Where does profit start?
Before talking about pricing, you need to know cost of goods sold (COGS), which is the cost of the goods actually sold during the period, not everything you bought. It includes the purchase price after discounts, plus freight, clearance and non-recoverable customs duties until the goods reach the warehouse. Recoverable Value Added Tax (VAT), however, is not part of the cost.
A household supplies store during the year:
| Item | SAR |
|---|---|
| Opening inventory | 90,000 |
| + Net purchases | 380,000 |
| + Freight on purchases | 15,000 |
| − Closing inventory | 110,000 |
| Cost of goods sold | 375,000 |
| Sales excluding VAT | 500,000 |
| Gross profit | 125,000 |
Note that cost of goods sold is directly linked to the inventory valuation method and the inventory system. Any error in counting closing inventory flows in full into cost of sales: if actual inventory were 100,000 SAR rather than 110,000, cost would rise to 385,000 SAR and gross profit would fall by the same amount. That is why an accurate inventory count is the first step in knowing your real margin, and any unrecorded shortage or damage makes the book margin higher than reality.
It is useful to calculate cost and margin for each item category, not only for the business as a whole, because the overall average margin may hide one category earning 40% and another barely exceeding 10%. This analysis guides decisions on shelf space, promotions and negotiations with suppliers.
Margin and markup: the same profit, two different percentages
- Gross profit margin (Gross Margin) = Gross profit ÷ Selling price. That is, the share of profit in every riyal you sell.
- Markup = Gross profit ÷ Cost. That is, how much you added on top of cost.
In the example above: margin = 125,000 ÷ 500,000 = 25%, and markup = 125,000 ÷ 375,000 = 33.3%. Both figures are correct and describe the same profit, but from two different angles. The problem starts when the owner says “I want a 25% profit” meaning margin, and the employee adds 25% to cost.
Pricing example: the common mistake
An item costs 75 SAR, and the owner wants a profit margin of 25% of the selling price.
The wrong way: 75 + 25% × 75 = 93.75 SAR. The profit is 18.75 SAR, and the actual margin = 18.75 ÷ 93.75 = only 20%.
The right way: Selling price = Cost ÷ (1 − Required margin) = 75 ÷ 0.75 = 100 SAR. The profit is 25 SAR, and the margin = 25 ÷ 100 = 25%.
If the store sells 20,000 units of this category a year, the difference between the two prices (6.25 SAR per unit) means 125,000 SAR of gross profit lost because two terms were confused.
Then the tax: the consumer price = 100 × 1.15 = 115 SAR including VAT. Always calculate margin on the price before tax.
The logic is simple: margin is based on the selling price, which is the larger figure, and markup is based on cost, which is the smaller figure, so the markup percentage is always higher than the margin percentage for the same profit.
Conversion table between margin and markup
The formulas:
- Margin = Markup ÷ (1 + Markup)
- Markup = Margin ÷ (1 − Margin)
| Required margin | Markup required on cost | Price of an item costing 100 SAR |
|---|---|---|
| 10% | 11.1% | 111.11 |
| 20% | 25% | 125.00 |
| 25% | 33.3% | 133.33 |
| 30% | 42.9% | 142.86 |
| 40% | 66.7% | 166.67 |
| 50% | 100% | 200.00 |
Note that margin can never reach 100%, while markup can exceed 100% without limit.
Pricing example for several items
Management wants a 30% margin on the electrical tools category. The cost prices of three items are 35 SAR, 140 SAR and 210 SAR.
| Cost | Selling price = Cost ÷ 0.70 | Gross profit |
|---|---|---|
| 35 | 50 | 15 |
| 140 | 200 | 60 |
| 210 | 300 | 90 |
For each item, profit makes up 30% of the selling price and 42.9% of cost. The price can then be rounded to a suitable marketing figure, making sure the margin does not fall below the required level.
Practical tips
- Agree on the term within the business: state explicitly in the pricing policy whether the percentage is “margin on sales” or “markup on cost.”
- A discount eats into margin more than you expect: an item with a 25% margin that is discounted by 10% (from 100 to 90) sees its profit fall from 25 to 15 SAR, meaning the margin becomes 16.7% and profit falls by 40%.
- Update the cost before pricing: use the latest purchase cost or the replacement cost when pricing a new shipment, not an old average.
- Gross margin is not net profit: salaries, rent and other expenses come after it. Make sure the margin covers them, and see the article on the break-even point.