For any small business owner, success comes from generating a profit. And generating a profit requires you to set fair prices that more than cover all the costs involved in manufacturing or purchasing the products you sell.
Calculating your ideal selling price requires you to understand the true costs involved in purchasing or manufacturing your products, including factors such as raw materials, packaging, shipping, storage and your various business overheads. Then, you need to account for a markup percentage which gives you a viable amount of profit, while still remaining price-competitive.
Markup is simply the difference between the total cost of making or purchasing a product, and the price at which you sell it. In order to generate a profit, the price you charge needs to cover all of your associated costs, plus a profit margin.
The markup calculation formula is therefore:
This is another of those questions that’s almost impossible to answer with a hard and fast figure. There are many factors involved in deciding your final selling price, which will vary from business to business and industry to industry.
However, it is common for businesses to aim for a markup in the region of 50%. Sometimes referred to as “keystone”, this figure means that the price you sell your product for is 50% higher than the total cost of making or purchasing it.
To determine your current markup as a percentage of the sales price, you can use this formula:
So, if a product costs $100 to manufacture, and is being sold for $150, the markup percentage is calculated by subtracting the unit cost from the selling price ($150 – $100 = $50), dividing this number by the unit cost ($50 / $100 = 0.5), and then multiplying by 100 (0.5 x 100 = 50). In this instance, the markup percentage is 50%.
Your markup margin doesn’t have to be 50%, but it’s a safe number that ensures you are earning a profit on each item sold, over and above the cost of manufacturing or purchasing that item.
The actual markup price of a product depends on how much it costs to make and how much it is being sold for, so the idea of an average markup price does not hold any meaningful value. It is more useful to think in terms of average markup percentage as this is something that can be compared across multiple product lines.
A business may sell two different products at entirely different prices; but it is still likely that they will aim for approximately a 50% markup on each product.
We see these terms used interchangeably sometimes, but while they both refer to the difference between what a product costs and its selling price, they are not the same thing.
Markup percentage is a percentage of cost. Specifically it is the percentage of cost added to determine a selling price.
Gross margin is a percentage of revenue. Specifically, it is the percentage of a selling price which constitutes profit.
Let’s take a look at an example to illustrate the difference:
Bob’s Hardware stores buys ladders for $20, and knows that with all factors taken into consideration, they cost him $30 in total. He sells them for $45.
Bob’s markup percentage is 50%. He is adding 50% of the total cost of the ladders to create his selling price.
Bob’s gross margin is 33.3%. Of the final selling price, ⅓, or 33.3% is profit. The other ⅔, or 66.6%, is the cost of the goods.
So in this example, both markup and margin are ways of describing the $15 profit that Bob makes on each ladder, but they are calculated from different perspectives.
Staying on top of your markup percentage is absolutely vital to running a financially healthy business. Knowing exactly where your markup stands not only ensures that you are making a profit – it also helps you make informed decisions when adjusting your pricing, perhaps to offer a customer a discount, or to run a one-off “sale”.
Calculating your selling price for physical products is relatively straightforward. We have already looked at how you take the cost of making or purchasing your product (plus costs like packaging) and add your choice of markup percentage to those costs to achieve a selling price.
If your product costs, for example, $10 to manufacturer and package, and you wish to add a 50% markup, then you simply calculate $10 x 50% = $5. You add $5 to your costs to arrive at a selling price of $15.
When dealing with a business that sells services, it is more common to work with gross profit margins. This is because the selling price of a service is often not determined directly by calculating the cost of providing the service.
Take, as an example, a business that sells accounting services.
The price of their most popular accounting package is $600 per month. This price might be based on what competing firms in the area are charging.
However, although there is no physical product to manufacture, there are still costs associated with providing the service. An accounting assistant needs to be hired, and accounting software licences purchased, for example.
The business determines that for each accounting package sold, the cost is $200 for salary and licences.
The formula to calculate gross margin is:
Using the formula they calculate that their gross margin is ($600 – $200) / $600 x 100 = 66.6%.
Larger profit margins (greater than the keystone 50%) mean more money from each product or service sold can be invested back into your business.
Billwaze
Jeff Liebov is the CEO & Founder of BILLWAZE. Jeff envisioned a simpler way out of the complicated world of accounting apps and created BILLWAZE. As a tool, BILLWAZE makes things easy for those who want to get things done fast, without all the hassle. Jeff and the team are continuously improving the platform and are passionate about making the entire billing process simpler than ever.
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