The easiest way to explain this is with an example – using something pretty basic… Let’s decide to run a cake stall at the local market – selling 10 cakes each weekend. OK so it wont make us millionaires, but it will help out the local school…
DIRECT COSTS: Having started with some maths we calculate every cake costs $5.50 in ingredients, and packaging.
INDIRECT COSTS: Plus we need to add some tiny portion of our rent and electricity (by taking a guess of the cost), a small charge for our time baking selling and organising, and we want to print a few flyers that will cost $10 – we reckon all this costs about $50 in total each week so you work out this is $5.00 of overheads per cake…
TOTAL COSTS: That takes the total costs up to $10.50 per cake.
We then agree to sell our cakes at $15 each so:
We then decide to sell our cakes at $15 each so:
* MARK-UP: is $4.50 ($10.50 cost + $4.50 mark-up= $15.00 sales price)
which is a mark-up of 43% ($4.50 mark-up ÷ $10.50 cost price = 43% mark-up)
* PROFIT MARGIN: is $4.50 profit margin ($15.00 sales price – $10.50 cost = $4.50 profit margin)
which is a 30% profit margin ($4.50 mark-up ÷ $15.00 sales price = 30% profit margin)
So in this example if we stick to looking at the dollar values both the margin and the mark-up are $4.50 – the same and annoyingly confusing!
But the calculation of the Percentages differ because one is based on cost and one is based on profit. Using percentages is really important if you have several product lines and are making a change, or adding new products/services – don’t get caught out.
Profit Margin % x Cost Price ≠ Selling Price
In this example that exact calculation will only give a mark-up $3.15 instead of the $4.50
(i.e. $10.50 x 30% = $3.15, and $10.50 + $3.15 = $13.65 – not $15.00)
This is why it is so important to understand the difference between mark-up and margin; mix them up and you may rip yourself off!
I know this is a bit maths-ey.. Don’t let that put you off – you are actually doing this maths every time you set a price… B using these simply maths calculation you are putting some more specific rigor behind your guesses and it will mean your price setting becomes less “gut feel” and much more profitable.