Start-up businesses often confuse the markup on cost and gross margin ratio but they are not the same thing. Both ratios link the selling price,cost price, and gross margin of a product.
|Selling price (162.50)|
|Cost price (65.00)||Gross margin (97.50)|
Quite simply, for a product, markup on cost is the gross margin (profit) divided by the cost price, and the gross margin ratio is gross margin divided by the selling price.
Markup on Cost Formula:
Markup on cost = Profit / Cost price
For example, if a product has a cost price of 65.00 and is sold for 162.50 then the markup on cost is calculated as follows:
Gross margin = Selling price - Cost price Gross margin = 162.50 - 65.00 = 97.50 Markup on cost = Gross margin / Cost price Markup on cost = 97.50 / 65.00 Markup on cost = 1.50
The markup on cost for this product is 1.50.
The markup on cost is useful when the cost price is known and you are trying to calculate the gross margin or the selling price of the product.
Calculating the Selling Price Using Markup on Cost
The selling price of a product can be calculated by multiplying the product cost price by (markup on cost + 1). The formula for selling price is as follows:
Selling price = (Markup on cost + 1) x Cost price
Using the example above, the selling price would be given as follows:
Selling price = (Markup on cost + 1) x Cost price Selling price = (1.50 + 1) x 65.00 Selling price = 2.50 x 65.00 Selling price = 162.50
To achieve a markup on cost of 1.50 the selling price needs to be 162.50.
The term (Markup on cost + 1) is sometimes referred to as the cost multiplier as it converts a cost price to a selling price.
Selling price = Cost multiplier x Cost price
In the example above the cost multiplier was 2.50, and the selling price could be calculated as 2.50 x 65.00 = 162.50. Some businesses talk in terms of markup on cost (1.50), and others talk in terms of the cost multiplier (2.50), be careful not to confuse the two.
Calculating the Gross Margin Using Markup on Cost
The gross margin on a product can be found by multiplying the cost price of the product by the markup on cost.
Gross margin = Markup on cost x Cost price
Using the figures in the example above, the product cost price is 65.00 and the gross margin on the product is calculated as:
Gross margin = Markup on cost x Cost price Gross margin = 1.50 x 65.00 Gross margin = 97.50
At a markup on cost of 1.50 the gross margin on the product will be 97.50
The markup on cost is a useful tool when negotiating prices with a supplier. For example, a buyer might be tasked with achieving a minimum markup on cost of 1.50. When negotiating prices, knowing the required markup, they can quickly calculate the required selling price to see whether this is feasible. In addition, having agreed the cost price, they can then work out the gross margin on the product.
Gross Margin Ratio
The gross margin ratio for a product is defined as the gross margin divided by the selling price, expressed as a percentage.
Gross Margin Ratio Formula:
Gross margin ratio = Gross margin / Selling price
For example, if a product has a selling price of 162.50 and cost 65.00 then the gross margin ratio is calculated as follows:
Gross margin = Selling price - Cost price Gross margin = 162.50 - 65.00 = 97.50 Gross margin ratio = Gross margin / Selling price Gross margin ratio = 97.50 / 162.50 Gross margin ratio = 60%
The gross margin ratio fer this product is 60%.
Although the gross margin above was for one product, since the gross margin shown in the financial projections income statement is in reality the gross margins of all the products sold added together, this gross margin formula can be used on the total revenue of the business.
Gross margin ratio = Gross margin / Revenue
In fact the gross margin in the financial projections is calculated by applying a projected gross margin ratio to the revenue. For example if the revenue is 40,000, and the projected gross margin ratio is 60%, then the projected gross margin will be 40,000 x 60% = 24,000.
It should be noted that we could equally well look at the overall markup of the business, but normally line items in the income statement are referenced back to the revenue as a base, and therefore the gross margin ratio is referred to when looking at the business as a whole.
To use the gross margin ratio in practice on a day to day level, a business can base its product buying and pricing decisions around the projected gross margin ratio.
The buyer in this case might know that the selling price of the product needs to be 162.50, and that they must achieve a gross margin ratio of 60% to align with the business plan financial projections. The required cost price they must negotiate can be calculated by multiplying the selling price by (1 – gross margin ratio).
Cost price = (1 - Gross margin ratio) x Selling price
Using the figures above as an example, if the selling price is 162.50 and the gross margin ratio is 60%, then the cost price the buyer must negotiate must not be greater than:
Cost price = (1 - Gross margin ratio) x Selling price Cost price = (1 - 60%) x 162.50 Cost price = 40% x 162.50 Cost price = 65.00
On this product, the cost price negotiated must be less than 65.00 to achieve a gross margin ratio of at least 60%.
Link Between the Markup on Cost and Gross Margin Ratio
It is clear that the mark-up on cost and the gross margin ratio are two different ways of looking at the same thing.
The following formulas show the link between the markup on cost and the gross margin ratio.
To convert from a gross margin to a markup on cost
Markup on cost = Gross margin ratio/(1-Gross margin ratio)
So for example if the gross margin margin is 60% them the markup on cost is given by:
Markup on cost = Gross margin ratio / (1 - Gross margin ratio) Markup on cost = 60% / (1 - 60%) = 1.50
Likewise, to convert from a markup on cost to a gross margin ratio
Gross margin ratio = Markup on cost / (1 + Markup on cost)
So for example if the markup on cost is 1.50 then the gross margin ratio is given by:
Gross margin ratio = Markup on cost / (1 + Markup on cost) Gross margin ratio = 1.50 / (1 + 1.50) Gross margin ratio = 1.50 / 2.50 Gross margin ratio = 60%
Both markup and margin ratios can be used to monitor trends in the business, and to make comparisons with other businesses. In addition, as we have seen above, they are also useful as a management tool to allow product buying and pricing decisions to be made. The mark-up on cost is useful when the cost price is known, the gross margin ratio is more useful when the selling price is known.
Mark-up on Cost Tables Download
The mark-up on cost tables are available for download in PDF format by following the link below.
These tables allow a gross margin ratio between 1% and 99% to be converted to a mark-up on cost, and a mark-up on cost between 0.01 and 99.00 to be converted to a gross margin ratio.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.