Markup (business)

What is Markup?

•Markup is the determination of a retail selling price, based on some percentage increase in the wholesale cost; also called margin. For example, a 20% markup on an item wholesaling at $100 would be $20, resulting in a retail selling price of $120. Typical markups are 28% for cameras, 41% for dresses, 46% for costume jewelry, and so forth. The size of retail markups tends to vary inversely with the wholesale cost and with turnover (the rate at which a quantity is sold).
•Markup is the amount by which the price of a product exceeds the cost of producing and distributing the product.

Initial Markup
The initial markup is the average markup required on all products to cover the cost of all items, incidental expenses, and to obtain a reasonable profit. The initial dollar markup is expressed as a percentage. Initial Dollar Markup = (Operating Expenses + Price Reductions + Profit) / (Forecasted Net Sales + Price Reductions)
Example:
Forecasted Sales = $380
Operating Expenses = $140
Anticipated Price Reductions = $24
Expected Profit = $38
($140 + $24 + $38) / ($380 + $24) = 50%
Thus the initial dollar markup on the product should be 50%. Price reductions, or markdowns, are reductions in the retail selling price when the item cannot be sold at its intended price and erode into profit. Operating expenses are costs incurred in addition to the total product cost and can vary depending on the product and service being sold. In reviewing operating expenses, annualized figures should be used since any individual month may not properly reflect the expenses incurred over a full year.
Initial pricing of a product is an important step in merchandising. The Keystone Method doubles cost of an individual product to arrive at its selling price (2 x total product cost ). The Dollar Markup Method takes into account the total amount of operating expenses and desired profit. These are then broke down on a per product unit basis, which is then added on to the total product cost. This addition onto the total cost is the dollar markup. This dollar markup is either expressed as a percentage of the total cost per unit or the selling price.

Price determination
1 As a fixed Amount
Assume:
retail list price = $1.99 and the product cost is $1.40
MARKUP = price − cost
1.99 − 1.40 = 0.59

assume the actual selling price was $1.60
MARKDOWN = List price − selling price
1.99 − 1.60 = 0.39

INITIAL MARKUP = list price − cost
1.99 − 1.40 = 0.59

MAINTAINED MARKUP = sale price - cost
1.60 − 1.40 = 0.20
2 As a percentage
INITIAL MARKUP % = initial markup / sale price
0.59 / 1.99 = 29%

MAINTAINED MARKUP % = maintained markup / sale price
0.20 / 1.60 = 13%

MARKUP % ON COST = markup / cost
0.59 / 1.40 = 42%

MARKUP % ON PRICE = markup / price
0.59 / 1.99 = 29%

To convert from markup on price to markup on cost:
MARKUP ON COST = markup % on price / (1 − markup % on price)
0.29 / (1 − 0.29) = 42%

To convert from markup on cost to markup on price:
MARKUP ON PRICE = markup % on cost / (1 + markup % on cost)
0.42 / (1 + 0.42 ) = 0.29

PRICE = cost / (1 − markup % on price)
1.40 / (1 − 0.29) = 1.99

COST = price / (1 + markup % on cost)
1.99 / (1 + 0.42) = 1.40

PRICE = markup / markup % on price
0.59 / 0.29 = 1.99
Cost-Plus Pricing with Elasticity Considerations
One of the most common pricing methods used by firms is cost-plus pricing. In spite of its ubiquity, economists rightly point out that it has serious methodological flaws. It takes no account of demand. There is no way of determining if potential customers will purchase the product at the calculated price. To compensate for this, some economists have tried to apply the principles of price elasticity to cost-plus pricing.
We know that:
MR = P + ((dP / dQ) * Q)
where:
MR = marginal revenue
P = price
(dP / dQ) = the derivative of price with respect to quantity
Q = quantity
Since we know that a profit maximizer, sets quantity at the point that marginal revenue is equal to marginal cost (MR = MC), the formula can be written as:
MC = P + ((dP / dQ) * Q)
Dividing by P and rearranging yields:
MC / P = 1 +((dP / dQ) * (Q / P))
And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:
(P / MC) = (1 / (1 - (1/E)))
where:
(P / MC) = markup on marginal costs
E = price elasticity of demand
In the extreme case where elasticity is infinite:
(P / MC) = (1 / (1 - (1/999999999999999))
(P / MC) = (1 / 1)
Price is equal to marginal cost. There is no markup. At the other extreme, where elasticity is equal to unity:
(P /MC) = (1 / (1 - (1/1)))
(P / MC) = (1 / 0)
The markup is infinite. Most business people do not do marginal cost calculations, but one can arrive at the same conclusion using average variable costs (AVC):
(P / AVC) = (1 / (1 - (1/E)))
Technically, AVC is a valid substitute for MC only in situations of constant returns to scale (LVC = LAC = LMC).
When business people choose the markup that they apply to costs when doing cost-plus pricing, they should be, and often are, considering the price elasticity of demand, whether consciously or not.