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Profit Margin vs. Markup: An Overview
Profit margin and markup are accounting terms that use the same inputs and analyze the same transaction. They show different information, however.
Both profit margin and markup use revenue and costs as part of their calculations but profit margin refers to sales minus the cost of goods sold, Markup refers to the amount by which the cost of a good is increased to get to the final selling price.
An appropriate understanding of these two terms can help ensure that price setting is done appropriately. It can result in lost sales or lost profits if the price setting is too low or too high. A company’s price setting can also have an inadvertent impact on market share over time because the price may fall far outside of the prices charged by competitors.
Key Takeaways
- Profit margin and markup are separate accounting terms that use the same inputs.
- They analyze the same transaction but they show different information.
- Profit margin refers to the revenue a company makes after paying the cost of goods sold (COGS).
- Markup is the retail price for a product minus its cost.
Terms to Understand
An understanding of the terms revenue, cost of goods sold (COGS), and gross profit is important to understanding profit margin and markup:
- Revenue refers to the gross amount of money received by a company for selling its goods and services.
- COGS refers to the expenses incurred by manufacturing or providing goods and services.
- Gross profit is any revenue that’s left over after covering the expenses of providing a good or service.
Profit Margin
Profit margin refers to the revenue a company makes after paying COGS. It’s calculated by taking revenue minus the cost of goods sold.
The difference is shown as a percentage of revenue. The percentage that’s gross profit is found by dividing the gross profit by revenue. A company’s margin would be $30 if it sells a product for $100 and it costs $70 to manufacture it. The profit margin stated as a percentage is 30% and is calculated as the margin divided by sales.
Important
Profit margin is sales minus the cost of goods sold. Markup is the percentage amount by which the cost of a product is increased to arrive at the selling price.
Markup
Markup shows how much more a company’s selling price is than the amount it costs the company to create it. The higher the markup, the more revenue a company makes.
Markup is the retail price for a product minus its cost but the margin percentage is calculated differently. The markup in our example is the same as gross profit or $30 because the revenue was $100 and costs were $70. Markup percentage is shown as a percentage of costs, however, rather than a percentage of revenue.
The markup percentage would be 42.9%, or ($100 in revenue – $70 in costs) / $70 costs.
What Is the Direct Cost of a Product?
A product can’t exist if its producer doesn’t pay the direct cost of a component or service that’s necessary for its creation. An ingredient for a recipe would be a direct cost for a restaurant. A direct cost can be fixed or variable and dependent on factors like inflation.
Do Other Factors Affect a Product’s Selling Price?
Pricing depends on a combination of internal and external factors. Internal factors include the cost of goods sold (COGS). External factors are those the producer has little or perhaps no control over. They include inflation, the pricing strategies of competitors, and market demand and supply.
Why Is Price Setting Important?
The sales price of a product generates revenue and contributes to the company’s profitability. It sets perimeters on competition with other producers and companies and it can impact consumer demand.
The Bottom Line
Profit margin and markup show two aspects of the same transaction. Profit margin shows profit as it relates to a product’s sales price or revenue generated. Markup shows profit as it relates to costs.
Markup usually determines how much money is being made on a specific item relative to its direct cost. Profit margin considers how much money is made relative to revenue. Profit margin can be computed for a single product, a product line or division, or for an entire company.
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