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Sunday
Jul132014

What’s the difference between cost, markup and margin?


Here’s a simple question, but it’s surprising how many people don’t answer correctly.

If I buy something for £1.50 and I want to make a 50% profit on sale, what’s my selling price?  Many will answer  (£1.50 + 50%) = £2.25.

But wait! I’m only making 75p profit! That’s only 75/225 or  33 1/3%,  not the 50% profit I’m looking for. What’s the catch?

Three fundamental terms are used in commerce when calculating profits or selling prices and it’s worth knowing what they mean.

  1. Cost is obviously the purchasing price of a product or service. I usually abbreviate cost price to (CP).
  2. Markup is the amount added onto a cost price, to calculate a selling price (SP). It’s usually a fraction or a percentage. For example we might say ‘We’ll mark the product up by a quarter or 25 percent’: i.e. we’ll add a quarter or 25% to our cost price to arrive at a selling price. 
  3. Margin is the amount of profit made from a sale. This could be expressed as a percentage or an amount.

So if my product has a cost price (CP) of £1.50, if I want to make 50% profit margin then the selling price (SP) will be £3.00 not £2.25. Then I get £1.50 cost and £1.50 profit.

There are basically two ways of handling cost and margin calculations.

Simple "Cost Plus" basis

The first method is a “Cost Plus” basis.  Simply take the CP and gross it up to arrive at a selling price (SP).

The simplest way is to take the cost price and "mark it up" by a percentage. (How much, depends what the boss says.) An item costing £2.85 could be marked up by a third to make £3.80 selling price. Your margin is 95p but note your profit margin is just 25% (95 / 380).

Often you'll have to calculate the sales price that yields a given margin.  A typical gross profit margin might be 40%.  In other words, 40% or 0.4 of my final selling price is the profit. That means the balance of 60% or 0.6 represents my cost price or CP.  So to find the selling price using the cost-plus basis, I can gross up the cost price by dividing it by 0.6.

Example,

A wheel bearing has a factory cost price (CP), including all labour, packaging and overheads of £6.90.

I'm told my profit margin on the sale must be 40%. Therefore, £6.90 is 60% of the final SP. So by dividing the CP by 0.6, I gross it up to the 100% SP which is £11.50.

6.90        CP (60%)
4.60        Margin (40%)

11.50     SP exc. Taxes

I may need to add sales tax (VAT) of 20% so my final SP is £13.80

As a result, the cost price has in fact been "marked up" by 66.6% resulting in a selling price of £11.50, giving me a margin of 40% or £4.60.

I got used to grossing up cost prices this way to find the selling price. If we wanted 30% profit, for example, just divide the cost by 0.7 to get the selling price.  An item costing £1.40 would therefore sell for £2.00. The margin is 60p or 30%.

I also got to recognise how "a half on is a third off" to get back to where I started.  £1.00 + ½ = £1.50.  Take off one third, gets me back to £1.00.

Reverse costings from sales price

The second method of handling costings is to work backwards from the Selling Price.  If I want to make 40% gross profit, then what must my cost price (CP) be?

For example,

I research the market and find a gap for a cycle tyre inflator. Various retailers tell me that if I could come up with a unit that retailed for £12.99 they would probably buy it. So I have to reverse-calculate what my CP must be if I’m to make a 40% margin on sales. And if I can make it even cheaper than that, so much the better!

The first step is to take out the sales tax (20% VAT) that’s included in the £12.99 retail sales price.

This method works for me:  if I divide by 1.2 then the VAT is removed. (E.g, £120 ÷ 1.2 is £100 without VAT, isn’t it? That’s because £100 x 1.2 adds 20% VAT on, so dividing by 1.2 takes it off again.)

£12.99 ÷ 1.2 = £10.82 which is the target selling price exc. VAT. This must now be split 60/40  cost/profit margin:

So my cost price must be no more than £6.49 (60%) to get £4.33 (40%) profit.

And if I can make it even cheaper than £6.49 then I stand to make even more profit. Or I could lower the selling price instead, to make it more competitive.

I haven't allowed for the retailer's own margins in this simple example. If they want to make 40% margin themselves, that means their buying price will be £6.49, so if I want to make a profit too my own cost must be no more than £3.89(!):

3.89 factory cost price (6.49 x 0.6)

2.60 factory margin (40%)

6.49 factory selling price = wholesale price or retailer's buying price  (3.89 ÷ 0.6)

4.31 retailer's margin (40%)

10.80 retailer's selling price exc. VAT (6.49 ÷ 0.6).

The above methods are exactly those I used working in consumer products at national retail level. Of course, a lot of effort also went into working out factory cost prices to start with, using timesheets, bills of materials and more, to factor in labour, transport, tooling and overheads before we got anywhere near working out the selling price.

Business calculators for cost, selling and margins

You can see that there are just three elements:  Cost Price,  Selling Price and Margin.  It’s normal in business and commerce to grapple with these figures, and usually if you know two of them you have to calculate the third.

Fortunately some dedicated business calculators will do the maths for you. By inputting two factors the third will be displayed automatically. Cost and Selling prices are keyed in directly whilst Margin may be inputted as a percentage.

Some calculators may also handle VAT/ tax calculations, adding on or taking off a pre-programmed rate of VAT. Otherwise remember to divide or multiply by 1.2  to remove or add on 20% VAT. Some calculators will also handle foreign currencies which you pre-programme at current exchange rates. If you sell in Euros or US$ it’s a worthwhile feature to look out for.

For commercial use a printing calculator like the Casio FR620TEC Calculator  from Amazon pretty much does everything: Cost/ Sell/ Margin,  currency conversions and tax. It’s a large mains-powered desktop calculator that will handle daily totaling, product costings and VAT and has a glowing 12 digit VFD (vacuum fluorescent display) that’s easily visible, plus two-colour print.

A cheaper Casio HR150TEC has an LCD instead and would be fine for medium duty or occasional use. Spares (ribbons, ink rollers, paper rolls, mains adaptors) are all available separately.  Ink rollers are very commonly available on ebay.

The Aurora PR710 from Amazon has 12 digit LCD, two colour print, Cost-Sell-Margin,  Tax, metric conversions and more, and is worth considering: it’s battery operated, so mains adaptors are separate and it’s a decent choice at an affordable price. Look out for excellent machines from Sharp as well, and some non-printing calculators are also available with Cost-Sell-Margin.

The Casio SL 310M has no printer but offers Cost-Sell-Margin buttons, and it handles time calculations as well. It's useful if you handle timesheets or worksheets for instance.  (E.g. 1 hour 30 mins is converted to 1.5 hours.).

Remember that most business machines work as "add-listers" - they are optimised for book-keeping and adding numbers into the register or subtracting them then simply hit the Total key. If you're used to ordinary pocket calculators you'll need to slightly adapt to the way an add-lister works.

I hope the above helps you to get to grips with the world of markups, margins and selling prices.

 

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