How are mark-up and margin used to measure profit? Is there a difference? And how can use you them?
Mark-up and margin are both the same and different at the same time! The money is the same, but we express the percentage differently.
Here’s who uses what, how, and why!
Sales and Operational people use mark-up
Sales and operational people add a percentage profit to their expected costs. These costs include materials, labour, transport, consumables.
Calculate it by adding a percentage on top of costs.
Financial people use gross profit margin or percentage
Financial people look at the same profit in money terms, but they calculate the profit percentage differently.
Calculate it by dividing the profit by the sales (also known as turnover) figure. That gives a different percentage. They call it gross margin or gross profit percentage.
How do the two calculations compare?
Here’s a visual overview. We know that a lot of people find percentages confusing! You’ll see that the money is the same in both cases, but the percentages are different.
In this example, both the sales and finance people are talking about the same £50, but they use a different percentage.
Why are the percentages different?
They are different because we express markup as a percentage of direct cost, whilst we express gross margin / gross profit as a percentage of sales.
So in the example your cost is £100 pounds and your sales are £150 so the markup percentage is 50/100 which is 50% and your gross profit % from a financial point of view is 33% which is the £50/£150, so it’s over sales.
What’s the problem?
Confusion can arise when finance people ask what profit the business is making. In this example, if the business owner says 50%, the financial person thinks that the business is doing better than it actually is! They’re only making 33% gross profit.
However, to achieve 50% gross profit, they need to mark up by a 100%. So you’d have to add a £100 onto the cost of sales to give £200 sales value and £100 profit.
How can we improve communication?
How should business owners explain profit to financial people?
We think it works both ways.
Firstly, explain your pricing. Say you’ve marked up by such and such a percentage. Secondly, tell them what gross margin you are expecting.
However at Wessex Commercial we feel that accountants and financial people (because they have training) should ask:
- Can you explain how you price?
- What mark-up do you use? (“Oh you mark up 50% so that should give you a gross profit margin of percentage of 33%”)
- What margin are you expecting?
- What happens when there’s miscommunication?
Graham shares his experience:
I’ve seen it where they have marked up around 50%, financial guys were expecting 50% and the actual margin was actually near enough spot on 33%.
So basically everything was as anticipated, but they spent so much time trying to work out why [the % was different] and delving in and thinking that something had gone wrong – was there waste, was there theft?
They were just talking different languages!
How can these tools help businesses?
You can use them to calculate your break even sales value. This is the number or monetary value of sales you need to make to avoid making a loss.
This has been a common question through the pandemic, and now in recession.
Here are the steps to follow.
- Work out your overheads. Those are your fixed costs that happen even if you are not selling anything. They include premises, running costs, staff who aren’t involved in making products or delivering services, marketing, admin costs, and financial costs.
- Work out your average gross margin percentage.
- Finally, work out the break even by dividing the overhead by the gross margin percentage.
For example, if you are selling widgets and have:
- overheads of £500,000
- gross margin of 33%
- your break even is £500,000 divided by 33% (which is £500,000 divided by 0.33), that is, £1.5 million.
Basically it’s treble the actual overhead cost. You need to sell £1.5 million. If your widget sells at £150, you that’s 10,000 widgets a year to break even.
But a word of warning.
A lot of small business owners take minimum salary and pay themselves dividends. You need to add these back into your calculation.
Say two director take a small salary of roughly £12,500 each and takes £80,000 dividends between them, in the example above. With Corporation Tax, that comes to roughly £100,000 a year. So your overhead goes from £500,000 to £600,000. That means your true break even increases to £1.8 million.
When else is breakeven useful?
Use it when you’re considering increasing your overheads:
- recruiting a salesperson or admin staff
- taking to a new location.
However it also applies if you’re going to cut back. Work out what happens if you want to:
- move to a smaller premises
- cut some costs
- make any redundancies.
We recently looked at what can happen to profits when you take on a new salesperson or increase costs in this blog.
How can you use mark-up and margin to understand your profit?
Which calculation should you choose? Graham advises:
Markup is very very good for pricing. It’s the easiest thing to use for pricing, but gross margin percentage is great for break-even analysis.
It’s vital that you understand your numbers, but also, that you understand financial language. If you don’t, make sure someone else does. And that you know things like markup, gross margin, and the difference between direct and overhead costs.
You need a good accounting system like Xero. You’ll also need support to ensure you have up-to-date numbers and meaningful information, because the business world is changing so fast.
Finally, analyse the true cost of your business decisions. Use these tools to ensure you are making the right decisions. Consider if there is a smarter way? Are you making the most of your resources? Are people, premises, stock, cash and systems working to your advantage? Are you automating where you can? Cutting waste? Can you clear slow moving stock?
Getting the language right
The world is changing, and for business owners it is very, very lonely. It’s so important to that people are talking the right language when discussing profits.
I’ve been in so many meetings with accountants and operational people and they’re talking and I’m going “Hey, hang on you’re talking different languages”.
It’s tricky for business owners. It’s one of those roles you don’t tend to go into with formal training. You do it because it’s something you’re good at, something you love, or an opportunity you want to make the most of. So it’s so important to get the language right.
Think you need finance? Think again!
Our next LinkedIn Live event takes place on the *new date and time* of 10:30am on Tuesday 18 October 2022: Think you need finance? Think again!
If any of this is resonates with you and you’d like to discuss profits and resilience in your business, get in touch and we’ll set up a time to talk. Alternatively, you can book a Business & Xero Review for a fixed low fee.Business & Xero Review