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Actual Cost, Selling Price and Profits: The Difference Between Margin and Markup

written by: •edited by: Donna Cosmato•updated: 7/11/2011

Business owners need to be very aware of their bottom line. This means understanding the differences in what they pay for an item, what the item is sold for and what their end profit will be. While these calculations may get rather complicated, this is a necessary function of ensuring profitability.

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    Purchasing Products for Resale

    Profit Margin Nearly all business owners who deal with physical products (versus services) will have to understand the difference between margin vs. markup. The simple explanation is that markup is the actual cost of a product versus the selling price of a product while margin is the selling price of the product versus the profit that will be earned on that product.

    An example of this would be a book is purchased from a distributor for $8.99, and then sold to a consumer for $14.99 meaning the markup is $6.00 per book. This does not necessarily mean that the business owner has earned $6.00 on the book. The reason for this is that there are operating expenses associated with the sale of the book that must be deducted to determine the business owner's margin.

    Operating expenses and margins

    Operating expenses must be taken into consideration when determining the margin on all products. The cost of doing business includes salaries (or commissions, wages, etc.), leases (or rent) on property or equipment, repaying loans that have been taken out on the business (or for the purchase of inventory) and cost of utilities.

    In addition, other factors must be included in this calculation such as how much the products cost the business or how much the business may lose due to merchandise that is damaged or merchandise that is stolen. In addition, if a product is not moving off the store shelves, it may be necessary to reduce the cost meaning this will also have to be included in operating expenses.

    Operating expenses examples

    Here is an example of how a business owner would record operating expenses to determine how much of a markup they need to allow for items that are purchased:

    Annualized Expenses (excluding product costs):

    • Rental/Lease property: $80,000
    • Utility expenses: $10,000
    • Wage expenses: $40,000
    • Loan expenses: $8,000
    • Misc. expenses: $5,000
    • Product loss (est.) $500.00

    Total expenses: $143,500

    This means that before a business owner begins to earn a profit, they must make $143,000 before they can even consider purchasing their products. Using the book example above, here is what this would look like assuming that the business had a target of selling 50,000 books in a year.

    Necessary sales price is then calculated by adding these two figures together (for a net total of $593,000) to calculate how much the seller must charge a consumer for the books. In this case, the cost would be $11.86 before the seller will make a profit on the books. To secure a profit, the seller could then increase the price to $15.00 which would make the margin $3.14 per book sold. This amount then represents the net profit on the product or approximately $156,824 (rounded and based on losing approximately 56 books to theft or discount). Netted out over a year, the profit would be approximately $13,100 per month which would be sufficient to purchase additional items for sale without incurring debt.

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    Understanding the Difference is Crucial

    For a moment, let us assume that a business owner did not necessarily understand how to properly calculate margin and markup and sold all of the books for $10.00 each. With the calculated loss of books (e.g. as mentioned above approximately 56), the business would show a loss for each book sold (remember the minimum amount that the product must sell for is $11.86 per book) of $1.86 or a net loss of $92,895.84. This could bankrupt a business if this is the only product they are selling. Not only is this a critical mistake, it is a mistake that can have devastating consequences.

    Consumers are unlikely to be completely aware of how much a store is paying for a product that they are selling. In some cases, consumer demand will be down meaning that the business owner will be required to reduce the sales price of the product in order to sell it and get it off the shelves to make room for new products.

    Business owners who have made the proper distinction between markup versus margin will be far less likely to suffer an undue hardship if this becomes necessary. Those business owners who have made serious calculation errors could find themselves suffering dramatic losses which can have a long-term negative impact on their business.

    Proper management, understanding capital costs and product costs, and keeping control over company expenses can all help the bottom line of a business and allow them to successfully grow their business. The basic rule of all business is that success begins with a profit. Understanding the calculations needed to ensure a profit on items sold is the first step to finding this success.

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    Resources

    Sources:

    1. Entrepreneur Encyclopedia: Pricing a Product http://www.entrepreneur.com/encyclopedia/term/82380.html

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