Margin vs Markup: Understanding the Difference
Bruce Robb
Is it a ‘margin’ or a ‘markup’? I often see builders confusing margins with a markup. If you think you are using a margin, but actually, it is a markup, then you could be cutting yourself out of profits.
When it comes to pricing and profitability in the construction industry, it’s crucial to understand the distinction between margin and markup. Many builders mistakenly interchange these terms, potentially depriving themselves of significant profits. Let’s clarify the disparity between margin and markup to avoid this pitfall.
Firstly, a “margin” refers to a percentage of the sales price, excluding taxes (such as GST), while a “markup” represents a percentage of the cost price, also excluding taxes. The disparity between the two can be substantial, especially in building homes where sales and cost prices often reach hundreds of thousands of dollars.
To illustrate this disparity, let’s consider two calculations. Assuming a cost price of $100, a 20% markup would equate to 20% of $100, which amounts to $20. Therefore, the selling price using a markup approach would be $120, obtained by adding the markup to the cost price ($100 + $20 = $120). On the other hand, if a 20% margin is used for the same $100 cost price, you would divide $100 by 0.8 (100 – 20 divided by 100), resulting in $125. Taking 20% of the selling price, which is $125, you would obtain $25. Subtracting $25 from $125 yields the original cost price of $100 ($125 – $25 = $100).
It’s important to note that when using a markup instead of a margin, for every $100,000 in cost price, you could be missing out on $5,000 in profit. Therefore, understanding the distinction between margin and markup becomes vital for maximizing profitability in the construction industry.
So, why should you use a margin? A margin, often called a “sales margin,” is calculated based on the sale price rather than the cost price. This makes it significantly more convenient to utilize when creating a business plan. When forecasting your activity or sales for the year, you typically rely on the selling price rather than the cost price. Predicting the average selling price is usually easier than determining the actual costs. For instance, let’s say you’re preparing a business plan and project that you’ll sell 40 homes at an average selling price of $250,000, excluding GST. This projection would result in forecasted revenue of $10 million. Using this information, you can then identify the necessary resources to sell and complete those 40 homes.
Consider the additional costs, such as overheads totalling $1.5 million (including salaries, marketing expenses, office costs, sales commissions, and finance costs). You’ll also need some net profit to sustain and grow your business—say $500,000. To express the overhead costs and net profit as a percentage of the selling price, you would divide the total costs ($2 million) by the projected revenue ($10 million). This calculation yields a 20% margin.
By starting with a comprehensive business model, you can create a business plan and develop a strategy to guide your operations. This approach allows you to accurately forecast your profitability and allocate the necessary resources to achieve your goals effectively.
In conclusion, understanding the difference between margin and markup is crucial in the construction industry. Confusing these terms can have a significant impact on your profitability. By employing a margin-based approach, which considers the sales price, you can develop accurate business plans, make informed decisions, and maximize your profits.
