Marginal cost pricing is the practice of setting the price of a product at or slightly above the variable cost to produce it. This approach typically relates to short-term price setting situations.
This situation usually arises in one of two circumstances:
- A company has a small amount of remaining unused production capacity available that it wishes to use; or
- A company is unable to sell at a higher price
The first scenario is one in which a company is more likely to be financially healthy - it simply wishes to maximize its profitability with a few more unit sales. The second scenario is one of desperation, where a company can achieve sales by no other means. In either case, the sales are intended to be on an incremental basis; they are not intended to be a long-term pricing strategy, since prices set this low cannot be expected to offset the fixed costs of a business.
The variable cost of a product is usually only the direct materials required to build it. Direct labor is rarely completely variable, since a minimum number of people are required to crew a production line, irrespective of the number of units produced.
The Marginal Cost Calculation
ABC International has designed a product that contains $5.00 of variable expenses and $3.50 of allocated overhead expenses. ABC has sold all possible units at its normal price point of $10.00, and still has residual production capacity available. A customer offers to buy 6,000 units at the company's best price. To obtain the sale, the sales manager sets the price of $6.00, which will generate an incremental profit of $1.00 on each unit sold, or $6,000 in total. The sales manager ignores the allocated overhead of $3.50 per unit, since it is not a variable cost.
Advantages of Marginal Cost Pricing
The following are advantages to using the marginal cost pricing method:
- Adds profits. There will be customers who are extremely sensitive to prices. This group might not otherwise buy from a company unless it were willing to engage in marginal cost pricing. If so, a company can earn some incremental profits from these customers.
- Market entrance. If a company is willing to forego profits in the short term, it can use marginal cost pricing to gain entry into a market. However, it is more likely to acquire the more price-sensitive customers by doing so.
- Accessory sales. If customers are willing to buy product accessories or services at a robust margin, it may make sense to use marginal cost pricing to sell a product on an ongoing basis, and then earn profits from these later sales.
Disadvantages of Marginal Cost Pricing
The following are disadvantages of using the marginal cost pricing method:
- Long-term pricing. The method is completely unacceptable for long-term price setting, since it will result in prices that do not capture a company's fixed expenses.
- Ignores market prices. Marginal cost pricing sets prices at their absolute minimum. Any company routinely using this methodology to determine its prices may be giving away an enormous amount of margin that it could have earned if it had instead set prices at or near the market rate.
- Customer loss. If a company routinely engages in marginal cost pricing and then attempts to raise its prices, it may find that it was selling to customers who are extremely sensitive to price changes, and who will abandon it at once.
- Cost focus. A company that routinely engages in this pricing strategy will find that it must continually hold down costs in order to generate a profit, which does not work well if the company wants to transition into a high-service, higher-quality market niche.
Evaluation of Marginal Cost Pricing
This method is useful only in a specific situation where a company can earn additional profits from using up excess production capacity. It is not a method to be used for normal pricing activities, since it sets a minimum price from which a company will earn only minimal (if any) profits. It is generally better to set prices based on market prices.