Were your dealership’s actual profits last year less than the profits you expected? The answer for this may simply be a result of a mistaken accounting computation.
Hot tub dealers—even highly successful ones—sometimes make critical errors based on a common misunderstanding of financial concepts. Unfortunately, mistakes growing out of hazily-recalled (or never learned) rules of finance often have a significant impact on the bottom line.
One of the most common missteps in the retail accounting environment involves the concept of markup vs. profit margin. Many spa dealers are incredible business people, but are not necessarily trained accountants, and sometimes assume markup and margin are essentially interchangeable terms. Or dealers may mistakenly presume that both concepts ultimately lead to the same destination. Unfortunately, that kind of misapprehension can be costly.
Not understanding the difference between markup and margin will either overprice your product or reduce your expected revenue dollars.
Jim Sueppel, Vice President of Sales at Bullfrog Spas, has advised spa dealerships for many years and has dealt with this issue many times. Sueppel says the distinction between markup and margin is a key one. “Not understanding the difference between markup and margin will either overprice your product or reduce your expected revenue dollars,” he said.
Those two outcomes are guaranteed to send a shiver down any business owner’s spine. To help prevent that from occurring, we’ve outlined the core distinction between markup and margin, and what every hot tub retailer needs to consider when weighing the two approaches.
Markup vs. Margin: The Basics
To better illuminate the essential difference between markup and margin, let’s quickly define our terms. Profit margin addresses the profit as it relates to selling price while markup addresses the profit margin as it relates to cost. According to Investopedia, “The two concepts are telling different sides of the same story.”
Profit margin = Difference between sales price and cost / Sales price
Product markup = Difference between sales price and cost / Cost
So both markup and profit margin look at the difference between what it costs a business to sell a product and the actual sales price. For example, if a spa costs a dealer $6,000—and is later sold for $10,000—the difference is $4,000. But the two concepts look at this difference as it relates to two separate numbers, either the selling price ($10,000) or the cost ($6,000). So in this example, the profit margin would be 40%, or $4,000/$10,000. The markup, on the other hand, would be about 67%, or $4,000/$6,000.
Example profit margin = ($10,000 – $6,000) / $10,000 = 40%
Example product markup = ($10,000 – $6,000) / $6,000 = 67%
This subtle distinction can create much confusion for retailers and point-of-sale employees. In either case, the retailer is still earning an extra $4,000, but the markup and margin each render a different percentage. And when the wrong percentage is used to determine expected earnings or set future pricing, a business runs the risk of making misinformed decisions that could ultimately put them out of business.
What a Mistake Can Mean
If a dealer has a hot tub that costs him $6,000 and he strives to make a 40% profit margin, that dealer should not simply multiply the cost by 1.4 or 40% to determine price. Why? Because he’ll end up $1,600 below expected earnings every sale. And for a dealer selling 100 spas a year, that adds up to a $160,000 shortfall. In other words, if you want to ensure your business makes a profit margin of 40%, you’ll need to mark up the sales price on your hot tubs by 67%.
Incorrect sales price calculation for 40% margin:
Cost x (1 + 40%) = $6,000 x 1.4 = $8,400
Correct sales price calculation for 40% margin:
Cost x (1 + 67%) = $6,000 x 1.67 = $10,000
Difference between expected and actual earnings = $10,000 – $8,400 = $1,600
It’s critical to understand that markup is not a direct expression of the profit gained from each sale. Margin is always going to be a percentage of markup, and therefore a smaller number. When a dealer marks up a spa, only a part of that markup is his actual profit.
Many spa dealers assume markup and margin are essentially interchangeable terms ... Unfortunately, that kind of misapprehension can be costly.
Though markup is often used by dealers and their staff to set prices, it often overstates the profitability of the sales transaction. Mathematically, markup is always going to be larger than the gross margin. So when retailers mistake markup for margin, they think they’re making a larger profit than they actually are. By figuring sales prices based on margin instead of markup, dealers can ensure their expected profitability is realized.
Considerations when Working with Markup and Margin
So how does this work in the real world of product or service retailing? Both concepts can be used to derive an appropriate sales price, so it’s important to consider all relevant variables—and your own comfort level with each method—when making a decision.
What other factors should retailers consider when setting pricing with markup or margin calculations? In Sueppel’s opinion, business owners need to focus on three things: market conditions, customer demographics, fixed/variable overhead costs.
Looking at market conditions helps a retailer determine which price points other businesses are focused on—something that is crucial when attempting to price products competitively. A rigorous look at customer demographics will also insure products are priced appropriately enough to hit expected volume targets.
As I’m sure your accountant has explained, examining overhead costs is imperative to finding a profit margin that serves as a goal for each product sale. Entrepreneur’s Small Business Encyclopedia defines overhead costs as “The indirect costs or fixed expenses of operating a business (i.e., the costs not directly related to the manufacture of a product or delivery of a service) that range from rent to administrative costs to marketing costs.” In other words, overhead costs, which can be either fixed or variable, include all non-labor expenses incurred while operating a business.
When asked about a preference for one method or the other, Sueppel said he often focuses on margin when working with dealers, using markup as a method to help them achieve their overall margin objective. The ultimate goal is to help business owners arrive at the desired margin they want to achieve, then incorporate markup formulas to arrive at that profit margin.
Essentially, Sueppel recommends retailers first determine the proper margin, then employ markup as the tool to make it happen.
Another reason Sueppel said he prefers employing margin: It more closely relates to a retailer’s financials. Income and sales information on financial reports are expressed in the same mathematical language, more or less, as margin calculations. This added familiarity is a plus for some retailers who prefer working with margin.
From Margin to Markup to Sales Price
Imagine your dealership is aiming to make a 40% profit margin. How would you go about determining what your markup and sales price need to be? The markup can always be calculated using the following formula:
Markup = Margin / (1 – Margin)
To achieve a 40% margin, the markup should be 67% (which agrees with our calculations above). To find the sale price, the cost of the spa to the dealer would then be multiplied by 1.67. So if a hot tub costs the dealer $6,000, the selling price should be marked up to $10,000 (which also agrees with numbers above).
Let’s look at a new example. Your store is looking to make a 30% margin. The markup is going to be 43%, with a multiplier of 1.43. On a hot tub that costs the dealer $6,500, the selling price target should be $6,500 multiplied by 1.43, or $9,295.
Here’s an example Margin vs Markup table that your dealership can use to accurately calculate product sales prices so that actual earnings will equal or surpass those expected.
|Desired Margin %||Markup %||Markup Multiplier|
It’s not surprising that so many people confuse markup and margin, given the overlap involved. Yet understanding the core distinction between these concepts—and the mathematical nuances involved—is critically important for spa retailers aiming to establish accurate pricing.
There are two actionable steps a dealer can take after reading this article to avoid confusion when working with markup and margin rates. First, download a Margin vs Markup table that lists markup rates and corresponding cost multipliers to determine sales price based on a desired profit margin. And second, train your sales staff about these differences, which can include showing them how to use the table.
Put in practice, you’ll begin to see how targeting the margin rather than the markup can work to increase your dealership’s bottom line by an additional 2 or 3%.