Pricing Strategy: Determining and Evaluating Marginal Cost Pricing with Pros and Cons
In the dynamic world of business, setting the right price for a product or service can make all the difference. Two popular pricing strategies that businesses often consider are marginal cost pricing and cost-plus pricing.
Marginal cost pricing, a strategy that sets prices equal to the marginal cost of production, is a method that charges a product according to its incremental cost of production. This approach, which is often used when a company wants to sell a product at cost or in situations of intense competition, can lead to lower prices due to its focus on the cost of producing one additional unit. However, this pricing strategy may result in lower short-term profits or even losses if fixed costs are not covered.
On the other hand, cost-plus pricing sets prices by adding a markup (a fixed percentage) to the total cost of production, including fixed and variable costs. This approach guarantees a certain profit margin above all costs, leading to more stable and often higher profit margins per unit sold. However, because prices are typically higher than marginal cost pricing, cost-plus pricing may limit market share expansion, especially in competitive markets where customers are price-sensitive.
A comparative summary of these two pricing strategies reveals some key differences. Marginal cost pricing is efficient in allocating resources and requires detailed cost analysis, while cost-plus pricing is simpler to implement and provides predictable returns. Market share growth can be boosted with marginal cost pricing due to competitive pricing, but this strategy may sacrifice potential profitability. Conversely, cost-plus pricing ensures profitability but may limit market share growth if prices exceed those of competitors.
In practice, marginal cost pricing is often used for market penetration or when economies of scale are important, aiming at increasing market share even with lower margins. Cost-plus pricing is preferred when stable profitability and covering total costs are prioritized, often in less competitive markets or with less price-sensitive consumers.
For instance, a company might use cost-plus pricing for the first 18 units of output, charging $15.75 per unit. Once it reaches its break-even point at 18 units of output, it may switch to marginal cost pricing for the next 6 units, pricing them at $6.7 per unit. The total revenue from 18 units' sales would be $283.5, while the total revenue from the next 6 units at marginal cost would be $323.7.
In conclusion, understanding marginal cost pricing and cost-plus pricing is crucial for businesses seeking to optimise their profits and market position. While marginal cost pricing favours market share growth at the expense of short-term profitability, cost-plus pricing tends to ensure profitability but may sacrifice potential market share expansion.
Investing in the right pricing strategy can significantly impact business profits and market position. For instance, marginal cost pricing, which determines prices based on the incremental cost of production, aims to increase market share even at the cost of lower margins, while cost-plus pricing adds a fixed percentage to total production costs to ensure profitability but may limit market share expansion in competitive markets.
