One of the most common mistakes committed by inexperienced entrepreneurs is confusion of margins with overhead. It may seem amazing, but more than one company has got into financial problems because of that. That is why in today’s article we explain the differences between margin and markup.
What is the margin?
In the simplest terms, the margin is the ratio of profit on sales to the sales price, expressed as a percentage.
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Let’s explain it with an example. Suppose a company buys a product for PLN 80 and then sells it for PLN 100. Profit on sales is, therefore, PLN 20, and the sale price is PLN 100. In this situation, the margin is 20% because:
20: 100 = 20%
It is also worth clarifying here the difference between the net margin and the gross margin. Well, net margin means the ratio of net profit to the total value of sales in this period. Therefore, the net margin includes all costs incurred by the company in a given period. On the other hand, the gross margin takes into account only the costs directly related to the sale (eg costs of production or purchase of goods, merchant’s commissions, etc.), but it does not take into account indirect costs (eg office operating costs, rents, etc.). In other words – the gross margin indicates how profitable sales were at a given time, and the net margin determines how profitable the whole business was.
Of course, the margin is the greater, the greater the profit from the sale. At present, however, we are increasingly able to observe a decrease in margins, which consists of many factors (including increasing costs of purchasing and functioning of the company, increasing competition or poverty of a part of society, which in turn means that customers expect lower prices).
Margin is a very important parameter in company management because it allows evaluating the company’s effectiveness and testifies to its financial success. The margin also gives the opportunity to assess how much the company is able to generate profit with different sales volumes. The margin is also a good reference point, allowing to assess the location of the company against competitive enterprises from the same industry.
What is overhead?
Overhead is the ratio of profit on sales to the purchase price (or wholesale price), expressed as a percentage.
And this time we will explain it on the example cited at the beginning of the article. The company buys a product for PLN 80 and sells for PLN 100. Profit on sales is PLN 20, and the purchase price (wholesale price) is PLN 80. The overhead is therefore 25% because:
20: 80 = 25%
The overhead is also an important indicator because, on its basis, the price of the product is determined quite often. This is not always a way to obtain the optimal price, because the price set on the basis of the mark-up does not take into account many factors, such as eg demand or the perceived value of the product.
What are the consequences of confusing margins with overhead?
Misleading the margin with overhead brings with it certain consequences. The first of them is discredit in the eyes of the customer. It will be difficult to gain the trust of a client, who does not distinguish between the basic concepts related to his work. Often you can hear from the traders return: “150% margin”. In the meantime, it is impossible – if you sell goods at a price even by a penny greater than the purchase price, the margin will not reach 100% anyway. Only the mark-up rate can be 150%. This would happen, for example, if you bought products for PLN 500, and sold them for PLN 1,250, because:
(1250-500): 500 = 750: 500 = 150%
However, the margin in such a situation would be 60%, because:
(1250-500): 1250 = 750: 1250 = 60%
We also mentioned that it is possible that the price of the product is determined on the basis of the margin or mark-up. In such a situation, the result of mistaking the margin with the mark-up may be the wrong pricing policy of the company. For example – if you want to sell a product for PLN 100, and the margin is to be 30%, then you should buy this product for PLN 70. If, on the other hand, you want to sell a product for PLN 100, and the markup is to be 30%, then you should buy this product for 76.92%.
Besides, if you make a mistake with the markup, you will not know how much you have actually earned on the sale. Once again, let’s explain this in the example given at the beginning of the article. We buy a product for PLN 80, and we sell it for PLN 100. Let us remind you that in such a situation, the margin is 20%, and the mark-up is 25%. If, for example, a company employee thinks about the bedspread, he tells the boss that the margin was 25%, involuntarily misleading, because the boss will then expect that the company earned more sales than it actually did. Of course, the difference of 5 zlotys does not matter, but if within a month the company sells 1,000 such products (in total worth 100,000 zlotys), it is very important for the boss if he earned 20,000 zlotys. or 25,000 zł.
Misleading the margin with the mark-up can, therefore, not only discredit you in the eyes of customers but also put your business into financial trouble. That is why it is worth you to be aware of the difference between these concepts and know how to use the margin and markup in managing the company’s finances.