Margin v. Markup

Margin is based on sales price. Markup is based on cost.

Many companies price products based on cost plus a target markup. For instance, say you have a jewelry store and your policy is to markup items by 57%. So, you buy a diamond ring for $1,000 and mark it up by $570 and sell it for $1,570. Your margin is $570, but the margin stated as a percentage of the sales price is 36.31%.

This method of establishing prices has limits though. For instance, different products will support different margins and markups. According to analysts at the Retail Owners Institute, the gross margin percent trends for jewelry businesses have stayed relatively consistent in recent years. Gross profit margin is calculated by subtracting the cost of goods from a business’s revenues. In 2013, the gross profit margin for jewelry stores was 43.5 percent. In 2017, it was 42.6 percent.  However, the average grocery store chain has an average profit margin of about 2.2%. This means that for every dollar of sale a grocery store has, they make 2.2 cents of profit.

That means that there is a very small markup and a slim margin, but the store makes up for the tiny margins on volume. Next time you are in the grocery store and you see an item that sells for $4.54, you will know that it cost the grocery store $4.44 and they added $0.10 to their cost:

Mathematically, the margin is the markup % / (1 + markup %). For our jewelry store example, the markup % was 57 which is 0.57, so the margin would be 0.57/1.57 or 0.363057325…which rounds to 0.3631 and converts to 36.31%.

Watch this video about calculating the retail gross profit margin.

You can view the transcript for “Retail Tip: Gross Profit Margin” here (opens in new window).

Cost-Plus Contracts

In a cost-plus contract, also known as a cost-reimbursement contract, the seller is paid for all of the expenses plus a specific agreed-upon amount for profit. This type of arrangement is often used in construction.

Here is a an overview of cost-plus contracts:

You can view the transcript for “Cost-Plus Contracts: Pros and Cons” here (opens in new window).

Because a cost-plus contract reimburses the contractor for direct costs and often indirect or overhead costs, all expenses must be supported by documentation of the contractor’s spending in the form of invoices or receipts. The indirect cost allocation will be specified in the contract, usually as a percentage of direct costs or some other measurable amount. The contract will also specify the “plus” amount above the reimbursed amount that is basically the company’s profit.

For example, assume Calligan Construction Corp. has a contract with Central City to build a million dollar bridge. The contract awards Calligan costs, not to exceed $30 million, plus 10%, and provides an incentive fee of $1 million if the project is completed within twelve months. So, total profit, if the project comes in on time and on budget, will be 10% of $30 million plus a $1 million incentive for a total of $4,000,000.

Calligan must submit dated receipts for all expenses, and the client will inspect the job site for quality to verify that specific components are completed to specification. The contract allows Calligan to incur direct costs such as materials, labor, and costs incurred to hire subcontractors. Calligan can also bill indirect, or overhead, costs, which include insurance, security, and safety at $50 per labor-hour and those costs do not have to be documented.

The contract also calls for progress billings using the percentage of completion method to account for profit and to submit bills to the client, and that provides specific percentages for billing.

For example, Calligan can bill for 20% of the full contract price once 20% of the materials are purchased, and the client verifies the concrete foundation is in place. At that point, Calligan sends an invoice for 20% of the $30-million contract and that same proportion of the firm’s profit, for a total billing of $6,000,000 in direct and indirect costs plus $600,000 in profit.

Companies often use cost-plus contracts when they outsource research and development (R&D) activities. Governments generally prefer cost-plus contracts because they can choose the most qualified contractors instead of the lowest bidder. For example, the U.S. government likely uses cost-plus contracts with military defense companies in order to develop new technologies for national defense. If you would like to find out more about government cost-plus contracting, visit https://www.acquisition.gov/far/subpart-16.3

Now, check your understanding of cost-plus pricing.