Unravelling the difference between profit markup and profit margin can mean the difference in a company’s profitability. Mixing the two up is a common mistake that many entrepreneurs make in their pricing strategies. Consider the following story that illustrates the difference between profit margin and profit markup to help you set accurate prices for your desired profit.
John is a fictional pool service technician, the owner of John’s Pool Service. Although he’s owned his service company for 15 years, he’s never been able to take his business or its profits to where he really believed they should be.
John earns a profit, in most years anyway, but he never earned the profit he felt he should. He believed his prices had enough cushion built into them, but year after year, the statements came back from his accountant saying that he was doing OK, but not great. He earned a profit, but not the profit he was certain he was building into his jobs.
John had always priced his work for profit. He never started a job until he knew what it was going to cost. He always priced his jobs based on the cost of his labor, material, equipment, and subs, and then added markups to cover his overhead and profit. He thought he shot for a fair profit.
He was ahead of some of the other contractors he knew, but no matter what John aimed for, the actual results were always something less.
Things changed one day when John was helping his son with his homework. They were learning how to calculate profit margins. John knew the formula backward and forward, having run his business for 15 years. He wrote it out for his son. The formula for profit margin is price minus cost, divided by price, he said.
(Price – Cost) ÷ Price John decided he would show his son with a real-life example, because his son had been asking for an electric bike. They looked at bikes online, and John showed his son the price. The one his son wanted was $2,500. John then told his son to assume the store paid $2,000 to buy the bike, so the price was $2,500, and the cost was $2,000. John’s son took the numbers and plugged them into his formula for profit margin. John went to the kitchen to make himself some coffee while his son did the math: ($2,500 – $2,000) ÷ $2,500 = 0.2 “Is that 20 percent, Dad?” the boy asked.
John was looking for the cream, so he was a little distracted as he said, “Not quite, son. $2,500 is a 25 percent profit margin, so check your math.”
Confused, the boy tried again, and came up with the same answer.
“I did it again, Dad, and its still 20 percent,” the boy said.
Coffee in hand, John walked over, saying, “You’re doing something wrong. Twenty-five percent profit on $2,000 is $2,500. Let me show you how it works.”
So John took the pencil and calculator and did the numbers with his son, and sure enough, he also got 20 percent.
John struggled to understand what he was doing wrong. How could this be? He scribbled numbers on the paper: 25% of $2,000 = $500 And $2,000 + $500 is obviously $2,500.
So the price has to be $2,500, he thought. “What could be wrong?” he thought. But there, with the numbers right in front of him, John found the missing piece.
$500 is 25 percent of $2,000. But $2,000 is the cost of the bike — not the price. The price of the bike is $2,500. $500 is only 20 percent of $2,500 — not 25 percent, as he’d thought.
So that was it. John had been adding 25 percent to the cost to come up with a 25 percent profit, but that was leaving him a little bit short every time because the formula for an actual profit margin is price minus cost, divided by PRICE.
And so if $500 is only 20 percent of the price, that’s why his profit margin was coming out at 20 percent.
This got John worrying some more. What had happened with all the work he’d priced in the past? He’d always priced his work this way: $2,000 + 25 percent = $2,500. That was how he came up with his price. And using that formula, he would have assumed he’d had 25-percent profit on the job, when in fact, he’d been making a 20-percent profit.
So now he wondered: How could he find what he should have been pricing to get a 25-percent profit on $2,000?
To find the right pricing based on a profit margin of the cost, the formula is: Cost ÷ (1 – Profit Margin%) You simply need to take the cost and divide it by one minus the profit margin you’re looking for.
John tried the formula on the bike example: $2,000 ÷ (1 – 25%) = $2,000 ÷ (1 – .25) = $2,666.66 No wonder he hadn’t been making the money he wanted!
John’s old method — adding the profit margin to the cost — is called a profit markup. You are marking up the cost to come up with a price. It’s a valid formula, but it’s not going to give you a correct profit margin.
And if you are using a profit markup instead of a profit margin, you are losing money on every job that you price.
And worse yet, the difference between profit markup and profit margin grows bigger the bigger the profit margin you are looking for. See accompanying table: If you are aiming for a 30-percent profit margin and you mark up your costs by 30 percent, you’re only going to get a 23-percent profit margin. You’re losing 7 percent even before the contract has been signed.
