Profit Margin vs. Markup: What Retail and e-Commerce Businesses Need to Know
Here’s why using markup percentage can be problematic and impact profitability
The method to make a profit for retail and e-commerce businesses seems simple enough: price products high enough to cover costs. But too often small business owners don’t know how to price products correctly, leading to underpricing or overpricing their products, lost sales and even accounting errors.
At Finatics Accounting, we get that understanding how to strategically price products can be confusing, particularly for retail and e-commerce businesses in their early years or when business expands. An important first step is to understand the difference between two methods of pricing, and why we recommend using margin percentage to our clients.
Before we dive in, let’s briefly look at three terms that will come into play when calculating profit margin and markup percentages:
Cost of Goods Sold (COGS): These are the direct costs – the expenses – of producing the retail and e-commerce products, which may include costs such as materials, packaging, purchased cost of the product, labour, and landed costs (freight, customs, etc).
Revenue: This is the income earned by selling the products before any deductions.
Gross Profit: This is the revenue remaining after paying the expenses of making or reselling the products – meaning, the revenue minus COGS.
To understand the difference between using profit margin vs markup percentage calculations, let’s look at a very simple example.
Samantha owns a designer earrings store and it costs her $150 to make each set. Here is how the two pricing methods compare:
Margin
Samantha wants to keep 50% of the total revenue. Each pair of earrings costs $150 to make (COGS), so she sells each pair of earrings for $300 (Total Revenue) to keep 50% of the Total Revenue.
- The Gross Profit is calculated by Revenue minus COGS: $300-$150 = $150
- The Margin formula [(Gross Profit/ Revenue) x 100] is used to calculate the percentage: ($150/$300) x 100 = 50%
Selling at a margin of 50%, Samantha gets to keep $150 of the total revenue.
Markup
Samantha wants to markup her products by 50%.
- The Markup calculation (COGS x markup percentage) is used to calculate the selling price: $150 x 1.50 = $225
- The next Markup calculation [(Selling price minus COGS) / Selling price) x 100] is used to calculate the percentage: ($75/$225) x 100 = 33%
Selling at a price of $225, Samantha only gets to keep $75 of the total revenue or 33%.
Why using the markup method can be problematic
A common misconception is that markup percentage equals the profit percentage – but as you can see from the example with Samantha, a 50% markup only yields a 33% profit.
As well, using the markup method to price products may not account for fluctuations in consumer demand and the market, so a fixed markup percentage may lead to overpricing products or underpricing products, which then impacts sales and profitability.
The margin method, however, allows retail and e-commerce businesses more control and can help small business owners more accurately determine the impact of their pricing decisions.
Still unsure how best to price your products? Get in touch so we can help you price effectively for greater profit.