I get asked this question so often so the following represents how you identify and use gross margin or mark up. Depending on the industry, some prefer to use margin and others prefer mark up. I have found as a general rule, larger businesses tend to use margin. Stockholders tend to like to see margin in annual reports. A higher margin seems to say that my product is of a higher scale and this can in my opinion lose you money for the sake of saying you have a high margin product.
I had a case with my Board of Directors and various investors that they wanted to see our margin be a steady 30%. I come across a large distributor and they wanted to purchase 10,000 of an item that sold for $3,000 wholesale. They asked for a discount based on the volume that would have brought our margin down 12 percentage points so our margin as stated in the Annual report would be lower than the stated 30%. The order was for $30,000,000 and with the discount it was $26,400,000.
I was forced to turn down the order because of the margin issue and I explained that an order of this magnitude would give us a gross profit of 18%, get our name in front of 10,000 additional end users, lower our cost of good because of the volume, give us name recognition with a national distribution chain, give us additional warranty revenue and open up the door for additional products that are synergistic to our product line.
To say I was upset is an understatement but this is an example of how to lose money but keep up your margin. If we used percent of markup, I would have won the deal. Ultimately, I managed to convince the Board of doing an off book deal and it reflected differently in the Annual Report.
What is the difference between gross margin and markup?
Gross margin or gross profit
is defined as sales minus cost of goods sold. If a retailer sells a product for $10
which had a cost of $8, the gross profit or gross margin is $2. The
gross profit ratio or the gross margin ratio expresses the gross profit or gross margin
amount as a percentage of sales. In our example the gross margin ratio
is 20% ($2 divided by $10).
Markup is used several ways. Some retailers use markup to mean the difference between a product’s cost and its selling price. In our example, the product had a cost of $8 and it had a markup of $2 resulting in a selling price of $10. The $2 markup is the same as the $2 gross profit. However, the markup percentage is often expressed as a percentage of cost. In our example the $2 markup is divided by the cost of $8 resulting in a markup of 25%. (Some retailers may use the term markup to mean the increase in the original selling. For example, if the $10 selling price was increased to $11 because of high demand and limited supply, they would say the markup was $1.)
If I want a gross margin of 25%, what percent should I mark up my product?
To achieve a gross margin or
gross profit percentage of 25%, you will need to mark up your product’s cost by
33.333%. The following illustrates how this is calculated.
Assume a product has a cost of $75 and a selling price of $100. Since the gross profit is defined as selling price minus the cost of goods sold, this product will have a gross profit of $25 ($100 minus $75). The gross margin or gross profit percentage is 25% (gross profit of $25 divided by selling price of $100). The mark up of $25 on the cost of $75 equals 33.333% ($25 divided by $75).
Let’s prove this with one more example. Assume you have a product that you purchased for $9. If you mark it up by 33.333%, you will have a markup of $3 and the product will sell for $12. The income statement will show a sale of $12 minus its cost of $9 for a gross profit of $3. The gross profit of $3 divided by the selling price of $12 equals a 25% gross margin or gross profit percentage or gross profit ratio.
What is gross margin?
Gross margin is the
difference between 1) the cost to produce or purchase an item, and 2) its
selling price. For example, if a company’s manufacturing cost of a product is $28 and the product is sold for $40, the
product’s gross margin is $12 ($40 minus $28), or 30% of the selling price
($12/$40). Similarly, if a retailer has net sales of $40,000 and its cost of
goods sold was $24,000, the gross margin is $16,000 or 40% of net sales
It is important to realize that the gross margin (also known as gross profit) is the amount before deducting expenses such as selling, general and administrative (SG&A) and interest. In other words, there is a big difference between gross margin and profit margin (or net profit margin).