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Financial Advice

Markups And Margins: Why It’s Important To Know The Difference

Markups And Margins Why It's Important To Know The Difference Beyond Accounting

Markups and margins are concepts that seem easy on the face of it but quickly get confusing for anyone not well-versed in accounting. In fact, I come across lots of business owners who think they understand how the maths works but are actually getting their calculations wrong. If your head hurts when you hear terms like margins and markups, this blog is for you!

Know if you’re including or excluding VAT

In B2B, everyone talks about net costs and prices as a matter of course. If your business delivers a service to another business, it wouldn’t occur to you to use the VAT-inclusive price. But, in retail, you are selling to individual customers, and they need to know the overall price they will pay. This effectively makes the VAT hidden to the customer, but you must never forget it’s there! A typical consumer might not even know whether VAT is chargeable on the item they are buying.

As a B2C retailer, you’re dealing daily with two ways of calculating: when you’re talking to your suppliers, you’re discussing costs that are net of VAT and when you’re setting prices for sale, you’re thinking of amounts that are inclusive of VAT. This isn’t intuitive and requires to you to be always aware if you are looking at net or gross figures.

Calculating amounts between net and gross

I’ve noticed that many people struggle with calculations that go from gross to net and net to gross.

My first financial exercise for you as a retailer is to get used to thinking of your sales price calculation as being net of VAT (also known as VAT-exclusive). If an item is on the shelf for €100, that isn’t your real sales price! You must subtract the VAT first so that you are using the right figure.

A common mistake I see people make is calculating their net price by working backwards from the goss amount. So, they’ll work backwards from the total and take off the VAT rate:

€100 x 23% = 23

€100 – €23 = €77

This is wrong! You’ve taken the total amount and applied 23%, but sales tax is always applied to the net amount. The correct calculation is:

100 ÷ 1.23 = €81.30

(The wrong answer above is over 5% lower than the correct answer, by the way. So, in this example, you are missing out on €4.30. Now imagine losing that same level of revenue across your entire store.)

If you’ve run your gross to net calculation and don’t feel confident in the answer, simply go the other way with your calculation. In this case, that means:

€81.30 x 23% = 18.699 (round up to 18.70)

€81.30 + 18.70 = €100

Even with 25 years’ experience working in accounting and financial management, I still check my work by reversing the calculation. I recommend you do the same.

Markups and margins in retail – what’s the difference?

It can sound like these two terms are interchangeable and that you’re simply talking about the same thing. But these two concepts have different uses and a different place in accounting. It’s important to understand how they are used when running financial calculations for your business.

How to calculate a markup

A markup should be used when you are talking about pricing. As a retailer, you buy in products at a certain price then add an amount to it to arrive at your selling-on price. As an example, let’s say I buy in clothes at €100 per shirt and add a 100% markup. That means I will sell the shirt for €200 plus VAT at 23%:

€200 x 23% = €46

€200 + €46 = €246 final shelf price

Markup should be easy enough to work out, as you can see. You’re starting with a net product cost, and only add VAT once you have included your markup percentage – which has to account for all the costs of running the business such as rent, utilities, staff, marketing and advertising, profit, etc.

How to calculate a margin

A margin should be used when you are talking about results. Margin is sometimes referred to as gross profit. Let’s say I’m looking at how the past week went for the shop. I know the shop pulled in €10,000 in sales (remember we’re not including VAT in these numbers because that is simply sales tax and not part of our revenue, so your till rolls will be giving you an amount of €12,300 and you need to find your net figure). If your total sales were €10,000 and the goods cost you €6,000 (again, net of VAT), then your margin was €4,000, which is 40%:

€10,000 – €6,000 = €4,000

€4,000 ÷ €10,000 x 100 = 40%

Calculating a margin can be more complicated than the above, however. You may have purchased a stock of a particular product on 10th January – so there will be a cost to the business showing in the accounts that week – but it might take until 20th March before they are all sold. In any given week, how do you apportion the cost of that purchase to the sales you have made?

This is where an accountant would look at your ‘cost of goods sold’ (COGS) rather than taking the lump sum cost of any supplier invoices you paid. This works in the following way: I get a delivery in and I put that in my stock or inventory figure. It’s now an asset that can be balanced against the sales I make. Now the margin will be clearly identified when I look at the profit and loss account (P&L).

When I look at an inventory figure as an asset and take out whatever has been sold, I see a clear picture of what the inventory value should be. But this of course does depend on doing periodic stock takes to ensure the number is correct – at month-end is a good time as this also allows you to run your monthly management accounting report with confidence.

Calculating discounts – use the right starting point

Another area where I’ve seen people miscalculating the markup is with discounts. Let’s say I have regular customers and trade customers at my shop. Trade customers expect to receive some kind of discount, so I have opted for 20% off. A product costs me €10 and I mark it up by 100%, or €10. The net of VAT price is €20 and I apply my trade customer discount of 20%.

I may now think that I have given away 20% of my 100% markup, so still have 80% and that is sufficient, but this is faulty thinking as I have in fact given away 40% of my markup, not 20%. Run the maths and see for yourself: i.e. 20% discount on €20 is €4 which means the discounted price is €16, not €20. The €16 selling price is only a 60% markup on my cost of €10 in this example. This common error happens because the markup is applied to the cost, whereas the discount is applied to the sales price. We’re not comparing apples with apples.

Having the right information to assess your financial health

When I talk to smaller retailers, it’s not unusual for them to have confused markups and margins, or to have included the sales tax in their calculations. This meant they were not making as much as they needed to cover all their costs and salaries and still make a profit. I think this is a tragedy because retailers work so hard and yet many don’t make any money and don’t survive very long. I think in many cases this can be avoided by upskilling on financial concepts and embracing an easy and consistent methodology for your pricing.

Getting used to applying markups of 100% or more takes confidence, too. An experienced retailer knows that they must achieve this level of margin to pay for salaries, rent, and overheads while leaving a reasonable surplus at the end. It’s important that your business brings in sufficient cash to stay financially healthy. This is particularly important if you sell products that are seasonal or when confronting unforeseen shocks such as global pandemics.

This is really, really, important and if you feel you are not as on top of this as you should be do not be afraid to reach out for help. On the surface, it seems easy and a lot of people will be afraid to ask basic questions but our experience is that these questions trigger productive conversations and increased understanding in a very crucial area. So start those conversations now – with your partners, your staff, your accountant, and your peers.

Did you know? We offer a financial coaching service, so you can get upskilled in the specific areas you need at a pace that works for you. We’d be happy to walk you through financial concepts like this, plus show you how it applies directly to your business and your bottom line! Get in touch today.