I spent time on Friday helping a client update spreadsheets and Excel reports that used an incorrect formula to calculate the margin on bids for construction jobs. While this particular client was looking for a margin of 25%, he was actually getting one closer to 20%. On a $100,000.00 bid, that can be the difference between profit and disaster.
I see sellers new to retailing make this same mistake over and over again.
The seller wants a “mark up” of 30%
So they take their cost (the wholesale price), multiply that by 30% and add the result to the wholesale cost to find the retail, or selling price.
You can certainly find a retail price that way, but it won’t give you a 30% margin. The confusion stems from
- Confusion about calculating percentages
- The difference between margins and mark ups
YOUR MARK UP IS NOT YOUR MARGIN
Although it is less important, let’s talk about mark up vs margin first. Many people use these terms interchangeably to mean the difference between what you pay for goods and what you sell them for – that is, gross profit. However, they are not the same thing. Misunderstanding the nature of mark ups and margins can make it easier to calculate them incorrectly – which cuts deeply into your bottom line.
A margin is, most simply put, the percentage of the selling price that is the profit.
- If you pay $6.00 for an item and you sell it for $10.00, you made a gross profit of $4.00.
- $4.00 is 40% of $10.00 – so you have a margin of 40%
- Notice this important distinction- the 40% margin is 40% of the final selling price, not of the wholesale cost.
A mark up is the percent of the cost you add to the wholesale price to get to the selling price.
- If you pay the same $6.00 and sell the item with a 40% mark up, you make a gross profit of only $2.40
- 40% of $6.00 is just $2.40
- A mark up of x% will yield a smaller profit than a margin of x% because the mark up is a percentage of the lower wholesale cost.
For example, assume you bought something at a cost of $100 and you want to get a margin of 20%(1/5) then you have to multiply with a markup of 25% (1/4) which is $100 * 1.25. This means you will sell it at $125 and make $25 as your profit margin ($25/$125 is 20%). Similarly, when you markup something with x%, your actual margin is 100/(100/x +1). For example, you markup by 20% (1/5), it means your margin is 20/120 which is 1/6 = 1(5+1). So, margin is always 1/(markup+1). Margin is always lesser than markup. People usually think they get 25% margin when they actually get 25% markup and 20% margin.
30% markup gives 23% margin, 25% Markup gives 20% margin, 20% Markup gives 16.67% margin, 16.67% markup gives 14.2% margin.
IT DOESN’T MATTER IF YOU MIX UP THE TERMS AS LONG AS YOU DO THE MATH RIGHT
Many people say “mark up” when they mean “margin.” If you are fussy about language, this is annoying but it will not lead to financial disaster. It’s just words.
However, if you’ve confused the two concepts and are calculating your margins by mutliplying the wholesale cost by the margin percentage, you could be headed for trouble.
Just remember – you want to calculate your profit as a percentage of the final value, not as a percentage of the original cost. When a customer hands you $10.00, you need to know how much goes into your pocket and how much goes to your vendor.
Do you need a 40% profit margin to survive? Then you want to keep $4 out of every $10.
Also keep in mind that this is a gross profit margin. It does not take into account overhead, fees, etc. You may put $4 into your pocket, then have to turn around and give $1.00 to the landlord, 75¢ to the tax man, 15¢ to the bank for processing fees, etc.
You might end up keeping only $1.50 (net profit) of the original $4.00 (gross profit). Which is why calculating your margin by incorrectly using the wholesale price can be such a disaster. You can actually lose money with every sale!
WHAT’S THE FORMULA?
Now that you know you want your margin to be a percentage of the final cost, how do you actually figure it out?
Relax – as long as you have a calculator handy, it is easy.
Say you want a 40% margin. We know that 100% less 40% leaves 60%. So your wholesale cost represents 60% of the final value. To find the remaining 40%, divide the wholesale cost by .6
- If you want a 90% margin – divide the wholesale cost by .1
- If you want a 80% margin – divide the wholesale cost by .2
- If you want a 70% margin – divide the wholesale cost by .3
- If you want a 60% margin – divide the wholesale cost by .4
- If you want a 50% margin – divide the wholesale cost by .5
- If you want a 40% margin – divide the wholesale cost by .6
- If you want a 30% margin – divide the wholesale cost by .7
- If you want a 20% margin – divide the wholesale cost by .8
- If you want a 10% margin – divide the wholesale cost by .9
As long as you follow this formula for calculating retail price, you will get the margin you want.