Published on May 26, 2023

What Is Marginal Cost Pricing & How to Calculate It

Understanding Marginal Cost

Marginal Cost Formula

When can marginal cost pricing approach be applied?

Example of Marginal Cost

Advantages of Marginal Cost Pricing

Disadvantages of Marginal Cost Pricing

The Bottom Line

How Priceva’s Tools Can Help with Marginal Cost Pricing

FAQ

Understanding Marginal Cost

At first glance, marginal cost pricing seems to be unprofitable at all, however, this strategy has certain benefits for businesses if applied in the correct cases, which we will describe later. But first, let’s find out how marginal cost pricing is formed.

Marginal Cost Formula

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**

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.

When can marginal cost pricing approach be applied?

- The business has achieved the break-even point. When it happens, the expense of manufacturing has been totally covered by revenue. Hence, all the extra units produced may be sold at their marginal cost without hurting profit and economical viability.
- The amount of additional production the company can produce is still larger than the volume needed to break even.
- The business implements an aggressive pricing approach, such as a loss leader.

Example of Marginal Cost

Break-even volume = Fixed cost / (Selling price per unit – Variable cost per unit) = $100 / ($ 15.75 – $10) = 18 units (rounded up).

With an output of 18 pieces, the manufacturer has fixed costs of $100. Meanwhile, its variable costs are $180 = 18 pcs x $10. Thus, the total cost is $280 at that volume.

The revenue from selling 18 items is $283.5 (18 pcs x $ 15.75).

With its current capacity, the company can still increase its output to 24 pieces. For the next 6 outputs, it can apply marginal cost pricing.

Let’s calculate the marginal cost resulting from raising output from 18 units to 24 units.

Total fixed costs stay the same ($100). With the average variable cost of $10, the total variable cost is $240. So the total cost of producing 24 units is $340 ($100 + $ 240).

Marginal cost = ($340 – $280) / (24 – 18) = $10

The initial 18 units of production are priced at cost plus. The business charges a selling price of $15.75 per unit with a markup of 5% over average cost. At that rate, the business made $283.5 in profit and can cover its $280 manufacturing expenses.

For the following six units, marginal cost pricing is set at $10 per unit. The business generates $60 in sales at that pricing.

You can see that the company will record total revenue of $343.5 ($283.5 + $60) if it sets the selling price of the additional output at its marginal cost. It barely generates any profit, but companies use such pricing approach if their primary goal is to increase market share.

If the company's primary objective is to make a profit, it may set the selling price for the additional 6 units of output at the break-even point average cost ($15). In this case, extra manufacturing generates $90 for the company (6 pcs x $15). The company would make total sales of $373.5, which is more than its entire cost of producing 24 pieces of product ($340).

Advantages of Marginal Cost Pricing

- The computations are not sophisticated – you can figure out marginal cost using simple formulas.
- It allows attracting highly price-sensitive customers and making some extra money from these clients.
- This pricing strategy can be useful if a company has surplus manufacturing capacity. The business may boost production and sell it for less than it would normally cost.

Disadvantages of Marginal Cost Pricing

- This strategy may not work out in the long term unless the business has all its manufacturing expenses fully covered.
- Customers anticipate that the business will keep its prices low even further. Therefore, increasing rates in the future will be more difficult.
- Buyers may resell products bought for marginal cost and make profit. The manufacturer risks losing a part of customers and its revenue.

The Bottom Line

If you don’t know whether keeping prices close to marginal cost is a good idea for your business, implement the repricing tool by Priceva: it will help you optimize rates so as to meet your profit goals. No manual analysis – the software will calculate the best price based on pre-set formulas and, if necessary, update it right in your online store.

How Priceva’s Tools Can Help with Marginal Cost Pricing

FAQ

Why Is Marginal Cost Important?

What Is the Difference Between Marginal Cost and Average Costs?

Does Marginal Cost Equal Price?

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