What’s it: Marginal cost pricing refers to a pricing approach in which a firm charges a product according to its marginal cost. In this case, the company takes into account the variable costs per unit.
How to calculate marginal-cost pricing
To be honest, when I first read this concept, I felt confused. How is it possible for a firm to set prices equal to the marginal cost? Doesn’t that have implications for significant losses?
However, I slowly began to understand how marginal-cost pricing works.
Before giving an example of calculating marginal-cost pricing, I will briefly review three useful concepts in this article.
First, fixed costs. It is a type of cost whose value does not change when output changes. An example is the cost of a production machine. When increasing production, the firm bears the same fixed costs.
Second, variable costs. It is a cost that varies with changes in output. When the output increases, the value will increase. Likewise, if production falls, variable costs will also decrease. An example is raw materials.
Third, marginal cost. It is an extra cost when the company adds one unit of product. The formula is as follows:
Marginal cost = ∆ Total cost / ∆ Quantity = (∆ Total fixed cost + ∆ Total variable cost) / ∆ Quantity
Fixed cost change (∆ total fixed cost) is equal to zero. Total fixed costs will be unchanged as output increases (the firm can still use the same machines to increase production). Therefore, we can rewrite the above formula to be:
Marginal cost = ∆Total variable cost / ∆ Quantity
Examples and calculations
Now, let’s take a simple example.
A company managed to increase its production to 20 units. Increasing output lowers average costs because it can spread fixed costs ($ 100) over a more massive output.
|Quantity||Fixed Cost ($)||Variable Cost ($)||Total Cost ($)||Marginal Cost ($)||Average fixed cost ($/unit)||Average variable cost ($/unit)||Average total cost ($/unit)|
Say, to sell 20 units of output, the firm adopts cost-plus pricing and takes a profit margin of 5% of the cost. From the information, we can calculate that the selling price per unit is $ 15.75 per unit = $ 15 x (1 + 5%).
Meanwhile, if the company adopts a marginal cost pricing strategy, it charges $ 5 per unit. Isn’t this absurd? Isn’t the company going to lose significantly?
Yes, companies cannot use this strategy in every situation. Companies will usually use a marginal cost pricing approach when:
- The company has reached a break-even point. That is the point at which revenue has covered the costs of production. After the break-even volume is reached, the company can determine the price using the marginal cost pricing approach.
- The company still has a level of capacity to add output that is higher than the break-even volume.
- The company adopts an aggressive pricing strategy, such as a loss leader, for each additional output once it breaks even volume.
Well let’s find the break-even volume first. You can use the following formula:
Break-even volume = Fixed cost per unit / (Selling price per unit – Variable cost per unit) = $ 100 / ($ 15.75 – $ 10) = 18 units (rounded up).
With an output of 18 units, the firm bears the fixed costs of $ 100. Meanwhile, the firm’s variable costs are $ 180 = 18 units x $ 10. Thus, the total cost is $ 280 at that volume.
Next, the revenue from 18 units’ sales is $ 283.5 (18 units x $ 15.75).
Say, with the current capacity; the company can still increase its output to 24 units. For the next 6 outputs, the company may use marginal-cost pricing.
Let’s calculate the marginal cost of increasing the output from 18 units to 24 units.
Total fixed costs are unchanged, at $ 100. Meanwhile, with the average variable cost $ 10, the total variable cost is $ 240. So the total cost of producing 24 units is $ 340 ($ 100 + $ 240).
Marginal cost = ($ 340 – $ 300) / (24 – 18) = $ 6.8
So, in this case, the company uses two approaches:
- Cost-plus pricing for the first 18 units of output. With 5% above average cost markup, the company charges a selling price of $ 15.75 per unit. At that price, the company earned $ 283.5 in revenue and could cover production costs of $ 280.
- Marginal cost pricing for the next 6 units is priced at $ 6.7 per unit. At that price, the company earned $ 40.2 in revenue.
You can see that if the firm sets the selling price of the additional output equal to marginal cost, the firm will book total revenue of $ 323.7 ($ 283.5 + $ 40.2). That is still lower than the total cost of producing 24 outputs (18 breakeven volumes and 6 additional outputs) of $ 340.
Companies continue to do so if their primary goal is to increase market share.
However, if the goal is profit, then the firm may charge the selling price of the extra 6 units of output at the break-even point average cost ($ 15). That way, the company earns $ 90 (6 units x $ 15) from extra production. The firm’s total revenues will equal $ 373.5, which is higher than the total cost of 24 units of output ($ 340).
The advantages and disadvantages of marginal cost pricing
The marginal cost pricing approach is a short-term strategy. Companies may use this approach when adopting loss leader pricing or promotional pricing. Aren’t those two also pricing methods?
Yes, it is, but of the two, you cannot determine what the price should be. Using marginal cost pricing, you can mathematically calculate the selling price and profit (loss).
- Under the loss leader strategy, the company sets low selling prices for some products. In the example above, the firm could set a lower selling price (at marginal price) for the additional 6 outputs and a higher selling price (with a markup above the average cost) for the first 18 units. The company’s potential loss is around $ 16.3 ($ 323.7- $ 340).
- Under the promotional price, the firm can set a selling price of $ 15.75 for the first 18 outputs. Furthermore, for the additional 6 units of output, the firm can discount the selling price and offer it at $ 15. Under this strategy, the company still made a profit of $ 33.5 ($ 373.5- $ 340).
Advantages of marginal cost pricing
- The calculations are relatively simple. You can calculate them using simple arithmetic operations.
- It is useful when the company has excess production capacity. The company can increase production and sell it at a discount than the regular price. It not only benefits but also attracts more bucks (discounted price).
Disadvantages of marginal cost pricing
- Strategies are unsuitable for long-term goals. The company must operate profitably and profitably. Therefore, it needs to recover all production costs and operate profitably.
- Consumers expect the company to maintain a lower price even further. That makes it more challenging to raise prices again in the future.
- Customer resale. They can take advantage of the lower marginal cost price. They could sell it to other customers and prevent buying directly from the company.