Confusion frequently surrounds the meaning of gross margin and markup, probably because they are two different ways of expressing the same thing. Both measure the difference between the price that you receive for an item you sell and the cost you incurred to obtain the item. We’ll define gross margin and markup below.
Gross margin = (price – cost) / price.
Therefore, gross margin is the difference between price and cost divided by price. Note that gross margin is typically expressed as a percentage. On the other hand,
Markup = price / cost.
Expresssed another way, price = markup X cost
Markup is the number you multiply cost by to get price. Expressed as a percentage:
Markup percentage = (price / cost) – 1 = (price – cost) / cost.
Therefore, gross margin is the difference between price and cost divided by price, while markup is the difference between price and cost divided by cost. Since price is more than cost, (hopefully), for any given price and cost, the markup percentage will always be larger than the gross margin.
If your head is about to explode, a quick example may prove helpful. Suppose that you are a distributor. You pay $80 dollars for an item -- this is the cost. You sell this item for $100 -- this is the price. Therefore,
Gross margin = ($100 - $80) / $100 = 20 percent.
Markup percentage = ($100 - $80) / $80 = 25 percent.
Also, note that
Price = markup X cost = 1.25 X $80 = $100.
Markups are typically used when you know the cost and want to determine the price. For example, a retail store may have a policy of marking up the products it sells by 50 percent. In other words, to determine the price, the retailer takes the cost paid for an item and multiplies it by 1.5.
Gross margin is typically used when you know both the price and the cost, and you want to communicate how much you made on the sale. Therefore, if you paid $100 for an item that you sold for $150 (a 50 percent markup), the gross margin would be 33.3 percent = ($150 - $100) / $150. The result is that a 50 percent markup yields a 33.3% gross margin.
This may lead to a second question: Is there a direct relationship between gross margin and markup? The answer, of course, is yes.
Gross margin = 1 – (1 / markup)
In the most recent example, we saw that a 50 percent markup yields a 33.3 percent gross margin. Plugging into the equation confirms this.
Gross margin = 1 – (1 / 1.5) = 33.3 percent.
In the same way, if you want to know what markup to use to obtain a given gross margin, the following equation will help.
Markup = 1 / (1 – gross margin).
We know that to get a 33.3 percent gross margin, you have to use a markup of 1.5. The equation confirms this.
Markup = 1 / (1 – .333) = 1.5.
The relationship between gross margin and markup can be confusing. We hope this explanation makes the concepts a bit easier to grasp.