When companies sell something, they want to earn profits and need to set their prices accordingly. A markup formula is a math tool that gives businesses a way to figure out what they should sell something for while still making money and covering overhead expenses like materials. Customers sometimes use these equations to get a sense of whether something is overpriced, although an accurate picture requires information about the overhead expenses that the average buyer might not have. The formulas might involve dollar amounts, percentages or a combination of the two, depending on the goals people have. Experts say it’s better to adjust the formula that is applied by the categories of goods and services offered, rather than to rely on just one method.
A company might use the following general formula:COST x MARKUP PERCENTAGE = ADDED AMOUNTCOST + ADDED AMOUNT = SELLING PRICE
To use this formula, the seller determines the desired percentage, and everything follows from that. Figuring out what this needs to be can be very complex, however. A business manager must consider a wide range of overhead expenses that need to be covered, such as employee wages, taxes, webhosting, utilities, taxes, rent and maintenance. He then has to look at the financial goals of the company and figure out how much net profit he would like to gain from the sale, understanding that the higher the added amount is, the fewer items he needs to sell to meet whatever profit level he wants.
The keystone method is an example of a very simple approach to markup and presents a different formula. To use this method, a person simply doubles the amount the company pays to determine the retail price. A $5 US Dollar (USD) item therefore is sold for $10 USD, while a $500 USD item would be sold for $1,000 USD. Note that while the formula is consistent—COST x 2 = SELLING PRICE—the profit for each sale goes up with the initial expense of the item. Put another way, the keystone method has a 50% margin and 100% markup. Showing this in terms of the general formula for the two pricing examples gives:
a) $5 USD x 100% = $5 USD
$5 USD + $5 USD = $10 USD
b) $500 USD x 100% = $500 USD
$500 USD + $500 USD = $1000 USD
How Customers Calculate Additions
In some cases, a customer might look at a sale price and want to know how much a business added to its cost. She can figure this out looking just at dollar amounts, or she can calculate the percentage the company used. Using just monetary values, for example, an item might sell to consumers for $100 USD. The merchandise only set the seller back $75 USD. The buyer would subtract the what the company paid from the selling price:
SALE PRICE – COST PRICE = ADDED AMOUNT
$100 - $75 = $25
If a customer wants to look at the added amount in terms of the percentage the business used to get the final sale amount, she has to use a more complex formula:
100 X ([SALE PRICE – COST] / COST) = ADDED AMOUNT
Using the figures from the previous example, this would become:
100 x ([100 – 75] / 75) = 33%
Markup Formula Versus Profit Margin
People sometimes confuse the final value involved in a markup formula with profit margin. A markup is an amount added to the company’s cost to get the final selling price. It includes the expenses a company has to cover as well as the amount of money it wants to keep, and it is always relative to what the business pays. By contrast, a profit margin is the percentage of the sale amount that is gross profit, and it is always relative to the what the consumer pays. To find net profits, or the amount of money from a sale that the organization actually can hang onto, a person has to subtract overhead expenses from the gross profits.
A business has to resist the temptation to add big amounts to boost profits, because customers will compare the sale price to the prices other competitors set. If the addition puts the sale price well above the general market value for the item, buyers might assume that the company is purposely exaggerating what it charges. If the customer thinks the company is unfair, he likely will go to a different seller that offers a lower rate. In this sense, market value and what a company adds are always connected.
Even though a customer can figure out how much a business has added to the original purchase or manufacturing price, without being an insider to the company, he really can’t determine the profit margin the organization has. An addition of 50% might seem like too much to the buyer, for instance. If the manufacturer or retailer has extremely high overhead expenses, however, the margin will be low.