Does The Added Profit Margin (Markup) Constitute a “Real Addition”?

Does The Added Profit Margin (Markup) Constitute a “Real Addition”?

discover | Sunday - 09 / 06 / 2024 - 10:32 pm

Please don’t rush to answer and read this blog post to the end. As usual, we’ll start by defining the concept as follows: The added profit margin (the markup) is the amount you add to the cost of a product to get the selling price that suits the company and enables it to achieve its targeted profits. It is generally expressed as a percentage.

Added profit margin: A “mercurial” metric (rapidly and unpredictably changeable metric)!

To prove this to you, consider the following question: is the added profit margin for inexpensive products… low or high? 

While logic assumes that it should be low, this is not necessarily the case. Some products with a low selling price (such as bottled water and popcorn at the cinema) have a very high added profit margin (because the original cost is very low).

 

Why is added profit margin important for your company?

Identifying added profit margins for different product categories helps you determine appropriate selling prices even if the cost changes. For example, the added profit margin for grocery products is low, which means you need to sell large quantities to make money. In contrast, for other products like electronics, which can have an added profit margin of 250% to 500%, you don’t need to sell as many products to be profitable.

 

Key Differences Between Markup and Profit Margin:

Is there a difference? Absolutely, there is a difference. Day in and day out, these two terms are used interchangeably, but a misunderstanding can pose a threat to profitability. Markup and profit margin are not the same thing! The way each is calculated is also different!

Many people – mistakenly – believe that if the markup for a product/service is, say, 25%, then the total profit margin will appear in the income statement at the same rate (25%). Where is the error in that? I will show you with the numbers.

We do not need to calculate the markup for more than the purchase price and the selling price, so the equation looks like this:

Markup = (Selling price – Cost price) ÷ Cost price … then multiply the result by 100.

For example, if a product costs 100 SAR, the selling price with the mentioned 25% markup = 125 SAR.

So what about the profit margin?

The equation for calculating it, as is known, looks like this:

Gross profit/Selling price = 25 SAR/125 SAR = 20%.

See?! The percentage has changed.

 

Markup determines the amount of revenue generated from a particular product, while the other measures overall profitability. Your company can control markup (to some extent), while profit margin depends on a number of external factors and costs (which we covered in a previous blog post).

 

Why are both important?

Because the markup plays the role of the “driving force” of revenue, while the profit margin is a measure of profitability. This means that the two complement each other. For example, if profit margins decline (due to an increase in the cost of goods sold or operating expenses), it may be necessary to increase the markup to boost profitability.

 

When to Use Markup Margin:

Markup margin should be used to determine an appropriate selling price that covers your costs and generates profit. Naturally, pricing strategies are influenced by other factors such as demand and competition. Depending on your industry, markup margin percentages may be similar across all your product options or may vary between product/service categories.

 

When to Use Other Profit Margins:

Profit margins, whether gross or net, should be used when you want a precise measure of profitability that can help you identify areas of inefficiency in your business and find ways to save money. For instance, a wide gap between gross and operating margins may indicate that operating expenses are too high.

 

Converting Margin to Markup Margin:

What if you don’t have the price and cost of a specific product? What if you only know the markup margin percentage?

In general, you won’t face this problem if you’re using Logix system for financial management, where you can find the selling price and cost at any time. But let’s say you’re just trying to do quick conversions, we’ll resort to a simple trick as follows:

Let’s take an example of a 50% margin and see how to express this value as a markup margin.

Markup Margin = Margin / (1 – Margin)

Coding = 0.50 / (1 – 0.50) = 1.0

That is, a 50% margin is equivalent to a 100% markup margin.

 

When should you use margin over markup margin?

If you’re interested in calculating profits, it’s best to use margin, not markup margin. Margin also provides a better overall view of the profitability of your products.

On the other hand, markup margin is very useful when looking for initial product pricing. Markup margin can also indicate potential problems within pricing levels.

 

Utilize Both to Gain a Clearer Picture:

Calculating both the gross margin and the markup rate are crucial metrics that business owners can employ to gauge the profitability of their operations and determine whether their pricing strategies are adequate to cover all the necessary expenses incurred in purchasing or producing a particular product. In essence, by calculating the margin, you’ll be able to assess the profitability of your business, while calculating the markup rate serves two purposes:

– Enables you to set appropriate pricing for any new product or service

– Allows you to revisit pricing levels to determine whether adjustments are necessary or they are not. 

 

Factors to Consider When Calculating Markups:

Your markup should be strong enough to cover all your current and future expenses (such as discounts, potential stock shortages, and reductions).

 

Additional factors to consider include:

Market Prices:

Before calculating your markup, research how your competitors are pricing their products. Average product prices vary by industry. Most customers already have a clear idea of what they are willing to spend on your product because they have seen the average prices of similar products. If they see your product priced higher than your competitors, well… you know what happens!

 

Sales Volume:

Now you know that some high-selling products may have lower markups and still generate significant profit for you. Loogics financial management system helps you identify those products so your customers are encouraged to buy more of them.

 

Brand Reputation:

As your company grows, so does the popularity of your brand. Using marketing tactics to build brand awareness will make more people want to buy your products.

 

Feeling a bit puzzled?

Added profit margin is a fundamental pillar when creating a pricing strategy or when deciding to review your current pricing strategy. However, understanding or using added profit margin can be challenging, especially if you are new to the world of business and finance.

 

But don’t worry…

Logicx financial management system allows you to skip the complex calculations and get a real-time view of your profitability through simple dashboards and built-in margin calculations (of various types). Our unique and easy-to-use cloud system helps you make smart decisions about product pricing and simplify expenses in your business.