Margin and markup are different
Margin divides profit by the selling price. Markup divides profit by the cost. The same sale gives two different percentages, and mixing them up is a classic way to underprice a product. A 50% markup produces only a 33.3% margin, while a 50% margin needs a 100% markup.
Gross profit = revenue - COGS. Gross margin = gross profit / revenue. Markup = gross profit / COGS. Operating margin = (gross profit - operating expenses) / revenue. Net margin = net income / revenue. Price for a target margin m = cost / (1 - m), and markup = m / (1 - m).
A worked example
A small furniture maker sells $240,000 of tables in a year. The wood, hardware and direct labor cost $150,000. Rent, marketing and other operating expenses are $60,000, interest is $6,000 and the tax rate is 25%.
| Line | Amount | % of revenue |
|---|---|---|
| Revenue | $240,000 | 100.0% |
| Cost of goods sold | -$150,000 | 62.5% |
| Gross profit | $90,000 | 37.5% |
| Operating expenses | -$60,000 | 25.0% |
| Operating profit | $30,000 | 12.5% |
| Interest | -$6,000 | 2.5% |
| Tax (25%) | -$6,000 | 2.5% |
| Net income | $18,000 | 7.5% |
Gross margin is 37.5% and markup is 60%, since $90,000 is 60% of $150,000. The pricing box shows the other direction: a unit that costs $60 needs a price of $60 / (1 - 0.40) = $100 to earn a 40% gross margin, which is a markup of 66.7%.
What each margin tells you
Gross margin shows whether the product itself pays. If it is thin, no amount of cutting overhead will fix the business. Operating margin shows whether the company covers its running costs, and net margin is what is left for owners after interest and tax. Compare each with companies in the same industry, since grocery stores and software firms live at very different levels.
A falling gross margin with steady sales usually points to rising input costs or discounting. A healthy gross margin with a weak net margin points to overhead or debt. The calculator charges no tax on a loss, which is a simplification, because real rules allow losses to offset other years.
Mistakes that cost points
- Using markup as if it were margin when setting a price. A 40% markup is not a 40% margin.
- Putting operating expenses inside COGS. Gross margin should reflect only direct costs of the goods sold.
- Dividing profit by cost when the question asks for margin.
- Comparing margins across industries with different cost structures.
- Forgetting returns and discounts, which reduce revenue before the margin is calculated.
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