Gross Profit Margin vs. Mark-up
Businesses need to determine how much to charge a customer by marking up the cost of a product to arrive at the final price. There are two basic methods but both give the same result which is an indication of the gross profit of the sale. The two methods express the result differently.
Markup can be expressed either as a decimal or as a percentage, but is used as a multiplier. Here is an example:
If a product costs the company $100 to make and they wish to make a 50% profit on the sale of the product they would have to use a markup of 1.5 or 150%. To calculate the price to the customer, you simply take the product cost of $100 and multiply it by the markup arriving at the selling price of $150.
While we understand that we made a $50 profit on the example above, markup does not tell us directly what percentage of our selling price is profit. If someone told you that they just sold a product for $339 at a 1.66 markup it is hard to directly understand exactly how many dollars of profit was realized on the sale.
Most people find it easier to work with Gross Margin because it directly tells you how many of your sale dollars are profit. In reference to the two examples above:
The $150 price with a 1.5 markup is actually a 33% gross margin. As you can see, gross margin is just the percentage of the selling price that is profit. In this case 33% of our price is profit, or $50.
In the more complex example of $339, a markup of 1.66 is equal to a 40% gross margin. This means that 40% of the $339 is profit. Again, gross margin is just the direct percentage of profit in your sale price.
Converting between Gross Margin (GM) and Markup
The formula to convert a Markup to Gross Margin is:
Gross Margin (GM) = 1 - (1 / Markup)
- Markup = 2.0
- GM = 1 - ( 1 / 2.0 ) = 50% GM
- Markup = 1.66
- GM = 1 - ( 1 / 1.66 ) = 39.7% GM
Using Gross Margin to calculate your selling price
Sometimes a salesperson will be asked to use gross margin in their sales. For example, your sales manager may ask that all sales offers be a 40% gross margin minimum. This means that you as the sales person need to calculate the selling price using the cost of the product and the required GM.
Formula to calculate Selling price using Gross Margin
Selling Price = Cost / (1-GM)
For example, if your product costs $100 and the required gross margin is 40%, then your Selling Price = $100/(1-0.4) = $100/0.6 = $166.6