Understanding The Difference Between Profit Margin and Markup
Many people have a problem with accountants’ jargon and often get confused between the terms “profit margin” and “markup” which are often bandied about freely or used interchangeably. Although these two terms are used to express different things, they are also, in fact, two different ways of analyzing the cost and profit of a product or service in your small business .
Let’s explain in simple terms.
Say you bought an item for $50 and could sell it for $100, doubling your money.
In this case your markup would be (the difference between selling price and cost price) divided by the cost of the item and multiplied by 100 to bring it to a percentage.
ie ($100 – $50) = $50(difference). $50(difference) / $50(cost) = 1 x 100 = 100% (here “/” stands for divide)
Your markup was then 100%.
When you look at the profit margin on that sale, that would be (difference between selling price and cost price) divided by the selling price and multiplied by 100 to bring it to a percentage.
ie ($100 – $50) = $50(difference). $50(difference) / $100(selling price) = .5 x 100 = 50%
As you can see in the examples given above, the only difference in the equations are in red (dividing by the cost or by the selling price).
“Profit” is the difference between what you sell it for and what you paid for it. “Margin” simple means you turn that into a percentage of the selling price. You do this so you can compare different items easily.
So the difference is that markup is your profit as a percentage of the cost price and profit margin is your profit as a percentage of your selling price.
When would you use the terms?
When you are deciding how much you want to make on the item and determining the price in which the goods should be sold, you would use markup. You would know it costs you $50 and if you want to double your money you would use a markup of 100%. Of course, you could just double the $50 as well and get to the same price.
When you are looking at the success of your business afterwards and know how much money you took in, you would calculate the profit margin because those are the figures immediately available to you at that stage.
The “profit margin” as calculated here is actually a Gross Profit. In order to find out how much money you’re actually making, you would need to calculate Net Profit, which is simply the gross profit minus what it cost you apart from the cost price to produce that income (your expenses). Your costs such as your rent, utilities, travel, telephone, advertising costs, etc. are deducted, so you know how much money you actually made in the end.
Inventory Turn Over
Now let’s look at how inventory turn-around can drastically affect the bottom line of your simple small business.
Say you bought 10 of the items in the example above at $50 each and it took a year to sell them all.
You would have to pay 10 x $50 = $500 up front for the goods. With a markup of 100% (or a 50% profit margin) you would be selling the items for $100 each and your gross sells for the year would be $1000. Your profit for the year (again remember you have a 50% profit margin) would be $500.
But say you only bought 2 of the items, sold them, and then bought another 2 and continue this until you had sold 10 in total for the year? 10 items sold at $100 still equals $1000.
You would have to lie out 2(items) x $50 (cost) = $100 but would still be selling 10 in . That $100 will bring you back $200 (remember it is with a 100% markup) in gross sales. You keep half of the sales and reinvest the other half ($100) for two more items. Again, after a year your gross sales is $1000, but you never invested more than $100. This gives you a gross profit of $900 (because you only invest $100) as opposed to the $500 gross profit in the first example.
If, as in the first example, you had originally had $500 to invest but only needed to invest $100, you would still have $400 with which you could buy other types of goods for sale.
Here your stock turn around would be five times. This helps you “leverage’ (multiply) the money you have so you can make a bigger actual profit in cash terms. And many of your expenses would be fixed, such as your overhead. You would also increase your net profit margin (total sales minus cost of goods sold and minus all expenses to produce those sales as a percentage of total sales) as well. This means more cash in your pocket or to invest. Keeping a close eye on your inventory and cash flow can help reduce your risk. In fact, the risk that you might not be able to sell all your goods is reduced to a bare minimum of only two items rather than ten.
Your understanding of this principle should be made apparent in your one page business plan.
This type of leverage is a big factor to many simple small businesses. Many small traders in third world countries only have $10 or $20 to invest and yet make a living because they turn their goods over every day. The small profits they make are enough, especially with their low cost of living, to provide for a family. In fact, there is a bank in Bangladesh which specializes in lending money to these very small traders using these very principles. Apparently these loans are very good risks because the borrowers understand their own niches so well and are grateful for the opportunity they have been given.
If people with such limited education can turn the power of stock turnover to their advantage, then so can you.