup so you can set the right pricing for your products and services.
Remember, a good margin could ensure you’re generating a profit and a good markup can help you set the appropriate price. And getting them both right could mean optimal profitability which will drive your business towards its financial targets.
Calculating your margin and markup doesn’t need to be complicated, but it can sometimes be overwhelming. If you need assistance or if you have further questions about margins vs markup, our expert advisors and accountants can help you calculate what is right for your business. Get in touch with us at firstname.lastname@example.org or call us at 07 3878 9181.