Markup refers to the percentage of profits which the company derives during the period over cost price of the product sold by it and the same is calculated by dividing total profits of the company of the period by cost price of the product and then multiplying the resultant with 100 in order to derive the markup percentage.
It may also be the difference between an investment or security’s lowest current offering priceOffering PriceOffering Price is the price that is decided by an investment banking underwriter when a company plans to go public list shares in the stock exchange for raising capital. This price is based on the future earning potential of the company, however, the price shouldn’t be too high then the shares might not be sold in full and if it is too low then the potential to raise more capital is lost. contrast to the price which is charged to the customers, and this is usually common among broker-dealers.
Types of Markup
- Consumer Goods MarkUps: In this case, the cost price is increased by a certain ratio to thus arrive at the selling price after considering the profit margin.
- Broker-Dealer MarkUps: When a dealer sells certain security to a retail customer from his own account, his only form of compensation comes from the markup, which essentially stands to be the difference between the purchase price and the price at which the dealer sells the security to the retail investor.
Below is the formula –
The margin is nothing but the difference between the selling price and the cost of the product. Let us consider an example of a markup formulaMarkup FormulaMarkup formula calculates the amount or percentage of profits derived by the company over the cost price of the product and it is calculated by dividing the profit of the company by the cost price of the product multiply by 100 as it is shown in the percentage terms..
Example of Markup
Consider an example where Mr. John produces a certain product. The cost of the product being produced is $7, and Mr. John now desires a margin of $3.
Calculate the markup and ascertain the selling price so as to enable John to achieve his desired margin.
Here the markup percentageMarkup PercentageMarkup percentage is a percentage markup over the cost price to get the selling price and is calculated as a ratio of gross profit to the cost of the unit. During decision-making for selling price, companies use markup on selling price for increasing profit margin. comes up to 42.86% ($3 / $7).
If one were to now apply the markup on the cost, we would multiply 7 * 1.4286 and would arrive at the selling price being $10.
Now the difference of $3 ($10 – $7) is the desired margin of the producer.
Advantages of Markup
There are certain advantages by making use of markups in pricing the product by a manufacturer as listed down below.
- Fixation of Margin – By keeping in mind the desired markup that is required, a manufacturer will be well placed to fixate on the margin as desired by him to pocket out on the profit. Hence the profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. will be very well carved out, leaving little scope for uncertainty.
- Control on Selling Price – By deciding on the desired markup required, a manufacturer or seller will be well in control of the selling price so as to enable him to stay firm with regard to the selling price and not make way for the negotiation of margins.
- Better Negotiation – Once the producer has decided on the margin arrived through markups, he will be in a better position to bargain or negotiate on deals without affecting his profitability since the margin that he wants to earn is now very well fixated.
- Reduced Cost of Decision Making – When the required margin is pretty much fixed through the markup procedure, the management need not waste time and efforts in having to figure out the fair price, as they are pretty much clear with the cost that they have incurred and the required profits they would need to have it covered up. Hence there is no wastage of time and effort on the part of the management. This overall effectiveness reduces the cost of decision making.
- Simple Method – The procedure is adopted in case of markup pricing is quite simple and does not take laborious tasks and procedures as the management is well aware of the cost that they have incurred and then go on to fix the minimum required margin to cover the same and thus provide for profits. It is done so by merely adding up the required margin to the cost and is, in fact, a really simple process.
- Minimum Information Dependence – The producer is relying on its own data with regard to cost and expense figures, and hence there is little dependence on external information such as markets. The company or producer is making use of its own data to decide on the same.
Disadvantages of Markup
- Not Future-Oriented – This method is not forward-looking as it does not consider the future demand for the product, which usually is the base on which the decision around the fair price usually revolves.
- Competition not Considered – This method does not take into account the actions of the competitor and the impact of such actions on the price of the product. If one goes on to solely rely on internal company cost data to pick up the price of the product, it surely is a recipe for disaster as it does not consider the external factors.
- Ignores Opportunity Cost – Opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven. being the cost of the next best alternative foregone, the company may sometimes go on to over-estimate the price of the product as it includes sunk costSunk CostSunk costs are all costs incurred by the firm in the past with no hope of recovery in the future and are not considered while making any decisions since these costs will not change regardless of the decision's outcome. but goes on to ignore opportunity costs totally. There may also be the presence of a certain personal bias while deciding on the profit margin that has to be added to the product.
This method does not factor in external conditions and situations like consumer demand, external competition, etc. and is merely relying on internal cost data, which may not make the product significantly efficient.
A producer may very well adopt a simple procedure of markup to arrive at the selling price by making way for the desired margin, after considering the markup into the cost of the product. This method is simplistic, avoids too much dependence, and reduces the cost of decision making.
However, since it suffers from not considering the factors like external competition, it becomes imperative that the management goes on to look at these factors such that the pricing of the product arrived at through a process of markups can be even more efficient. In this manner, both external and internal considerations, being a necessary margin for the producer, are pretty much factored in that makes the price all the more efficient.
This has been a guide to what is Markup and its Meaning. Here we discuss the top 2 types of markup along with an example, advantages, and disadvantages. You can learn more about profitability ratios from the following articles –