It is common to hear in the forest industry that logging contractors should earn a 10% profit. Profit means different things to different people. By definition, profit means a financial gain experienced by the amount earned exceeding the amount spent. When talking about profit, you need to make sure all participants are speaking of the same profit.
There are two common methods observed to calculate profit in logging. The first is markup and the second is margin.
Markup profit is the practice of adding together the costs and then calculating the profit on top as a percentage of costs. For example, consider a business that has costs of $900,000 and earns a 10% markup or $90,000. The business generates revenue of $990,000.
The business has earned a 10% markup ($90,000 profit / $900,000 costs = 10% markup) and realized a 9.1% margin ($90,000 profit / $990,000 revenue = 9.1% margin).
Margin profit is the practice of earning a profit as a percentage of revenue. For example, consider the business that has costs of $900,000 and wants to earn a 10% profit margin. To determine the necessary profit margin, a more complicated calculation is required. The costs are divided by the inverse profit margin (1 – 10% = 90%) to determine revenue and then subtract the costs to determine profit.
The business has earned a 10% margin ($100,000 profit / $1,000,000 revenue = 10% margin) and realized a 11.1% markup ($100,000 profit / $900,000 costs = 11.1%).
Which Business is Earning 10% Profit
The two examples of above demonstrate that two companies with the same costs would be generating different amounts of revenue and profit while both believing they are each earning a 10% profit. And in fact, they are. They are just using a different definition to frame profit. The difference is subtle but worthy of note.
When contractors and licensees are negotiating rates using a cost based model, you both need to be aware of how the other party is defining profit. While the difference between markups of 10% and 11.1% or margins of 9.1% and 10% may seem small but they are not. If a licensee is expecting to pay a 10% markup and the contractor is expecting to earn a 10% margin, the difference for the contractor is 9% of their profit. Conversely, if the licensee is paying 10% margin and the contractor is expecting 10% markup, the contractor is earning 11% more profit than they expected.
Agreeing up front on the definition of profit method of calculation as markup (as a percentage of costs) or margin (as a percentage of revenue) is an important step to successful negotiations and sustainable business practices.