January 10th, 2018
Making Pricing Decisions – How Marginal Costs should be considered for Price Determination
Costs that vary with volumes of production – marginal costs – are an important consideration for pricing decisions, in both special order and regular decisions. In special order pricing decisions, marginal costs help assess whether the lower price for the special-ordered unit should be accepted where (a) the entity has an unutilised capacity for manufacturing that would remain idle if the special order is not taken up, (b) the fixed costs are not altered by taking up such a special order (c) regular sales are not affected by that special order, and (d) the special order does not require additional nonproduction-variable expenses (Drury 2006; Bamber, Braun & Harrison 2008). The latter is the case since special orders will usually not have arisen from the company efforts but from the entity making the special order thus the entity making the sale may not incur expenses such as sales commission and advertising (Drury 2006; Bamber, Braun & Harrison 2008). In that case, the where the special price is higher than the marginal cost per unit the entity would receive a positive contribution margin from such sales thus increasing its operating income (Drury 2006; Bamber, Braun & Harrison 2008).
In regular pricing decisions, marginal costs are also critical for both target pricing and cost-plus pricing decisions. Target pricing is mainly used by entities that are price-takers while cost-plus pricing is employed by those that are price-setters (Bamber, Braun & Harrison 2008). For target pricing, variable costs helps an entity determine how much of such costs it needs to reduce to achieve a target profit if the fixed costs cannot be lowered. Variable costs could be lowered by such factors as renegotiating lower costs for direct materials. For cost-plus pricing, variable costs importance is equal to that of fixed costs since this method involves the addition of desired profit to the full cost (variable and fixed costs) then dividing the result by the number of units (Bamber, Braun & Harrison 2008). Due to the observation that some costs usually vary by other aspects other than volume, a costing method based on the number of activities – i.e. activity based costing – has been suggested to help arrive at better pricing decisions (Lere 2000).
Costing information is critical for internal reporting purposes which, for instance, involve short-term decisions about pricing. Assessing the validity of the claim that “to maximise profit, you need to sell your output at the highest price” and evaluating how marginal costs are used in price determination was the concern of this paper. The claim advanced is invalid since selling at increased prices could significantly alter the quantity demanded thus affect the contribution margin and thus the operating income adversely. Marginal costs use in pricing decisions range from assessing whether to take special orders at a particular price, through target pricing, to cost-plus pricing decisions where the full cost of operations is critical. Since some costs could change by other variable but not volume, the use of other methods such as activity based costing that does not cost based on volume variation is argued to better pricing decisions.
Bamber, LS, Braun, KW & Harrison, WT 2008, Managerial Accounting, Prentice Hall, New Jersey.
Drury, C 2006, Cost and management accounting: an introduction, 6th edn, Thomson Learning, UK.
Lere, JC 2000, ‘Activity-based costing: a powerful tool for pricing’, Journal of Business & Industrial Marketing, vol. 15, no. 1, pp. 23-33.