Small businesses need to price their product or service so that it turns a profit but is still competitive in their market and appealing to consumers. A pricing markup achieves this by adding a percentage to a product's costs and setting final prices that guarantee a profit with each sale.
Here's how to determine how much to mark up your product or service and how to best leverage this pricing strategy for your small business.
A pricing markup vs. profit margin
While both a profit margin and pricing markup use revenue and cost as part of their calculations, these indicators display different aspects of a transaction.
A profit margin represents the sales revenue after accounting for the cost of goods sold. For example, if your company offers a $100 product that costs $70 to make, your profit margin is $30, or 30%.
A pricing markup refers to the percentage added to a product's cost to determine its final selling price. Using the previous example, your markup would be $30. However, expressed as a percentage of costs, the markup percentage would be 42.9% ($100 in revenue - $70 in costs) / $70 costs x 100).
Each of these metrics can be used to gain different insights depending on your business goals. For example, if your business wants to identify its ideal product price, using markups can help you find that sweet spot. However, if you want to determine the profitability of your business or its products, the profit margin can give you a more accurate picture.
[Read more: 5 Pricing Models and What They Mean]
How to calculate your markup
When determining what to charge for your product or service, you should account for what price is attractive to your target audience yet high enough to help you turn a profit.
To find your ideal markup price, start with the following formula:
(Sales price - Unit cost) / Unit cost x 100 = Markup percentage
First, calculate the markup by subtracting the unit cost from the sales price. Then you'll divide the markup by the unit cost and multiply that number by 100 to convert it to a percentage.
As a rule of thumb, your markup should always be higher than your profit margin — otherwise, you're in jeopardy of a financial loss.
Figuring out how to distribute your markup on a price-per-unit basis requires further calculations. Use a markup calculator like the Omni calculator to help simplify the process and do the math for you. Be sure to also account for internal labor costs or vendor fees that affect your profits after calculating your markup.
[Read more: What Businesses Must Know to Establish an Effective Pricing Strategy Today]
If you think it's time to change your pricing, test different price points or survey customers about your product/service's perceived value.
Benefits of markup pricing
As a small business owner, using the markup pricing structure to sell your products or services offers several key benefits, including:
- Increased profitability: With markup pricing, profit margins are built into every sale, ensuring each transaction contributes to your bottom line.
- Flexibility: This strategy allows you to adjust your pricing based on market fluctuations rather than being locked into a specific price.
- Simplified pricing strategy: This approach simplifies the pricing process by using existing business data instead of relying on extensive calculations and market research, helping to set financially viable prices for your business.
- Assurance that your expenses are covered: Markup pricing accounts for overhead and product costs, ensuring that your expenses are covered and mitigating risk.
When to use markup pricing
There are plenty of times when a small business may use markup pricing, including the following:
- Setting product prices: Markup pricing makes setting competitive and fair prices easy while ensuring profitability.
- Developing an initial pricing strategy: This strategy is ideal for setting your initial prices as a new business. Then as you expand, you can revisit your strategy to accommodate specific goals and needs.
- Achieving business goals: Markups ensure that your business consistently earns a profit, enabling you to set realistic and achievable financial goals. It helps to cover expenses and production costs, preventing additional financial burdens that could affect your bottom line.
When to revisit your pricing strategy
Adjust your markup as the market changes to stay competitive. Setting prices much higher than your competitors may drive consumers to other businesses, while setting them too low could hurt your profitability.
When there's a supply chain issue that requires you to raise your markup, be transparent with your customers about why your prices are increasing. Most consumers have little insight into what it takes to manufacture a product, so the more information you provide, the better.
If you think it's time to change your pricing, test different price points or survey customers about your product/service's perceived value. This can provide valuable data to guide your pricing strategy and help determine your ideal price point.
[Read more: What Is AI Price Optimization?]
This article was originally written by Emily Heaslip.
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