Marginal Cost Pricing
Marginal Cost Pricing: The technique of establishing a product’s price at or slightly above the variable cost of production is known as marginal cost pricing. This method is most often used in instances when prices are established for a short period of time. This condition frequently emerges as a result of one of the following events:
A business has a tiny quantity of idle manufacturing capacity that it would want to utilise
A business cannot sell at a greater price.
The first scenario is a corporation that is more likely to be financially sound and just wants to increase its profitability by selling a few more units. The second situation is one of desperation, in which a corporation has exhausted all other options for generating sales. In either scenario, the sales are meant to be incremental; they aren’t meant to be a long-term pricing strategy, since prices this low can’t be anticipated to cover a company’s fixed expenditures.
A product’s variable cost is generally limited to the direct materials needed to construct it. Because a minimum number of workers are necessary to staff a manufacturing line, regardless of the number of units produced, direct labour is seldom totally flexible.
Calculation of Marginal Cost Pricing
ABC International has created a product with a variable expenditure of $5.00 and a fixed overhead charge of $3.50. At its typical price point of $10.00, ABC has sold all conceivable units and still has manufacturing capacity available. A client offers to purchase 6,000 units at the greatest price the firm can provide. To secure the sale, the sales manager sets a price of $6.00, which will result in a profit of $1.00 each unit sold, totaling $6,000. Because the assigned overhead of $3.50 per unit is not a variable cost, the sales manager disregards it.
Marginal Cost Pricing’s Benefits
Using the marginal cost pricing approach has the following advantages:
(I) Increases profits
Customers that are exceedingly price sensitive will exist. Unless a corporation was prepared to participate in marginal cost pricing, this group would not purchase from it. If this is the case, a corporation may be able to benefit from these clients on a part-time basis.
(ii) Entrance to the market
Marginal cost pricing may be used to gain entrance into a market if a firm is ready to forfeit earnings in the near term. However, by doing so, it is more likely to attract price-sensitive clients, who are more likely to quit if price points rise.
(iii) Sales of accessories
If clients are prepared to pay a high price for product accessories or services, it may make sense to utilise marginal cost pricing to sell a product on a regular basis and then benefit from subsequent sales.
Marginal Cost Pricing’s Drawbacks
The downsides of employing the marginal cost pricing approach are as follows:
(I)Pricing over a long period of time
The approach unsuitable for long-term price setting since it produces prices that do not reflect a company’s fixed expenses.
(ii) Doesn’t consider market pricing
Pricing is set at the bare minimum using marginal cost pricing. Any firm that uses this system to decide its pricing on a regular basis may be squandering a significant amount of profit that might have been collected if prices were set at or near market rate.
(iii) Loss of customers
If a firm uses marginal cost pricing often and then tries to increase its prices, it may discover that it is selling to people who are particularly price sensitive and will desert it immediately.
(iv) A cost-conscious approach
A firm that uses this pricing approach on a regular basis will discover that it has to keep prices low in order to make a profit, which is ineffective if the company wants to move into a higher-service, higher-quality market segment.
Marginal Cost Pricing Analysis
This strategy is only applicable in a certain case when a corporation can increase earnings by using surplus manufacturing capacity. It is not a strategy to be used for routine pricing operations since it establishes a minimum price from which a corporation can only make a little profit (if any). In general, setting pricing based on market prices is preferable.