View Full Version : Profit Margin vs. Markup?
11-16-2000, 10:28 AM
I'm taking on some new duties in my office among which is quoting prices for our clients. It turns out of been doing the quoting a bit wrong in that I was adding a price markup rather than adding a profit margin for my company. I was shown the math to do but given no explanation so I turn to my fellow dopers for what is going on.
To keep this simple take the math at face value and don't add things like overhead costs when determining profit margin. Also, what I describe below are merely examples and not necessarily the markups our company actually adds to the products it sells.
Say I order an item from our distributor that costs $8,000. I was adding 10% to the cost so the client would get a quote for $8,800.
I was told that this does not indicate a 10% profit margin but rather is a 10% markup.
What I'm supposed to do is divide $8,000 by 0.9 which gives me an answer of $8,888.89. This, they tell me, is a 10% profit margin.
Obviously the profit margin calculation is more favorable to my company so it's what I have to use but I don't understand what is happening here. If I buy a product for $8,000 and sell it to you for $8,800 I'm left with $800 in my pocket. Didn't I just make a 10% profit on the deal? Where does the other $88.89 come in? What is it?
I can keep doing the math I'm told to do but I'd be happier if I understood the reasoning behind it all (more than just the fact that it is more beneficial to my company to do it this way).
Thanks in advance!
11-16-2000, 10:38 AM
Well, as much as I'd like to help, it is just so obvious to me that I am not sure what it is you do not understand but I'll try anyway.
Markup uses the purchase price as reference while profit margin uses the sale price as reference. If you mark up by 10% your sale margin is not 10% but less. Your example shows this clearly.
Maybe if you explain better what it is you do not understand I can try to be more helpful.
11-16-2000, 10:44 AM
The easiest way to look at it is to realize that markup looks at the INITIAL cost of the item and then tacks on the profit or markup at the end based on a simple percentage: $8000 * .10 = $8,800
Profit Margin, however, looks at the FINAL cost of the item and calculates how much of that cost consists of the intitial cost of the item and how much is the profit margin component. In your case:
$8000/.9 = $8,888.89
(You divide by .9 because it is the reciprocal of the .10 margin that you wish to achieve)
$8,888.89 * .10 = $888.89 profit
In this case, $888.89 tacked on to the initial $8000 means that the profit component is exactly 10% of the total cost of the item.
Companies obviously prefer this method because it increases profit over the markup method.
11-16-2000, 01:09 PM
Maybe if you explain better what it is you do not understand I can try to be more helpful.
I guess I'm unclear on the concept of making 10% above your costs. I don't see what they are telling me beyond the fact that we make more money the second way (profit margin).
mavpace's explanation has helped somewhat in that the difference is between looking at the initial cost or looking at the final cost.
However, the final cost includes your markup so it seems as if you are doing a markup and then adding on yet more money to make for a 10% profit margin.
When you markup $8,000 by 10% you get a final cost of $8,800. To me you are left with $800 more than when you started (10%). However, when they did their math in reverse they showed that $8,800 is really a 9% profit margin. If you divide $8,000 by 0.9 you get $8,888.89 which, when you reverse your calculations, gets you a 10% profit margin.
While the calculator does the math just fine I'm confused as to how adding 10% gets you 9% in reality. Again, mavpace's initial cost vs. final cost is probably where this lies but I can't wrap my head around it. If I say I have an $8,000 item I add 10% to get $8,800. If that is really 9% (or .09) and I want to get to 10% (or .1) and figure off of $8,800 I get to $8,880. I'm still missing $8.89.
I'm just confusing myself worse here. Maybe it's enough just to do it the way they want and not ask why (besides the fact they make more money). If you can shed more light on it great otherwise I'll just have to make do.
11-16-2000, 01:41 PM
Originally posted by Jeff_42
While the calculator does the math just fine I'm confused as to how adding 10% gets you 9% in reality. Again, mavpace's initial cost vs. final cost is probably where this lies but I can't wrap my head around it. If I say I have an $8,000 item I add 10% to get $8,800. If that is really 9% (or .09) and I want to get to 10% (or .1) and figure off of $8,800 I get to $8,880. I'm still missing $8.89.You are still thinking, when you say 10% or 9%, that the percentage is of the initial price. It's actually a percentage of the final price.
So, 800/8800=.0909. This is the markup divided by the final price, and gives you just over 9% of that final being profit. In the other case, it would be 888.89/8888.89=.0100, which shows that the markup is 10% of the final price.
The .9 that they have you divide by is not really from this calculation. It is the portion of the final price you want the initial price to be. Since you want .1 to be profit, you want the initial price to be .9 of the final.
Did that help at all? These things are always more confusing to explain than one thinks they are.
11-16-2000, 01:43 PM
Sometimes, I find that it is helpful to switch over to really simple numbers to illustrate things like this.
Your boss sends you out to sell widgets that cost your company $10 a piece to make. He tells you as you walk out the door to sell lots of them, but more importantly, to get at least a 10% profit margin or job will be gone when you get back.
You go out, and immediately get a huge order from a large company at $11 a piece ($10 + ($10*.10)). You are thrilled. However, when you get back your boss immediately fires you.
You tell him that you did as you were asked so you deserve a raise, not termination. He explains very clearly that a $1 profit may be 10% over your $10 cost but it surely is not 10% of the $11 that you actually sold them for. It is only 9.09% of $11.
The point of this is that it just depends on how you are looking at the same situation. If you wanted to, you could build a table that translated markup into profit margin. A 10% markup always equals 9.09% profit margin.
Is that clearer?
Bottle of Smoke
11-16-2000, 02:25 PM
Or, if it hasn't clicked yet (and if it has, I apologize for beating a dead horse), try thinking of it in reverse, and use bigger percentages so the difference bewteen margin and markup is clearer:
Forget about your cost for a moment. Pretend your boss says that you have to sell your widgets for $10 each, and he wants you to make a 50% profit margin. In order to get a 50% margin, your cost would have to be $5 (your margin is the percentage left after your cost is deducted).
However, if you take this same widget, which cost you $5, and mark up the price by 50%, you will get a selling price of only $7.50. As you can see, it makes a big difference depending on which number you apply the 50% to.
11-16-2000, 02:34 PM
I can understand your boss. He wants 10% of the sale to be profit. Then he can just total up the sales and estimate his profit. Sales totals for a week, month or year are easy to generate.
Basing it on sales makes it easier to see how you are doing against competition. Getting sales information is easy; companies are willing to tell you how much they sell, but won't tell you how much their costs are.
It also makes the numbers look better for sales agreements. As your numbers show, his profits are more then his "profit margin".
11-16-2000, 03:12 PM
...I think I get it now.
This reminds me of that math trick/problem where three guys rent a room for $30 ($10 each). Later, the hotel manager figures he overcharged the gentlemen and instructs the bellhop to take $5 back to the men. The bellhop, figuring $5 doesn't divide easily into 3 slices pockets $2 and gives the guys $3 back. Now, each man has paid $9 (9*3=27) and the bellhop pocketed $2. 27+2=29. What happened to the last dollar out of the original $30?
I've seen this answered so I'm not looking for it here but the above situation seems like one of these problems. It all depends on which way you approach the problem from and if you mix two approaches you get hopelessly confused.
11-16-2000, 04:02 PM
I don't think you guys have it quite right. I had this specific problem at a sales office I worked at. We had a target of 20% profit margin. I was the only one who ever hit his target. Everyone else was very low. One day, I was helping a guy put together a deal, I told him to calculate an item at 20% margin. He multiplied times 1.2. WRONG! That's a 20% markup. I asked him what's the sales price on an item costing $80 with 20% margin, he said $100. Then I asked him to do it on his calculator, he input 80*1.2 and got $96.
So.. to calculate margin:
1 - (cost/selling price)
The easiest way to do this on a calculator (using our example) is (80/100)-1 which gives you -.2 (ignore the minus). If you're lucky enough to have a Hewlett-Packard RPN calculator, you can just use the "Delta Percent" key.
I showed this problem to my boss. He made me go around the office and teach everyone the difference between markup and margin. Incredibly, out of 20 sales reps, every single person was calculating margin incorrectly, and leaking 4 or 5 percent of our profits out of the company.
Markup=percentage you add to your cost
Margin=percentage that your price exceeded your costs
Cost = $100
Markup = 100%
Price = $200
Margin = 50% [($200-$100)/$200]
(You can see that your margin, =the part of your revenue that is free and clear of costs, =your profit, accounts for 50% of your revenue, not 100%. You need to double your costs in order to achieve this margin.)
I have noticed something of a flim-flam going on in some commercials I hear. "They usually mark their jewelry up 200% so even when they offer 50% off you're still paying 150% markup. Well, certainly not.
Original cost: $100
Marked-up price: $300
50% off marked-up price: $150
Mark-up given original cost: 50%
Something of a different issue, but it's easy to see how they hoodwink you. Advertising sharks. :)
11-16-2000, 07:24 PM
Sorry ... probably missing the point ... but by definition profit margin is included in the "wholesale" price, see AIA for pricing of services, etc. ... a mark-up is the add-on for resellers, non-OEM agents, etc.
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