Gross margin and markup on products are closely related in that your markup strategies dictate how much gross profit and margin you make on sales. The only difference in the calculation is that margin is based on a percentage of sales, and markup is based on a percentage of your costs of goods sold.
Gross Margin Basics
Gross profit is revenue minus COGS. Materials, direct labor and freight charges are common items that factor into a company's COGS. After calculating gross profit, divide by revenue to identify gross margin as a percentage of revenue. If COGS are $25,000 on revenue of $60,000 in a given period, gross profit is $35,000. This profit divided by $60,000 in revenue equals a margin of 58.3 percent.
Markup is based on how much you add to your COGS when setting prices for your customers. The formula for markup is selling price minus production or acquisition COGS, divided by COGS. In essence, it is an inverse of gross margin. If you pay $25 per item for inventory and price items at $60, your markup is $60 minus $25 divided by $25. The markup in this case is 140 percent. You intend to sell the items for more than twice as much for the items as what they cost you to make or buy them.
Using Markup to Achieve Margin Goals
The correlation between markup and margin is that your markup choices dictate your gross margin. When you lower your prices with constant COGS, your margin falls. When you increase prices with constant COGS, your margin grows. Know your margin objectives before choosing pricing strategies. If your goal is 55 percent-plus gross margin, a 140 percent markup on items that cost you $25 allows for that.
Setting overly aggressive margin goals, and therefore marking up items too much, does present some business risks. While you may achieve strong gross margins initially, prices that exceed customer demand limits your buying activity. Often, companies end up marking items down to clear out excess inventory. Having to take this step reduces your average margin per unit and your overall gross margin for the period. Coordinating inventory systems, pricing strategies and marketing activities ensure an optimized relationship between markup and margin.