Markup or contribution margin: which one to use when setting prices

Ask ten store owners how they arrive at their prices and many will answer something similar: "I take the cost and add about 50% on top." It is practical, quick and seems safe. The problem is that this calculation, the way it is usually done, leaves out things that weigh heavily at the end of the month. Many companies only discover this when they look at the results and can't understand where the money went.

Markup and contribution margin are two tools that help avoid this surprise. They don't compete with each other. One helps you arrive at a price. The other shows whether that price holds up.

What each one measures

Markup is a number you multiply by the product's cost to arrive at the selling price. If an item costs R$ 60 and the markup is 1.5, the price is R$ 90. It is quick, easy to apply to hundreds of products at once and, for that reason, it is the most widely used method in retail.

Contribution margin is what is left from each sale after paying everything that varies with it: the product cost, sales taxes, the salesperson's commission and the card fee. It is this remainder that pays the rent, salaries and other fixed expenses. Only what goes beyond that becomes profit.

Markup tells you what to sell for. Contribution margin tells you whether it is worth selling at that price.

The mistake of adding a percentage to cost

The most common problem lies in how markup is calculated. Adding 50% on top of cost seems to leave a good cushion. But taxes, commission and card fees are charged on the selling price, not on cost. And the company's fixed expenses still have to be paid. The 50% disappears much faster than it seems.

The safer way is to build the markup from the price. Add up, as a percentage of price, everything that has to come out of each sale: variable expenses, the share of fixed expenses and the profit you want to make. Then divide the product cost by one minus that sum:

Price = cost ÷ (1 − variable expenses − fixed expenses − target profit)

Let's look at an example. The product costs R$ 60. Variable expenses add up to 16% of the price (8% tax, 5% commission and 3% card fees). Fixed expenses represent 20% of projected revenue. And the profit target is 10%. Adding it all up, 46% of each sale already has a destination. The price comes to R$ 60 ÷ (1 − 0.46) = R$ 111.11, which is equivalent to a markup of 1.85. Quite different from the 1.5 that seemed enough.

Item	50% on cost	Markup on price
Selling price	90.00	111.11
Product cost	−60.00	−60.00
Taxes, commission and card fees (16% of price)	−14.40	−17.78
Contribution margin	15.60	33.33
Contribution margin (% of price)	17.3%	30.0%

Source: prepared by Farol Consulting. Hypothetical figures. Variable expenses: sales taxes (8%), commission (5%) and card fees (3%).

At R$ 90, each sale leaves 17.3% of the price to pay fixed expenses. But fixed expenses need 20%. In other words: even selling everything it planned, the company ends the month at a loss, and the more it sells, the bigger the hole gets. At R$ 111.11, the contribution is 30%. It pays the fixed expenses and still leaves the planned 10% profit.

Where markup falls short

Markup depends on an estimate. The fixed-expense percentage only holds for the sales volume used in the calculation. If sales drop, the same fixed expenses take a bigger bite out of every sale, and the price that seemed right no longer is. That's why day-to-day decisions call for the contribution margin:

• Discounts: in the example, a 10% discount brings the price down to R$ 100 and the contribution margin from R$ 33.33 to R$ 24.00, a 28% drop. To keep the same result, you would need to sell 39% more units. Worth remembering before the next promotion.
• Product mix: the best-selling item is not always the one that contributes most. Comparing the contribution margin of each product shows where to focus the sales team's effort and shelf space.
• Special orders: a large order at a lower price can be worthwhile when the company has spare capacity. The contribution margin shows how much it actually adds to the result.
• Break-even point: by dividing fixed expenses by the contribution margin percentage, the company knows how much it needs to bill each month to avoid a loss.

Which one to use

Both, each in its own role. Markup, calculated on price, serves to arrive at a starting price and keep the price list consistent. Contribution margin is the test: it shows whether that price holds up, how much discount there is room for and which products carry the company.

In practice, a simple routine works well. Use markup to build the price list. Once a month, look at the contribution margin of your main products in the management P&L. If any item is below what is needed, review its price, cost or discount policy.

When to redo the math

Margins tend to shrink without anyone noticing, because costs change gradually. It is worth redoing the calculation whenever one of these situations occurs:

• the supplier raised its prices;
• the company moved to a different Simples Nacional bracket or tax regime;
• the card machine fee or sales commission changed;
• fixed expenses went up, with a new employee or higher rent;
• sales volume fell consistently.

Frequently asked questions

Are markup and margin the same thing?

No. Markup is applied to cost to arrive at the price. Margin is calculated on price and shows how much is left from each sale. A markup of 1.5 on cost, for example, corresponds to a gross margin of 33% of price, before taxes, commission and card fees.

Can I use the same markup for all products?

Yes, as a starting point, as long as variable expenses are similar across them. But products with different shipping, commission or taxes deserve their own calculations. And the market matters too: sometimes the calculated price is above what customers are willing to pay, and then the solution lies in cost, not price.

What is a good contribution margin?

It depends on the business. The right number is the one that pays your fixed expenses and leaves the profit you need. A 30% margin can be great for one company and insufficient for another. That is why the calculation has to start from your company's numbers, not a market average.