on May 26, 2023

In our previous guides, we reviewed pricing strategies that rely on a large multitude of external factors: demand, buyer’s purchasing power, seasonality, and so on. But not all pricing approaches depend on market conditions – some businesses calculate the cost of their goods based on expenses involved. Marginal cost pricing is one of such approaches: it takes into account the cost of manufacturing a product. This article explains how it differs from cost-plus strategy, how to calculate margin cost pricing, and when it can be applied successfully.

Table of Contents

- 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
- FAQ
- Why Is Marginal Cost Important?
- What Is the Difference Between Marginal Cost and Average Costs?
- Does Marginal Cost Equal Price?

Understanding Marginal Cost

In economics, the practice of setting a product's price to cover the variable expense resulting from producing an additional unit is known as marginal cost pricing. This pricing policy presupposes charging only the addition to the total cost of labor and materials. When sales are low, businesses frequently set prices near to the marginal costs. For example, a company used to charge $3 for a cup of coffee. When demand declined, it lowered the price to $1.25 to cover $1 of raw materials and barista’s labor: it resulted in $0.25 of pure profit. The reason the coffeeshop would pick this strategy is because a 25 cent profit from the transaction is better than no sale at all.

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.

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

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:

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.

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.

When can marginal cost pricing approach be applied?

Yes, businesses cannot always employ this pricing strategy, but it proves to be efficient in the following situations:

- 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

Let’s observe price formation when the company reaches the break-even volume. We can deploy the following formula:

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).

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

Marginal cost pricing is used due to the following facts:

- 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

Before trying marginal cost pricing in your business, consider its drawbacks:

- 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

Although it seems to be unprofitable, margin cost pricing approach can be useful when it is applied properly. If you can allow manufacturing extra goods or delivering extra services without changing fixed costs and incurring large expenses, margin pricing allows attracting price-sensitive buyers and selling more products. Besides, you can use this strategy to penetrate the market and increase sales of accessories and related goods.

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.

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.

FAQ

Why Is Marginal Cost Important?

Marginal cost is important because it helps businesses make informed decisions about production levels and pricing. It represents the cost of producing one additional unit of a product or service. By comparing marginal costs with revenues, businesses can determine the optimal quantity to produce and the appropriate price to charge, maximizing their profitability. Understanding marginal cost also allows companies to identify potential inefficiencies and cost-saving opportunities within their production processes.

What Is the Difference Between Marginal Cost and Average Costs?

The average cost of items is the total cost of goods divided by their total number. Marginal cost is calculated differently: it increases when an extra unit of product or service is delivered. Marginal cost fluctuates when the total cost of production changes because of a different quantity of production.

Does Marginal Cost Equal Price?

Marginal cost does not equal price, because the latter can be formed under a multitude of factors, and sellers take into account other variables, not just margin. However, marginal cost can equal price sometimes. For example, in situations of perfect competition, it becomes possible – this is the equilibrium condition where the companies maximize their profits. At this point, price equals marginal cost and average total cost of producing one good. If a company charges a price above the marginal threshold, it may lose its market share.

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