Gross Margin vs. Gross Markup

Here at BidClips, we have frequent conversations with our clients about gross markup and gross margin, especially as they relate to pricing. Through these discussions, we noticed that gross margin and gross markup are commonly thought of as interchangeable, which can have disastrous impacts on pricing and bottom lines.

The way this usually plays out is a client sets a target gross margin of say 50% and then calculates their prices using the formula for gross markup. When they calculate their gross margin, they expect to see 50%, but they don’t, their result is 33%—an unpleasant surprise.

Our client mistakenly believed that gross margin and gross markup are equivalent, but they are not, they are related. And because of the way they are related, gross margin will always be less than gross markup. The client’s services will always be underpriced, and they will always fall below their target margin.

We want to eliminate the confusion surrounding margin and markup by exploring how the numbers are related and how each has its own uses. Before we do that, we need to define margin, markup, and a few other useful accounting terms used when discussing margin and markup.

Important Terms

Revenue (def.)how much you sell a product or service for. It is also known as top-line because it is the first line item on a Profit and Loss Statement.Pro Tip: What you sold.

Here is how revenue might look in your industry:

Cost of Goods Sold (COGS) (def.) your cost to produce a good or provide a service that is ready for sale. What costs you include in COGS will vary based on your industry, but you should cover all costs that can directly be attributed to generating revenue. Pro Tip: Cost of what you sold.

Here is how Cost of Good Sold (COGS) might look in your industry:

Gross Profit (def.) the difference between Revenue and Cost of Goods Sold. It is calculated by subtracting the Cost of Good Sold from Revenue. Pro Tip: Remaining revenue after paying COGS.

Gross Profit= Revenue - Cost of Goods Sold

Gross Margin (def.) the portion of revenue that remains after paying expenses to produce your goods or services expressed as a percentage of total revenue. Gross margin must always be less than 100%. Pro Tip: % of remaining revenue compared to revenue

Gross Markup (def.) the amount over cost you sell your goods or services for expressed as a percent. Gross markup must always be greater than -100%. Pro Tip: % over cost you sold your goods or services for

Gross Margin and Markup Are Related

There are a couple of rules we should know about the relationship between Gross Margin and Gross Markup. The first rule is so important we should remember it twice.

1. Every Gross Margin corresponds to precisely one Gross Markup
2. Every Gross Markup corresponds to precisely one Gross Margin
3. Gross Markup will always be higher than Gross Margin
4. Gross markup and gross margin can be converted from one to the other using the following formulas:

Using Gross Margin

Gross margin is an important number to watch for your business's overall health because it gives a clue about how efficient and effective you are at preparing your products or services for sale. It will also inform you what portion of your revenue is retained as capital to pay for general expenses or pay down liabilities and associated interest expenses.

You should have a general idea of the average gross margin for your industry and compare it to the margins in your business to see if you are below or above the industry average.

1. Margins are Below Industry Average

If your margins are below your industry average, then you know your prices are too low, your costs are too high, or some element of both. Avoiding pricing mistakes that result in prices that are too low (or too high) for your market is extremely important.

To do so, you should periodically review your pricing strategy to ensure you are maximizing profits while maintaining a competitive advantage.

Sales processes can also function to drive down gross margin even if your top line is priced well. Sales reps will often take any opportunity to close a sale, and discount diving is a real challenge we have witnessed from our own reps.

If you are going to offer discounts to help close sales, you need to set your reps' expectations about when and how they can be used. Establishing gross profit minimums and rewarding sales reps who achieve profit goals along with sales goals are two great methods.

If you decide you are in line with the competition after reviewing your pricing, you should examine your costs. Call around to alternative vendors and see what they offer. You may discover you need to renegotiate your current contracts or source materials from different suppliers. If you operate a business where labor is a significant component of production, you should examine if you are being as efficient as you can with your workforce.

2. Margins are Above Industry Average

What if you have looked at your gross margin and realized it's higher than your industry's average? That's a good thing! Right? Well, maybe not. Remember, many factors go into pricing aside from calculations and metrics. What the market can bear, or what your customers are willing to pay, will ultimately determine your final price.

Your price, coupled with your value proposition, will determine how much of the market is available for you to capture. By pricing higher than the average, you could price yourself out of growth opportunities, and your approach should be reviewed in your positioning and pricing strategy.

Using Gross Markup

Gross markup by nature does not lend itself to a straightforward analysis of what happened in your business compared to gross margin. However, it is a more natural way to envision what needs to happen to be profitable.

For instance, if you know your COGS on each sale is $100, and you have $2,500 each month in operating expenses, and you expect 50 sales, then you know you need $2,500 / 50 = $50 in gross profit on each sale to break even. That is a 50% markup, which is more comfortable for most people to envision and calculate than to recognize it as a 33% margin.

The uses for gross margin and markup discussed above lends to the idea that gross margin is an accounting function, and gross markup is a pricing function. We believe this is a narrow view because they can be equally powerful in pricing and accounting. Knowing gross margin and gross markup are different in form and use, but recognizing their relationship will empower you to use them in new and exciting ways.