Cost-based pricing methods

If a firm is to survive in the long run, it must be able to cover its costs of production. If revenues do not exceed costs, it will make a loss. It may be able to sustain a loss for a while, but in order to continue operating, it must generate enough revenue to cover wage bills and pay for materials and power, rent and rates, and other overheads.

Cost-plus pricing. This involves calculating the cost of producing each unit of output, and then adding a mark-up for profit. For example, if a firm produced 10,000 units of a product costing £20,000, the average cost would be £2. A 10% profit mark-up would mean that units would be priced for sale at £2.20 each.

Contribution pricing. It is relatively easy to calculate the variable costs of producing each unit of output. However, it is often difficult to calculate what proportion of fixed costs such as rent and rates, heating, night-time security, etc., to apportion to each product. Contribution pricing, therefore, involves setting a price for each unit that covers its variable cost and makes a contribution towards total fixed costs, as well as a mark-up for profit. The contribution per unit of output can be calculated as follows:

Contribution per Unit = Selling Price – Variable Cost

The selling price of each unit of output will be chosen so that the total contribution covers fixed costs and yields an acceptable profit, where:

Profit = Total Contribution – Total Fixed Costs

Contribution pricing can also be used to find the level of output at which a firm will break even. For example, returning to the case of Geoff’s Knitwear Ltd, we can calculate the contribution each jumper makes towards fixed costs as follows:

Contribution per Jumper Sold = 30 – 5 = 25

At the break-even output of 8,000 jumpers, the total contribution will be £200,000 (i.e. £8,000 x 25) – exactly equal to total fixed costs. Profit is zero. However, the 8,001st jumper sold will yield a profit of 25 and so on.

The break-even level of output can therefore be calculated using the following formula:

Fixed Cost 200,000

Break-even Output = ——————— = ———— = 8,000

Contribution 25

Contribution pricing methods can be a very useful means of assessing the performance of a business, allowing management to measure and compare the contribution made by all of the various products the firm produces. Some products may make a negative contribution – that is, variable costs may exceed the selling price – in which case, total profit may be increased by halting their production. However, sometimes firms may deliberately produce and sell a product generating a negative contribution as a loss-leader, in order to encourage interest in other products in the range. Closing down the production of such a product could damage sales of the other products, and reduce their contribution as well. For example, the Mini car is a popular make which car-dealers like to display in their showrooms to attract people in to browse – and hopefully to buy. However, for many years the production of the Mini resulted in a loss for its manufacturer.

Similarly, a product may make a negative contribution if it is a relatively new, competitively priced item, in the launch or growth stage of its life cycle.

Marginal cost pricing. The addition to total cost resulting from the production of an additional unit of output is known as the marginal cost. A decision to expand output by one or more units will be based on an assumption that unit price will be at least sufficient to cover marginal costs, such that the total profit earned on all previous units is not reduced. Sometimes firms will price just above marginal cost in order to use up spare capacity and ensure that at least a small contribution to fixed costs is made. For example, consider an airline selling flights to New York. Whether the plane flies full or half-empty, it will incur the same fixed costs for fuel, flight crew, and staff. Suppose 80% of seats at the standard fare are sold, yielding a reasonable profit on the flight. In an attempt to fill the plane, the airline can offer remaining seats at bargain prices. The marginal cost of each additional passenger will be small – just the cost of additional administration and on-board refreshments. As long as the fare price more than covers these small additional costs, the airline will be able to add to its profit.

Дата добавления: 2015-12-08