Why markup and gross margin are different percentages

A markup percentage compares the amount added above cost with that cost. A gross margin percentage compares gross profit with sales. The dollars can be identical while the percentages differ because they use different bases.

Before using a percentage in a price note or product comparison, write down what it is a percentage of. A label saying only profit percentage leaves that unanswered.

One sale, two percentages

Consider an invented retailer selling one stool for $80. The sale has no discount or return, and $80 excludes any sales tax. The stool's total recorded cost of goods sold is $60. Its gross profit on that sale is $20: $80 minus $60.

Markup: compare the $20 with cost

Divide $20 by $60. The result is one-third, or 33 and one-third percent. The retailer has added an amount equal to a third of the stated cost.

Gross margin: compare the $20 with sales

Divide $20 by $80. The result is one-quarter, or 25 percent. A quarter of the selling price remains after the stated cost of goods sold.

The sale has not changed between the calculations. The markup percentage is larger because the $20 is divided by the smaller base, $60.

OpenStax's markup explanation uses cost as the base. Its financial-accounting explanation of gross profit margin divides net sales less cost of goods sold by net sales.

A target needs the right calculation

Suppose a draft price sheet for this same stool says the target is a 25 percent gross margin. Its calculation takes the $60 cost and adds 25 percent of it: $15. The resulting price is $75.

The sheet has calculated a 25 percent markup and labeled it gross margin. At a $75 selling price, the $15 difference is 20 percent of sales: $15 divided by $75.

For the stated 25 percent gross-margin target, the $60 cost must occupy the other 75 percent of the selling price. Dividing $60 by 0.75 gives $80. That is why the original $80 sale meets this target while the $75 price does not.

On one sale, the mislabeled calculation leaves $15 of gross profit instead of $20. Whether the retailer can sell at either price is another question. The calculation translates a stated target; it does not supply demand or choose the target.

Check two unlabeled prices

Keep the same $60 cost. Someone has prepared two possible selling prices, $90 and $120. One is intended to give a 50 percent markup; the other a 50 percent gross margin. Match each price to its intended label before reading the answer.

At $90, the difference is $30. That is 50 percent of the $60 cost, so this is the 50 percent markup. It is only one-third of the $90 selling price, making the gross margin 33 and one-third percent.

At $120, the difference is $60. That is half the selling price, giving the 50 percent gross margin. It is also equal to the original cost, giving a 100 percent markup.

Write both rates beside each proposed price, then check whether the label matches the calculation. Before changing a price, settle which calculation the percentage is meant to describe.

Gross profit still has more costs to cover

The original $20 is gross profit on this product sale, not the retailer's net profit. Operating expenses and other company costs still need to be accounted for. Keep the cost definition attached to both percentages when comparing them.

Is this gross margin or contribution margin?

Gross margin and contribution margin can differ even when both use sales as their base. The question is which costs each has already subtracted.

Consider a separate invented retailer with $100,000 in net sales for one month. It buys and sells all its merchandise within that month, with no opening or closing inventory. The $60,000 cost of goods sold is entirely variable in this particular model. The retailer also incurs $10,000 of variable selling costs and $20,000 of fixed store operating costs. There are no other operating costs or income items; interest and income tax are outside the comparison.

• Gross profit: $100,000 sales less $60,000 merchandise cost of goods sold leaves $40,000. Dividing by sales gives a 40 percent gross margin.
• Contribution: $100,000 less both the $60,000 variable merchandise costs and $10,000 variable selling costs leaves $30,000. The contribution margin ratio is 30 percent.
• Operating profit: $30,000 contribution less $20,000 fixed operating costs leaves $10,000. Starting with $40,000 gross profit and subtracting the $10,000 selling costs and $20,000 fixed costs reaches the same result.

The $10,000 selling cost comes after gross profit but before contribution. The expense is counted once in either view. OpenStax’s contribution format subtracts variable costs first, leaving contribution to cover fixed costs and operating profit.

Cost of goods sold and selling expenses group costs by function. Variable and fixed describe how those costs behave as activity changes. The merchandise costs are variable because this invented case says so; that is not a rule that all cost of goods sold is variable. OpenStax’s manufacturing-cost comparison includes fixed production costs in cost of goods sold under one format.

Before comparing the reported percentages, ask whether selling costs have already been subtracted. This model supplies no cash collection dates or cost estimate for an additional order.

For the wider company picture, continue with revenue, profit and cash flow. To start the book, read the opening of Infinite Upside: Building Wealth With Room to Live.