If you have ever set a price by adding a percentage to your cost, you need to read this. Markup and margin are two of the most commonly confused terms in small business pricing, and mixing them up can mean you are making less money than you think, sometimes a lot less.
Let's start with the basics.
Markup
Markup is the percentage you add on top of your cost to get to your selling price. If something costs you $100 and you want a 20% markup, you add $20 and sell it for $120. Simple enough.
In this case: $120 = $100 x (1 + 0.20)
Margin
Margin is the percentage of your selling price that is profit. If you sell something for $120 and it cost you $100, your margin is $20 divided by $120, which is 16.67%. Not 20%.
In this case: 16.67% = ($120 - $100) / $120
So what is the difference in practice?
Here is where it gets important. If you want a 20% margin, meaning you want 20% of your selling price to be profit, a 20% markup will not get you there. It will only get you to about 16.7%.
To actually achieve a 20% margin you need to mark up your cost by 25%.
$25 profit / $125 selling price = 20% margin
This might seem like a small difference but across hundreds of transactions or on large ticket items it adds up fast.
A real world example
Say you run a small retail shop and you buy a product for $40. You want to make a 35% margin on everything you sell.
If you think a 35% markup gets you there, you price it at $54. But your actual margin is $14 / $54 = 25.9%. You are leaving money on the table every single sale.
To hit your 35% margin target you need to price it at $40 / (1 - 0.35) = $61.54.
Why does this matter?
Because if you are running a business on thin margins - and most small businesses are - the difference between a 30% markup and a 30% margin could be the difference between a profitable year and a disappointing one.
It also matters when you are talking to your accountant, your banker, or anyone else about your business. Margin is the language of financial reporting. Markup is a pricing tool. Knowing which one you are talking about and when keeps everyone on the same page.
The quick reference
To convert markup to margin: Margin = Markup / (1 + Markup)
To convert margin to markup: Markup = Margin / (1 - Margin)
So a 25% markup = 20% margin. A 30% markup = 23% margin. A 50% markup = 33% margin.
This post is meant to help you understand the difference between markup and margin as general concepts. Your specific pricing situation may have additional factors to consider. When in doubt, talk to your accountant.