What is a Markup?
A markup represents the difference between the lowest current offering price of an investment among broker-dealers and the price charged to the customer. Markups occur when brokers act as principals, buying and selling securities from their own accounts at their own risk rather than earning a fee for facilitating transactions. Many dealers double as brokers, giving rise to the frequent use of the term ‘broker-dealer’.
In retail, markups are also prevalent. Retailers increase the selling price of merchandise by a certain amount or percentage to ensure profitability. The method used to establish a selling price by adding a markup to total variable costs is known as the variable cost-plus pricing method.
Key Takeaways
- A markup is the difference between the market price of a security held by a broker-dealer and the price paid by a customer.
- Markups are a legitimate way for broker-dealers to profit from the sale of securities.
- Dealers are not always required to disclose the markup to customers.
- In retail, markups occur when retailers raise the selling price of goods to make a profit.
Understanding Markups
Markups appear when certain marketable securities are sold directly from dealers’ accounts to retail investors. The dealer’s compensation comes from the markup—the difference between the security’s purchase price and the selling price. Dealers assume risk as the market price of a security might drop before being sold to investors.
In business, a markup represents the price spread between the cost to produce a good or service and its selling price. Producers add a markup to cover costs and ensure profit, which is expressed either as a fixed amount or a percentage over the cost.
Markups vs. Markdowns
A ‘markdown’, in contrast, happens when a broker buys a security from a customer at a price lower than its market value or sells at prices below the current market bid price. Retailers might markdown prices to stimulate additional buying or to clear outdated seasonal merchandise from shelves.
Retailers utilize price markdowns to manage inventory, especially for obsolete products, in hopes of avoiding being stuck with unsellable goods.
Benefits of Markups
Markups are an authentic way for broker-dealers to earn on securities sales. Securities come with a spread, determined by bid and ask prices. Dealers, acting as principals, can markup the bid price to create a wider bid-ask spread, thus earning more profit. Unlike a flat fee, brokers acting as principals benefit from the markup (gross profits) of securities later sold to customers.
Special Considerations for Markups
Dealers usually need only to disclose the transaction fee, typically a nominal cost, keeping the original transaction and markup undocumented. Consequently, buyers are unaware of the dealer’s markup unless they research market prices. Comparing dealer-paid prices to real market prices can reveal if buyers receive a fair deal, especially through platforms reporting bond transactions daily.
Dealers compete intensely, often reducing markups to attract customers. Bond buyers can avail themselves of various sources to verify if they are paying a reasonable markup, thereby ensuring they conduct fair transactions.
Related Terms: markdown, variable cost-plus pricing, marketable securities, price spread.
