Definition
Marginal Cost Pricing is a pricing strategy where a product’s selling price is determined solely based on its marginal costs. The marginal cost is the additional cost incurred to produce one more unit of a product. This approach excludes the allocation of fixed costs and focuses only on the variable costs associated with production.
Detailed Explanation
What is Marginal Cost?
Marginal cost is the cost of producing one additional unit of a product. It includes only variable costs, such as direct labor, materials, and direct overheads associated with production. Fixed costs like rent, salaries, and utilities are not included in marginal costs.
When is Marginal Cost Pricing used?
Marginal Cost Pricing is usually employed in exceptional situations such as:
- Intense Competition: When competition is fierce, companies may resort to marginal cost pricing to stay competitive and retain market share.
- Short-term Financial Decisions: Companies might use this strategy temporarily to clear out excess inventory or penetrate a new market.
- Price Wars: During price wars, a firm might use marginal cost pricing to attract more customers, even at the risk of making no profit or incurring a loss.
Risks of Marginal Cost Pricing
This pricing strategy comes with significant risks:
- Failure to Cover Fixed Costs: Since fixed costs are not covered, relying solely on marginal cost pricing can lead to a company incurring losses if done on a prolonged basis.
- Unsustainable Long-term: In the long-term, consistently pricing products at marginal costs can damage the financial health of a company.
- Competitor Reactions: Competitors may also lower their prices, resulting in a price war that diminishes profitability across the industry.
Examples
- Seasonal Products: A company that sells seasonal products might reduce prices to marginal cost toward the end of the season to clear out inventory that would otherwise be unsold.
- Technology Products: In the high-tech industry, firms might use marginal cost pricing to quickly penetrate the market or to phase out outdated models.
- Perishable Goods: Grocery stores often utilize marginal cost pricing to sell perishable items before they spoil, ensuring they at least cover some of their costs.
Frequently Asked Questions
What is the major drawback of Marginal Cost Pricing?
The primary drawback is the failure to cover fixed costs, which can lead to losses if the strategy is used extensively.
Can Marginal Cost Pricing be used for all products?
It is generally not advisable, as it may lead to financial losses. It is mostly used in exceptional or short-term situations.
How does Marginal Cost Pricing differ from full cost pricing?
Full cost pricing covers both variable and fixed costs, aiming for a profit on each unit sold, whereas marginal cost pricing includes only variable costs.
Why would a company use Marginal Cost Pricing?
Companies may use marginal cost pricing to remain competitive in highly congested markets or during promotional campaigns to attract customers.
Related Terms
Fixed Costs
Fixed costs are business expenses that remain constant regardless of production levels, such as rent, salaries, and utilities.
Cost-Plus Pricing
Cost-plus pricing involves setting the price at production cost plus a fixed profit margin, covering both fixed and variable costs.
Full Cost Pricing
Full cost pricing is a strategy where the selling price includes all production costs (both fixed and variable) along with a markup for profit.
Online References
- Investopedia: Marginal Cost Pricing
- Accounting Tools: Marginal Cost Pricing
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren
- “Managerial Economics & Business Strategy” by Michael Baye and Jeff Prince
- “Principles of Economics” by N. Gregory Mankiw
Accounting Basics: Marginal Cost Pricing Fundamentals Quiz
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