Before providing an example of marginal-cost price calculation, we should outline three important concepts.
First, Fixed costs. Thisis a particular type of expense the value of which does not alter when production volume changes. The price of a manufacturing machine is a good case in point. The company incurs the same fixed expenses while raising output.
Second, Variable costs. They alter as production volume changes: grow when it increases, and go down when production declines. Most often, variable expenses include raw materials.
Marginal cost is the third category. When a company manufactures one extra unit of a product, it involves an additional cost.
The formula is as follows:
Marginal cost = ∆Change in total cost / ∆ Change in quantity
Now, let’s observe a simple example.
A manufacturer produces 20 units with variable cost of $10 per unit and fixed costs of $100. To sell 20 units of output, the manufacturer implements a cost-plus pricing strategy and decides on a profit margin of 5% of the cost. In this case, the selling price per unit is $15.75 = $15 + ($15*0.05).
However, if the manufacturer implements a marginal cost pricing strategy, it may charge $5 per unit. It seems to be unprofitable, doesn’t it? Not always – let’s observe the situations when marginal cost pricing strategy is typically applied.