marginal cost pricing

Definition:
According to this method, marginal costing often means variable or direct costing, which is the economists' marginal cost averaged over a large block of output units. Economists generally use the term 'marginal cost' to describe the increase in total costs, starting from a given level of output, that results from an additional unit of output without expanding the firm's production and distribution facilities, and while marginal costs and variable costs per unit may be the same at a given level of output, the economist clearly distinguishes between marginal and variable cost per unit. This approach is not exactly equivalent to the economists's approach of equating marginal cost and revenue, but it is a practical application of the principle which takes into account the cost of costing, time available for making calculations, the degree of accuracy required, and the multidimensional features of the modern firm. The philosophy underlying this approach to costing is that fixed costs are unavoidable, and that what matters is to cover variable cost and make some CONTRIBUTION to fixed cost. Whether or not to accept an order depends on what contribution will be made to fixed costs after variable costs are covered, the approach is an attempt to take account of the fact that it is difficult to allocate fixed overhead cost to production on a basis varying with the level of output and the recognition that the resources available for meeting the fixed expenses of a business depend directly on the contribution, which is the difference between sales revenue and variable costs, and a firm should seek to fix its prices so as to maximize its total contribution. In deciding prices according to this approach, fixed cost must be omitted from unit cost and the price determined on the basis of marginal cost. Marginal cost pricing is generally seen as being superior to full cost pricing for some or all of the following reasons: (a) it is more effective in the short run than full costing because of the virtual impossibility of calculating the total cost of different products in a product portfolio and because the optimal relationship between cost and prices will vary substantially both among different products and between different markets. Further, the emphasis upon innovation and the rate of change means that long-run situations are often highly unpredictable so that one should aim at maximizing contribution in the short run. (b) It lends a marketing rather than a costing orientation to pricing policy; prices are fixed in relation to market conditions so as to take advantage of the elasticity of demand. (c) Marginal cost is more relevant to pricing decisions than absorption cost as it reflects future as distinct from present cost levels and cost relationships. (d) Marginal cost pricing permits a manufacturer to develop a policy to make prices more differentiated and more flexible through time which leads to higher sales and possibly reduced marginal costs through increased marginal physical productivity and lower input factor prices. (e) It gives a much clearer indication of profit potential and so enables decision-makers to decide better which products they should sell in what markets.

Cross-References:
[contribution analysis] [demand, price elasticity of]

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