Gross Margin vs. Markup

January 29, 2016

 

Q.  I’m working on pricing for the products I sell. I’m getting confused about the difference between Gross Margin and Markup. Would you please explain this? Also, if I know the Gross Margin I want, can you tell me the Markup I’ll need to use to get it?

 

A.  There is frequently confusion around the meaning of Gross Margin and Markup, probably because they are two different ways of expressing the same thing. They both measure the difference between the Price that you receive for an item you sell and the Cost you incurred to get the item. We’ll define Gross Margin and Markup below.

 

Gross Margin = (Price – Cost) / Price

Therefore, Gross Margin is the difference between Price and Cost divided by Price. Please note that Gross Margin is typically expressed as a percentage. On the other hand,

 

Markup = Price / Cost

Said another way, Price = Markup X Cost

Markup is the number you multiply Cost by to get Price. Expressed as a percentage:

 

Markup % = (Price / Cost) – 1 = (Price – Cost) / Cost

 

Therefore, Gross Margin is the difference between Price and Cost divided by Price, while Markup is the difference between Price and Cost divided by Cost. Since Price is more than Cost (hopefully), for any given Price and Cost, the Markup percentage will always be larger than the Gross Margin.

 

If your head is about to explode, a quick example may prove helpful. Suppose that you are a distributor. You pay $80 dollars for an item—this is the Cost. You sell this item for $100—this is the Price. Therefore,

 

Gross Margin = ($100 - $80) / $100 = 20%

Markup % = ($100 - $80) / $80 = 25%

 

Also, note that

Price = Markup X Cost = 1.25 X $80 = $100

 

Markups are typically used when you know the Cost and you want to determine the Price. For example, a retail store may have a policy that it marks up the products it sells by 50%. In other words, to determine the

 

Price, the retailer takes the Cost paid for an item and multiplies it by 1.5.

 

Gross Margin is typically used when you know both the Price and the Cost and you want to communicate how much you made on the sale. Therefore, if you paid $100 for an item that you sold for $150 (a 50% Markup), the Gross Margin would be 33.3% = ($150 - $100) / $150. The result is that a 50% Markup yields a 33.3% Gross Margin.

 

This takes us to your second question; is there a direct relationship between Gross Margin and Markup? The answer, of course, is yes.

 

Gross Margin = 1 – (1 / Markup)

 

In the most recent example, we saw that a 50% Markup yields a 33.3% Gross Margin. Plugging into the equation confirms this.

 

Gross Margin = 1 – (1 / 1.5) = 33.3%

 

In the same way, if you want to know what Markup to use to obtain a given Gross Margin, the following equation will help.

 

Markup = 1 / (1 – Gross Margin)

 

We know that to get a 33.3% Gross Margin, you have to use a Markup of 1.5. The equation confirms this.

Markup = 1 / (1 – .333) = 1.5

T

he relationship between Gross Margin and Markup can be confusing. We hope the explanation above makes the concepts a bit easier to grasp.

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