Demystifying Profit Margins and Markups

Many of the inventors I meet got started because they wanted an outlet for their creativity or sought more freedom in their careers. Rarely do I meet someone who has approached inventing from a number-crunching background. It seems that many inventors just aren't that comfortable with "the numbers." However, if you create a viable product, you've got to sell it. And pricing and profit margins are a critical part of that process.

Whether you sell directly to end-users or to a retailer or distributor who sells to customers, you need to know how to price your product to ensure everyone in the process will make their required profits. As you probably suspect, this involves a bit of art -- and a lot of science.

Common sense dictates that the price you choose should be neither too high nor too low to attract the most customers and generate the greatest amount of profit. Your price also needs to cover the cost of doing business. This is where understanding the basics of "markups" and "gross margins" can help.

Before we get into these concepts, I'd like to define a few terms that people often confuse:

• Retail sales: This is sales of a product to an end user. Example: the price you'll pay for cookies at a grocery store

• Wholesale sales: This means the sales by a manufacturer or distributor to a retailer. Example: the price Nabisco charges grocery stores for its cookies

• Markup: This is the difference (reflected in both dollars and percentage) between what a retailer will pay for a product and its retail price (what the end user will pay). Example: XYZ Cookie Company sells a bag of cookies to the grocery store for $2, and the grocery store charges $5. The markup is $3 per bag.

• Gross margin: This is the percentage of profit derived from a transaction. (Both the manufacturer and the retailer will expect their own gross margin.)

How Markups Work

The best way to illustrate the concept of markups is with a simple example. Assume you, the manufacturer, make a product we'll call Gizmo for $1. You then sell it wholesale to a retail store for $3. Thus, your markup is $2 ($3 - $1 = $2), or 200% (2 / 1 = 2.00: Remember, percentages are determined by moving the decimal point two spaces to the right and adding the percentage sign, hence 2.00 = 200%). If the retail store, then sells Gizmo for $8, its markup is $5 ($8 - $3 = $5), or 166% (5 / 3 = 1.66).

Figuring Out Your Gross Margin

Now that you know your markup, you can figure out your gross margin. (These two terms are often mistakenly used as though they're synonyms. They are related, but they're not the same.) This number is calculated by dividing the markup by the price to acquire it.

Using the above example, we'll first figure out your gross margin as the manufacturer. Divide your markup ($2) by the price the retailer paid for it ($3). Thus, your gross margin as the manufacturer is 67% (2 / 3 = .67). So in this case, a 200% markup resulted in a gross margin of 67%.