Capital Expenditure
Capital expenditure occurs when a business gets a long-term advantage due to that expenditure.
It is usually incurred for the accusation of an asset. These expenditures do not occur in the regular
day to day transactions of the business.
Common examples




Purchase of furniture, office building etc.
Purchase of additional furniture or machinery
Expenditure incurred in connection with the purchase of a fixed asset. For example, carriage
paid of machinery purchased.
Purchase of patent right, copy rights etc.
Revenue Expenditure
Expenditure which is not for increasing the value of fixed assets, but for running the business on a
day to day basis, is known as revenue expenditure.
Difference between Capital and Revenue
expenditure
Buy a car is capital expenditure because its benefit to the business will be spread over a long time.
Fuel cost for running this care is revenue expenditure and it will be used up in a few days and does
not add to the value of the fixed asset.
Capital receipts
Capital receipts consist of


additional payments made to the business either by the owner or shareholder of the
business; or
from the sale of fixed assets of the business.
Revenue receipts


Any receipt in the normal running or through the day to day transactions of the business is
categorized as Revenue receipt.
Sales receipts of the business are revenue receipts.
What can be classified as Revenue
receipts & revenue expenditure?
Revenue receipts
Revenue expenditure
Subscription
Entertainment expenses
Competition fees
Rent of club premises
Income from Socials
Competition prizes
Rental fees
Cost of fund raising projects
Donation (if not capitalized)
Repairs and maintenance of property
Proceeds from fund-raising projects (not
capitalized)
Sundry expenses to run the activities of club
Staff wages
Interest on bank deposits
Postage & Stationery expenses
Receipts from sale of food in club restaurant
Electricity and water expenses
Depreciation
What can be classified as Capital
receipts and Capital Expenditure?
Capital receipts
Capital Expenditure
Legacies
Purchase of fixed assets
Building funds
Entrance fees
Life membership fees (if capitalized)
Trial Balance
Trial Balance is a statement prepared with the debit and credit balances of ledger
accounts to verify the arithmetical accuracy of the book.
The Trial Balance checks the equality of debits and credits in the ledger by listing each account
along with its ending balance.
Accounts to be placed Accounts to be placed
on the debit side
on the credit side
Assets
Expenses
Drawings
Liabilities
Capital
Revenue
Errors revealed by Trial Balance
Errors in calculation
Any calculation mistake, especially totaling mistake or balancing mistake will be revealed by Trial
Balance as both the side will not match.
Errors of omission of one entry
If by mistake only one entry is made for a transaction, Trial Balance will not balance.
Posting to the wrong side of an account
In case any entry is made on the wrong side of the account, it will be revealed by the Trial Balance.
For example, Credit sale of $100 was debited to Sales account.
Posting of wrong amount
When two different amounts are entered for the same entry, both the sides of the Trial balance will
not match. For example, Credit sales of $123 to James. James was debited with $123 but Sales was
wrongly credited as $132.
Limitation of Trial Balance
Though Trial Balance is prepared to check the arithmetical accuracy of double entries, there are still
some mistakes which cannot be identified by Trial Balance. These are:
Errors of omission
These are errors where the transactions are totally omitted. They are neither recorded in the Journal
or Ledge and thus do not appear in the Trial Balance.
Errors of commission
This means that a wrong amount is entered from the very starting in the Journal or Ledger and thus
a Trial Balance based on this amount may not show any mistake at all.
Errors of principle
These errors occur when the classification of accounts is wrongly done. For example, revenue
expenditure may be considered as capital expenditure. Repairs of machinery $200 were debited to
Machinery account whereas it should have been debited to ‘Repairs of machinery account’.
A complete reversal of entries
A complete reversal of entries cannot be revealed by Trial Balance. This is when entries have been
made to both the sides and thus there is no arithmetical mistake. Good sold to Raman were entered
as Sales debited and Raman Credited, whereas, it should have been vice versa.
Compensating errors
These errors are those which cancel themselves because the same error is committed on both
sides. For example, Purchases were debited by $100 more and at the same time Sales were also
credited by $100. This will neutralize the effect of both the entries.
Bank Reconciliation Statement
Bank reconciliation statement is a statement prepared mainly to
reconcile the difference between the ‘Bank Balance’ shown by the
Cashbook and Bank statement.
Usually, the trader maintains a Bank Column in the Cash book and does all the entries related to the
bank. At the end of the month, when he receives a Bank statement from the bank he might find
some differences between bank balance shown by Bank Statement and his Cash book. These
differences might arise due to many reasons. In order to reconcile and tally the differences, he will
prepare a Bank Reconciliation Statement.
Now the question arises,
What are the reasons for the difference in
Bank Statement and Cash Book?
These can be summarized as follows:









Cheque issued by the trader but the customer has not yet presented it to the bank for
encashment.
This will show a less bank balance in the trader’s Cash book as he has already issued the
cheque, but the bank will not reduce the amount until the cheque is presented to it.
Cheque received by the trader was deposited into the bank for collection but the bank did not
realize the funds and did not credit the Trader’s account.
Trader deposited a cheque into the bank but it was dishonored by the bank. The reason may
be the customer does not have sufficient cash in his bank account.
Bank pays interest to the trader on his deposit but the trader will not come to know this till he
receives the Bank statement and thus his cash book will show less balance as compared to
the bank statement.
The bank might receive direct payment of interest or dividends on behalf of the trader for any
investments made by the trader. The trader will not come to know the details till he gets a
bank statement and thus his Cash book will be understated.
The bank might charge transaction fees or Bank charges or interest on any overdraft which
the trader will only know when he receives the bank statement.
A customer or debtor might directly pay into the trader’s bank account and the trader might
not be aware of this.
A Bank may pay bills, insurance premiums or some payment based on the standing
instruction of the trader. The details of these transactions will only be available to the trader
once he receives the bank statement.
A bank reconciliation statement can be prepared by taking the balance either as per cash book or as
per pass book as a starting point.
If the statement is started with the balance as per bank column of the cash book, the answer arrived
at the end will be balanced as per pass book.
Alternatively, if the statement is started with the balance as per pass book, the answer arrived at in
the end will be the balance as per cash book.
A debit balance as per cash book shows the amount of the money in the bank, whereas, a credit
balance means that the business has taken an overdraft. In the same way, a credit balance as per
pass book shows a positive bank balance whereas debit balance as per pass book shows an
Overdraft.
Method 1: Bank reconciliation statement by
the Debit balance of Bank Column of Cash
Book.
Method 2: Bank reconciliation statement by
Credit balance as Cash Book (Overdraft).
Method 3: Bank reconciliation statement by
Credit balance as per Bank Statement.
Method 4: Bank reconciliation statement by
Debit balance as per Bank Statement
(Overdraft).
What are Non Profit Organizations?
Sole trader, Partnership and Limited companies have Profit as their main objective. However, Clubs,
societies and associations does not only exist to make profit. They may be formed to promote
cultural and recreational interest. Thus their final accounts are different from those organizations
which solely exist to earn profit.
What is Single entry system?
According to Carter ‘Single Entry system is a method or a variety of methods, employed for the
recording of transactions, which ignore the two-fold aspect and consequently fails to provide the
businessman with the information necessary for him to be able to ascertain the position’
Features





Usually, only Personal Accounts are prepared.
Cash Book records both business and personal transactions.
Too much dependence on Source documents to ascertain final status of the business.
There is no standard procedure in maintaining records and vary from firm to firm.
Usually found in a sole trader or a partnership firm.
Advantages




It is easy and simple method of recording business transactions.
Less expensive as qualified staff is not required.
Suitable for small businesses where cash transactions occur and very few assets and
liabilities exists.
Flexible method as there are no set procedures and principles followed.
Disadvantages




No double entry, thus Trial Balance cannot be prepared to check the arithmetical accuracy of
books of accounts.
Information related to assets and liabilities cannot be reliable because respective accounts
have not been maintained.
True Profit and Loss cannot be ascertained.
Comparison of accounting performance with previous year or other firms not possible as any
standard principle or procedure is not followed.
Finding Profit or Loss from
Incomplete Records
Two methods to find out the Profit or loss from incomplete records

Statement of Affairs methods

Conversion into Double entry method
FIRST METHOD-Statement of Affairs
method
In this method the capital of the business in the beginning of the period is compared with its capital
at the end of the period. The difference represents profit or loss during the period.


If the closing capital is more than opening capital, it shows a profit for the business.
If the closing capital is less than opening capital, the business had a loss.
Opening balance of capital can be ascertained by preparing an ‘Opening Statement of Affairs’.
Statement of Affairs is quite similar to a Balance Sheet (NOT exactly).
Click here to download FORMAT-STATEMENT OF AFFAIRS (pdf)
The difference between the assets and liabilities of the business is the OPENING CAPITAL of the
business.
Capital = Assets – Liabilities
Similarly, prepare a ‘Closing Statement of Affairs’ to get the CLOSING CAPITAL of the business.
Adjustments in the Closing Capital


Drawings are added to the Closing Capital.
Additional Capital is deducted from the Closing Capital
Once the Closing Capital is calculated, the Opening Capital is deducted from it.


If Closing Capital is MORE than Opening Capital, it is a PROFIT.
If Closing Capital is LESS than Opening Capital, it is a LOSS.
Net Formula
Profit = Closing Capital + Drawings – Additional Capital – Opening Capital
Some Adjustment
The profit achieved from this method is not the final net profit.
Adjustments which result in increase in expenses or losses must be deducted from the Profit figure
to get the accurate net profit. These are

Depreciation




Outstanding expenses
Interest on Capital
Interest on Loans
Provisions for Doubtful debts
Adjustments which result in increase in incomes and gains must be added to the Profit figure. These
are


Prepaid expenses
Interest on investments
At the end a final Statement of Affairs is prepared after these adjustments are done.
Note: When the Opening Capital is more than the Closing Capital, it shows a LOSS.
In this case, the adjustments which result in an increase in expense are added to the loss amount
and the adjustments which result in increase income are deducted.
SECOND METHOD-Conversion into
Double entry methods by finding
missing information
Following steps have to be taken



Opening Capital is calculated by preparing an Opening Statement of Affairs.
Cash Book is updated by adding all the missing information. Opening and closing cash
balance has to be ascertained.
Total Debtors Account has to be prepared.
CLICK HERE TO DOWNLOAD FORMAT-TOTAL DEBTORS ACCOUNT (pdf)

Total Creditors Account has to be prepared.
CLICK HERE TO DOWNLOAD FORMAT-TOTAL CREDITORS ACCOUNT (pdf)

Final Accounts are prepared i.e. Trading and Profit & Loss Account and Balance Sheet from
the information collected in Steps 1 to 4.
Finding Missing information using
Accounting Ratios
If Gross Profit is expressed as a percentage of the cost
price. In order words, Mark up is given.
Mark up = Gross Profit/Cost price
Example
Calculate the Gross profit if the Sales = $54,000, Mark up is 20%.
Goods costing $100 has been sold at $120.
If sales are $54000 then the Gross Profit = 20/120 * 54,000= $9000
If Gross Profit is expressed as a percentage of selling
price i.e. Gross profit margin.
Gross profit margin = Gross profit/ Selling price
If Stock turnover ratio is stated
Stock turnover is the rate at which the stock of goods is sold.
Stock turnover= Cost of goods sold/ Average stock
Example
Cost of goods sold= $3000
Opening Stock= $400
Closing Stock = $600
$400+$600
Average Stock =
= $500
2
Therefore, Stock turnover = $3000/$500 = 6 times per year or 2 months
The final accounts of a non-profit organization includes of
1.
2.
3.
4.
Trading Accounts (only if there is a restaurant or canteen)
Receipts and Payments Accounts
Income and Expenditure Account
Balance Sheet
5. Receipts and Payments
Account
6. Format for Receipts and Payments Account
Receipt and Payments Account
for the year ended 31 December 2010
Dr.
Cr.
Receipts
Balance b/d (Opening
balance)
Amount
Payments
Amount
XXXX All cash payments
xxxxx
All Cash receipts
XXXX
XXXX
Balance c/f (closing
balance)
XXXXX
7.
8.
Cash (beginning)
+ all cash receipts (revenue receipts and capital receipts) All Cash payments (revenue expenditure and capital
expenditure)
Cash (end)
Features




Similar to Cash Book
Cash receipts are on Debit side and Cash payments are on Credit side
All cash receipts and payments are recorded irrespective of their relation to current year.
There is an opening balance and a closing balance
xxxxx
XXXXX
Manufacturing Account
It is prepared to ascertain the cost of goods manufactured during an accounting period.
This account is prepared only by a business which is manufacturing goods.
Items appearing on the debit side
Stock
It is of three types:



Raw materials: raw material purchased but not yet consumed.
Work in progress: Goods which are still semi-finished.
Finished goods: Completed goods but yet unsold and laying in warehouse waiting to be sold.
Raw materials consumed during the period is calculated as follows
Opening Stock of Raw material
xxxx
Add: Purchase of Raw Materials
xxxx
xxxx
Less: Closing Stock of Raw Materials
xxxx
xxxx
Carriage Inwards
All expenses incurred for bringing the raw materials to the factory e.g. custom duty, excise etc.
Factory overheads
All indirect expenses related to the operation of factory such as



indirect materials (not direct raw material used in manufacturing) e.g. lubricants for
machinery
indirect labour (not direct labour) e.g. supervisor wages
indirect expenses such as factory insurance, rent, depreciation of machinery
Items appearing on Credit Side
Sale of Scrap
Scrap is the waste products during the process of manufacturing. Money realized by their sales (an
income!)
Any Work in Progress
Any unfinished goods left with the manufacturer at the end of the accounting period.
How to calculate the Cost of Production?
Total Debit Side – Total Credit Side
This balance is known as the Cost of Production
It is transferred to the Trading Account.
Format of Manufacturing Account
Income and Expenditure Account
for the year ended 31 December 2010
Dr.
Cr.
Expenditure
Revenue expenses only
Amount
Income
XXXX Trading Profit (if any)
Revenue Incomes only
Amount
XXXX
XXXX
Surplus
XXXX Deficit
(when income is more than expenditure)
(when expenditure is more than
income)
XXXXX
Income and Expenditure Account
Step in constructing a Income and
Expenditure Account
1.
2.
3.
4.
5.
6.
xxxxx
If there is a Trading Profit put it on the Credit side.
Put all the revenue incomes on the Credit side.
Put all the revenue expenses on Debit side.
Balance both the sides.
If the Income side is more than the expenditure side then we get a SURPLUS.
If the Expenditure side is more than the income side we get a DEFICIT.
XXXXX
Note



Only revenue receipts and expense are posted in this account
Only incomes and expenses pertaining that particular year are recorded. Incomes and
expenses pertaining to previous year or future year are adjusted for.
Distinction between Receipts and
Payments Accounts and Income and
Expenditure Accounts
Receipts and Payments Accounts
Income and Expenditure Account
Similar to a cash account showing total cash
receipts and total cash payments during a
particular period.
Similar to Profit and Loss account showing
incomes and expenses arising during a particular
period.
There is an opening balance representing cash or
bank balance
No opening balance
Records all cash receipts and cash payments
whether capital or revenue in nature.
Only records income and expenses of revenue
nature
Records all receipts and payments irrespective of
their relation to this year, previous year or next
year.
Records only receipts and expenses relating to
the current year.
At the end of the year excess of receipts over
payments shows a positive cash balance
whereas a negative balance signifies an overdraft
Excess of income over expenditure represents
net income whereas vice versa represents a net
loss.
Adjustments in Final Accounts
(Non-trading concerns)
Subscription Account
Subscriptions are paid by members as charges for using the facilities of a club or society for a
particular period of time. Usually it is on a yearly basis.
Receipt and Payment account records the actual subscription received. It may pertain to any year.
However, In order to post it to the Income and Expenditure Account adjustments have to be made to
the subscription as only subscription pertaining to that particular year is recorded in I/E account.
How to calculate e.g. for Year 2009
Total subscription received
1000
Less Subscription in arrears, at the starting of the year
200
Add Subscription received in advance for 2009, in previous years.
100
Add Subscription in arrears, at the end of 2009
300
Less Subscription received in advance (for next year), at the end of the
year
100
Subscription revenue for Year 2010
1100
You can also make a separate Subscription
Account and then post the final
subscription amount in the Income and
Expenditure Account
Dr.
Subscription Account
Amount
Subscription in arrears (b/d)
Cr.
Amount
XXXX
Subscription received in advance b/d
(collected during previous year)
XXXX
Subscription received during current
year (from Income & Expenditure
Account)
XXXX
Total Cash received as subscription
during the current year
XXXX
Subscription in advance c/d
XXXX
Subscription in arrears c/d
XXXX
(not collected during the previous year)
(collected for subsequent year)
(not yet collected for current year)
XXXX
Subscription in arrears b/d
XXXX
XXXX
Subscription in advance b/d
XXXX
What is Single entry system?
According to Carter ‘Single Entry system is a method or a variety of methods, employed for the
recording of transactions, which ignore the two-fold aspect and consequently fails to provide the
businessman with the information necessary for him to be able to ascertain the position’
Features





Usually, only Personal Accounts are prepared.
Cash Book records both business and personal transactions.
Too much dependence on Source documents to ascertain final status of the business.
There is no standard procedure in maintaining records and vary from firm to firm.
Usually found in a sole trader or a partnership firm.
Advantages




It is easy and simple method of recording business transactions.
Less expensive as qualified staff is not required.
Suitable for small businesses where cash transactions occur and very few assets and
liabilities exists.
Flexible method as there are no set procedures and principles followed.
Disadvantages




No double entry, thus Trial Balance cannot be prepared to check the arithmetical accuracy of
books of accounts.
Information related to assets and liabilities cannot be reliable because respective accounts
have not been maintained.
True Profit and Loss cannot be ascertained.
Comparison of accounting performance with previous year or other firms not possible as any
standard principle or procedure is not followed.
Finding Profit or Loss from
Incomplete Records
Two methods to find out the Profit or loss from incomplete records


Statement of Affairs methods
Conversion into Double entry method
FIRST METHOD-Statement of Affairs
method
In this method the capital of the business in the beginning of the period is compared with its capital
at the end of the period. The difference represents profit or loss during the period.


If the closing capital is more than opening capital, it shows a profit for the business.
If the closing capital is less than opening capital, the business had a loss.
Opening balance of capital can be ascertained by preparing an ‘Opening Statement of Affairs’.
Statement of Affairs is quite similar to a Balance Sheet (NOT exactly).
Click here to download FORMAT-STATEMENT OF AFFAIRS (pdf)
The difference between the assets and liabilities of the business is the OPENING CAPITAL of the
business.
Capital = Assets – Liabilities
Similarly, prepare a ‘Closing Statement of Affairs’ to get the CLOSING CAPITAL of the business.
Adjustments in the Closing Capital


Drawings are added to the Closing Capital.
Additional Capital is deducted from the Closing Capital
Once the Closing Capital is calculated, the Opening Capital is deducted from it.


If Closing Capital is MORE than Opening Capital, it is a PROFIT.
If Closing Capital is LESS than Opening Capital, it is a LOSS.
Net Formula
Profit = Closing Capital + Drawings – Additional Capital – Opening Capital
Some Adjustment
The profit achieved from this method is not the final net profit.
Adjustments which result in increase in expenses or losses must be deducted from the Profit figure
to get the accurate net profit. These are





Depreciation
Outstanding expenses
Interest on Capital
Interest on Loans
Provisions for Doubtful debts
Adjustments which result in increase in incomes and gains must be added to the Profit figure. These
are


Prepaid expenses
Interest on investments
At the end a final Statement of Affairs is prepared after these adjustments are done.
Note: When the Opening Capital is more than the Closing Capital, it shows a LOSS.
In this case, the adjustments which result in an increase in expense are added to the loss amount
and the adjustments which result in increase income are deducted.
SECOND METHOD-Conversion into
Double entry methods by finding
missing information
Following steps have to be taken



Opening Capital is calculated by preparing an Opening Statement of Affairs.
Cash Book is updated by adding all the missing information. Opening and closing cash
balance has to be ascertained.
Total Debtors Account has to be prepared.
CLICK HERE TO DOWNLOAD FORMAT-TOTAL DEBTORS ACCOUNT (pdf)

Total Creditors Account has to be prepared.
CLICK HERE TO DOWNLOAD FORMAT-TOTAL CREDITORS ACCOUNT (pdf)

Final Accounts are prepared i.e. Trading and Profit & Loss Account and Balance Sheet from
the information collected in Steps 1 to 4.
Finding Missing information using
Accounting Ratios
If Gross Profit is expressed as a percentage of the cost
price. In order words, Mark up is given.
Mark up = Gross Profit/Cost price
Example
Calculate the Gross profit if the Sales = $54,000, Mark up is 20%.
Goods costing $100 has been sold at $120.
If sales are $54000 then the Gross Profit = 20/120 * 54,000= $9000
If Gross Profit is expressed as a percentage of selling
price i.e. Gross profit margin.
Gross profit margin = Gross profit/ Selling price
If Stock turnover ratio is stated
Stock turnover is the rate at which the stock of goods is sold.
Stock turnover= Cost of goods sold/ Average stock
Example
Cost of goods sold= $3000
Opening Stock= $400
Closing Stock = $600
$400+$600
Average Stock =
= $500
2
Therefore, Stock turnover = $3000/$500 = 6 times per year or 2 months
In trading, the trader buys goods hoping to sell for more money than has paid.
The cost price is the price at which he pays for the goods and the selling price at which he sells.
If the selling price is greater than the cost price, a PROFIT is made. If selling price is lesser than the cost
price then a LOSS is incurred.
Mark Up And Mark Down
Mark Up Is the profit expressed as a percentage of the COST
PRICE.
Without this profit/mark up on cost price, the business cannot
cover its business.
Mark Down is the loss expressed as a percentage of the COST
PRICE.
Mark Down is due to the following reasons:
To encourage purchases in bulk, to dispose off old, damaged or
obsolete stocks and to close a line of merchandise.
Formula:
Mark up = Selling price –Cost price x 100%
Cost Price
Margin
Is the profit expressed as a percentage of the SELLING PRICE
ILLUSTRATION 1
Question on Mark Up
A trader bought a piece of furniture for $2000 and sells it for
$2,500.
(a) What is his mark up?
Later, he reduced the selling price ($2,000) by 5%.
(b) What is the revised mark up did he make?
Answer:
Profit = Selling price-Cost price
=$2,500-$2,000
=$500
(a)Mark up = Selling price –Cost price x 100%
Cost Price
=$500/$2,000 x 100%
=25%
(b) The revised Marked Up:
=Reduced Selling price =$2,500×0.95=$2,375
New Profit = Reduced Selling price-Cost price
= $2,375-$2,000
= $375
Revised Marked Up = $375/$2,000 x 100%
= 18.75%
ILLUSTRATION 2
Question: Calculate the Mark-Up if the margin is known to be
20%
Answer:
Let SP = Selling price CP= Cost price
Margin =Profit/SP x 100%
20%=Profit/SP x 100%
Profit=0.2SP=SP-CP
CP=SP-Profit
=SP-0.2SP
=0.8SP
Mark up = Margin x SP/CP
Mark up = 20% x SP/0.8SP
=25%
ILLUSTRATION 3
Question: A trader sells a machine for $30,000, gaining 72% on
his cost price. How much did he pay for the machine? What
was his profit?
Answer:
Let SP=Selling price CP= Cost price
SP= CP + 72%CP
30,000=CP+72%CP
CP=$30,000/1.72 =$17,441.86
Profit = SP-CP
=$30,000-17,441.86=$12,558.14
ILLUSTRATION 4
Question: Your one day’s takings is $5,000 and you expects
your margin to be 30%. Calculate your profit for that day?
Answer:
Margin = Profit/ Selling price x 100%
30% =Profit/$5,000 x 100%
Profit =$5,000 x30/100
=$1,500
Margin vs. markup. Whats the difference? How do we calculate both?
Well, it starts with deciding on how to price your products (which is a big deal!). How
you price your goods will depend on whether you buy your products in bulk, or if you
buy them from different vendors at differing prices. However, in most instances, once
you have a system in place to figure out the cost (a.k.a. cost of goods sold or your
purchase price), you can use cost to help derive your price.
This is where the concept of markup comes in. Depending on where you search, you
can get differing answers for what markup is, and what it has to do with something
called margin (or gross profit margin).
If you’re wondering how to untangle that web of M-words and learn what the difference
is between margin vs. markup, then you’ve come to the right place.
Let’s get started, shall we?
What is the markup formula?
You can think of markup as the extra percentage that you charge your customers (on
top of your cost).
The markup formula looks like this:
An example of using the markup formula
Now let’s make the example a little more concrete. Let’s say the cost for one of Archon
Optical’s products, Zealot sunglasses, is set at $18. That $18 is how much it costs
Archon Optical to create a single pair of the Zealot. They will then turn around and sell
each Zealot for the price of $36.
If we run through that calculation, we arrive at a markup of 100%:
Pricing products based on markup
However, some businesses might set their prices based on a certain pre-defined
markup percentage. They’d have the costs ready and have particular markup
percentages in mind to help them calculate a price.
How would we express the markup formula in this case? Let’s write this out:
Given a markup of 100% on the Zealot, the price would be $36.00:
Expressing markup as a percentage is useful because you can guarantee that you are
generating a proportional amount of revenue for each item you sell, even as your cost
fluctuates or increases. This means that the markups you set up at the beginning should
scale well as your business grows. We’ll discuss this more when you’ve scrolled further
down this page.
What about margin vs. markup?
Now that we’ve defined markup and how it helps you decide on a price, we should
discuss the other other big M-Word: margin. The type of margin we’re discussing in this
case is gross profit margin, which describes the profit that you earn on a product as a
percentage of the selling price.
What is the margin formula?
Margin is often expressed as a specific amount in currency, or a percentage (similar to
markup). However, margin uses price as the divisor. If we want to calculate the margin
on the Zealot sunglasses, here is what that looks like:
The gross profit margin on Zealot sunglasses is $18 ($36 price – $18 cost), or you could
say the margin is 50%.
Expressed in this way, margin and markup are two different perspectives on the
relationship between price and cost. Just like you could say: Maryan is taller than
Thomas, or Thomas is shorter than Maryan.
When should I use margin? When should I use markup?
The question then arises: if these two M words are so similar, how do we know which
one to express or use at a given time? Here’s our take on that:
Markup is perfect for helping ensure that revenue is being generated on each sale.
Markup is good for getting started because, as you are getting things set up, you are
keenly aware of the costs for your business, and you’re still learning about the kind of
revenue you can bring in through sales.
As you get to know your business better and you start to look at reports on your sales,
margin can be helpful for examining how much actual profit you’re making on each sale.
Fixed markup as percentage or dollar amount
The cost of manufacturing the Zealot may not always stay at $18 (actually, it definitely
won’t!). So the wise staff at Archon Optical will want to make sure that their prices are
always adjusted to reflect the increases in cost.
This where the concept of fixed markup really comes in handy, because it can help you
to automatically adjust your prices based on changed in cost. You could have cost and
price as separate numbers that you input into your spreadsheet or inventory
management software, but it’s much easier in the long run to have them linked.
Defining your markup as a percentage above cost ensures that you continue to earn
revenue on sales as costs increase, but it also means that you don’t have to keep
automatically going back to adjust your pricing. Manually adjusting your prices based on
cost is plausible for a smaller business, but this quickly becomes untenable as your
inventory expands to include hundreds of items.
If the Zealot becomes more expensive to produce over time, the price will have to go
up, and gaining a markup of $18 on a $36 item is very different a markup of $18 on an
item priced at $55. A fixed markup percentage would ensure that the earnings are
always proportional to the price.
What other factors affect markup?
We’ve described markup very simply thus far because we’re assuming a scenario
where Archon Optical makes the Zealot for a set cost and sells it at a set price, and
that’s all there is to it. Of course, real life is a little more complicated than that.
For each order of the Zealot, someone will have to be there to package and sell it.
That’s a labor cost that’s likely broken down into an hourly wage.
If you ship Zealot to customers in boxes or send them in trucks to stores around the city,
you’ll also have to factor the cost of freight charges. Sending express or two-week
shipping can make those costs vary wildly.
Since the Zealot is a product that Archon Optical had to develop over time (it didn’t just
materialize as a completed product), they need to account for all of the time and
expertise that went into making sure that the Zealot was as as cool, aesthetically
pleasing, and blocked as many of the sun’s harsh rays as possible. That product
development time can also factor into cost.
Markup in inFlow
If your markup percentages change often, you can use inFlow’s Product Pricing feature
to help you change prices for multiple products, with just a few clicks.