Profit margin versus mark-up

Posted by SkillMaker in Mar, 2018

Profit margin versus mark-up

Most people are familiar with the concept of mark-up but are generally unaware of gross profit margin.

Mark-up is the percentage added to a cost price to establish a selling price. For example, adding a 100% mark-up to an item costing $5 gives a selling price of $10 (i.e. $5 x 100% = $5 profit + $5 cost price = $10 selling price).

So, what % of this selling price is profit? The answer is 50%. There is $5 profit in the selling price of $10, so $5 profit ÷ $10 selling price = 50% gross profit margin (GP%).

Mark-up is a useful tool for setting selling prices. It is not so useful when preparing budget models and when reporting on the financial performance of a business. In financial management and reporting, gross profit % (not mark-up) has become the accepted standard accountants and financial managers use in setting prices and in reporting on the financial performance of a business.

Setting a selling price using GP%

How do you set a selling price using gross profit %? The formula is:

Selling price = cost price ÷ (1 – GP%).

So, using the example above, the selling price could have been set by using the 50% GP margin:

$5 cost price ÷ (1 – 50%) = $5 ÷ 50% = $10 selling price.

GP% classifications

It is rare for a business to use a flat GP% to set all the goods and services in their assortment offer. This is because every business faces competition and there are certain goods and services that are highly competitive and so attract a low GP%. On the other hand, some goods and services are targeted at niche markets or are not so competitive, and so can attract a higher GP%.

The skill in setting selling prices is knowing which product classifications need to be set below the average and which can be set above. Overall, a business should target the GP% that is expected for its industry and operations. Benchmarks that identify for a business what GP% is achieved in its industry and for a business of its size are compiled in reports published by the Australian Bureau of Statistics. These are available from the relevant industry’s trade association and made available online by certain financial institutions.