Markup (business)

Overview

Markup (or price spread) is the difference between the selling price of a good or service and its marginal cost. In economics, markups are the most direct way to measure market power: the extent to which a firm can influence the price at which it sells a product or service. A markup rule is the pricing practice of a producer with market power, where a firm charges a fixed mark-up over its marginal cost. Markup is often expressed as a percentage over the cost. A markup is added into the total cost incurred by the producer of a good or service in order to cover the costs of doing business and create a profit. The total cost reflects the total amount of both fixed and variable expenses to produce and distribute a product. Markup can be expressed as the fixed amount or as a percentage of the total cost or selling price. Retail markup is commonly calculated as the difference between wholesale price and retail price, as a percentage of wholesale. Other methods are also used. In labor economics, markdown refers to the ability of a firm to hold the price it pays for an input — usually labor — below the input's marginal product.

Derivation of the markup rule

The "markup rule" can be derived for a firm with price-setting power by maximizing the following expression for profit:

π = P ( Q ) ⋅ Q − C ( Q )

{\displaystyle \pi =P(Q)\cdot Q-C(Q)}

where

Q

{\displaystyle Q}

is quantity sold,

P ( Q )

{\displaystyle P(Q)}

is an inverse demand function, and thereby the price at which Q can be sold given the existing demand, and

C ( Q )

{\displaystyle C(Q)}

is the total cost of producing Q.

π

{\displaystyle \pi }

is economic profit. Profit maximization means that the derivative of

π

{\displaystyle \pi }

with respect to Q is set equal to 0:

P ′

Numerical example

The following is a numerical example of cost-plus pricing, where prices are determined by an exogenously set markup.

Cost × (1 + Markup) = Sale price or solved for Markup = (Sale price / Cost) − 1 or solved for Markup = (Sale price − Cost) / Cost Assume the sale price is $1.99 and the cost is $1.40 Markup = ($1.99 / 1.40) − 1 = 42% or Markup = ($1.99 − $1.40) / $1.40 = 42% To convert from markup to profit margin: Sale price − Cost = Sale price × Profit margin therefore Profit Margin = (Sale price − Cost) / Sale price Margin = 1 − (1 / (Markup + 1)) or Margin = Markup/(Markup + 1) Margin = 1 − (1 / (1 + 0.42)) = 29.5% or Margin = ($1.99 − $1.40) / $1.99 = 29.6% A different method of calculating markup is based on percentage of selling price. This method eliminates the two-step process above and incorporates the ability of discount pricing.

For instance cost of an item is 75.00 with 25% markup discount. 75.00/(1 − .25) = 75.00/.75 = 100.00 Comparing the two methods for discounting:

75.00 × (1 + .25) = 93.75 sale price with a 25% discount 93.75 × (1 − .25) = 93.75 × .75 = 70.31(25) cost was 75.00 and if sold for 70.31 both the markup and the discount is 25% 75.00 /(1 − .25) = 100.00 sale price with a 25% discount 100.00 × (1 − .25) = 100.00 × .75 = 75.00 cost was 75.00 and if sold for 75.00 both the profit margin and the discount is 25% These examples show the difference between adding a percentage of a number to a number and asking of what number is this number X% of. If the markup has to include more than just profit, such as overhead, it can be included as such:

cost × 1.25 = sale price or

cost / .75 = sale price

In macroeconomics

In macroeconomics, markups are an element of the wage-setting/price-setting model (WS/PS), which explains how the labor market (workers and firms negotiating wages) determines the overall changes in the price level (inflation) in the economy. From the firm's perspective, the pricing equation

P = ( 1 + μ ) W

{\displaystyle P=(1+\mu )W}

, where

μ

{\displaystyle \mu }

is the markup over costs, explains how businesses set the prices for the goods and services they sell.

P

{\displaystyle P}

is the average price level in the economy, and

W

{\displaystyle W}

are workers' wages. In a perfectly competitive market, firms can't charge a markup. But in reality, firms have some monopoly power, so they mark up prices to make a profit. Wages are determined by the wage setting relation

W = F ( u , z )

P

e

{\displaystyle W=F(u,z)P^{e}}

, where

u

{\displaystyle u}

See also

Administered prices Cost-plus pricing Marketing Markup rule Pricing

External links

To calculate official website markup Markup Calculator.net