Margin vs. markup

Recently I worked with Mike Sampsell, president of SuperiorScape near Birmingham. Mike’s company installs design/build and bid/build landscape projects in the greater Birmingham market. He also runs a metal fabrication company that performs functional metal work as well as creating works of art. During my discussions with Mike and his team, some very significant questions surfaced about some important financial concepts. The questions were: What’s the difference between a margin and a markup? Why is it important to differentiate between the two? How do you define gross profit margin?

Definitions.

Defining your terms clearly is critical when it comes to the various categories in budgets, bids, estimates and financial statements. You have to know what revenue and/or costs go where and why they go in a particular financial “bucket,” if you will.

Factors and products:
In the equation 2 x 3 = 6, the 2 and 3 are factors and 6 is the product.

Markup:
In the equation below, the $100 is the cost, the 1.25 (125%) is the markup, and the price is $125.

$100 x 1.25 = $125

Margin:
A margin is the difference between the cost and the price. It is expressed as a dollar amount and as a percentage. If the price is $125 and the cost is $100, the margin is $25 (as a dollar amount). As a percentage the margin is 20%.

$25 ÷ $125 = 20% margin

It is important to note that it requires a 25% markup to produce a 20% margin. You lose 5 points in the conversion.

How to produce a 20% net profit margin vs. a 20% markup.

If you desire a 20% net profit margin (NPM) on a bid, you divide the costs by 1 minus the desired NPM. It looks like this:

$10,000 cost ÷ (1.0 - .2) =$10,000 ÷ .8 = $12,500

The margin in dollars is $2,500

The margin as a percent is $2,500 ÷ $12,500 = 20%

If you apply a 20% markup to your cost, it looks like this:

$10,000 cost x 1.2 = $12,000

The margin in dollars is $2,000

The margin as a percent is $2,000 ÷ $12,000 = 16.7%

You lose 3.33% in the conversion.

A 10% net profit margin vs. a 10% markup:

$10,000 cost ÷ (1.0 - .1) = $10,000 ÷ .9 = $11,111

The margin in dollars is $1,111

The margin as a percent is $1,111 ÷ $11,111 = 10%

If you apply a 10% markup to your cost, it looks like this:

$10,000 cost x 1.1 = $11,000

The margin in dollars is $1,000

The margin as a percent is $1,000 ÷ $11,000 = 9.09%

You lose 0.91% in the process.

It may not seem like much to lose 0.91%, but if you lose it on sales of $1,000,000 per year, it is $9,100 annually. If you plan to work in this industry for 30 years, it is $9,100 x 30 = $273,000. Little numbers multiplied by big numbers turn out to be BIG numbers.

More definitions.

Let’s add a few more definitions to our discussion using a $10,000 project as an example. The terms to define are the break-even point (BEP) and the gross profit margin (GPM).

Break-even point (BEP): The definition for the BEP is: TDC + G&A overhead = BEP

$6,500 + $2,500 = $9,000 or 90%

Gross profit margin (GPM): The definition for the GPM is: G&A overhead + NPM = GPM

$2,500 + $1,000 = $3,500 or 35%

The BEP is that amount where you’ve covered all of your costs but you haven’t made any net profit. The GPM is the margin added to your total direct costs to achieve your price. GPM is a key indicator of market conditions. As the economy heats up and demand is greater than the supply, the GPM increases. In a recession where supply is abundant to fulfill a decreasing demand, the GPM decreases. GPM is also a key indicator (KPI) or benchmark on bids and the profit and loss (P&L) statement for measuring performance.

Once I explained these key financial concepts to Mike and his team, the numbers in their bids and financials made more sense. There’s not a huge difference between a margin and a markup, but remember, “A little number multiplied by a big number is a BIG number.” One, 2% or 3% extra net profit margin added to your bids over a career can add a lot of money to your bottom line and in your pocket.

Travels with Jim follows Jim Huston around the country as he visits with landscapers and helps them understand their numbers to make smarter decisions. He can be reached at: jhuston@jrhuston.biz.