Explain what is Marginal or Variable Cost Plus Pricing in Pricing Decisions ( Part 2 )

October 15th, 2006 Comments off
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In the earlier article, we have dealt with the importance of making the correct pricing decisions and the factors to consider before making a pricing decision.

This article refers to the various methods of pricing which include the following:

  • Full Cost Plus pricing;
  • Variable or Marginal Cost Plus pricing
  • Rate of Return Pricing;
  • Break-even Pricing;
  • Minimum Pricing;
  • Standard Cost Plus

Salient Points on Variable/Marginal Cost Plus pricing:

  • Selling price is determined by adding a mark up or margin on the total variable costs (marginalcost);

  • Based on the assumption that any price above variable cost would generate a certain level of contribution towards meeting fixed costs;

  • Consistent with the marginal costing technique;

  • When using this pricing method, need to be careful to ensure that it is sufficient to cover all fixed cost and to generate sufficient margin for profit otherwise the long term survival of the business might be at stake;

Simple Illustration:

Let’s look at Product A:

Production cost as follows:

Variable/direct material $1.50

Variable/direct labor $1.50

Variable Production overheads $1.00

Variable Administrative overheads $0.50

Variable Selling overheads $0.10

Total variable costs $4.60

Say required mark up of 65% $3.00

Variable Cost Plus Pricing $7.60

The selling price is determined at $7.60 where the company wants Product A to at least cover its total variable cost and contribute towards recovery fixed costs and profit.

Advantages Of Variable/Marginal Cost Plus Pricing:

  • As it adopts the margin cost approach, it provides better information as it segregate the variable and fixed costs;

  • Highlights the importance of contribution;

  • Useful for contract bidding where competition could be quite intense;

· Eliminates the difficulty of computing fixed costs into the products.

Disadvantages Of Variable/Marginal Cost Plus Pricing:

· For short term pricing decision, it’s alright otherwise needs to be very careful the pricing in the long term can recover fixed costs and generate sufficient profit for the business;

· Might be unsuitable for production costs consist a lot of fixed costs.

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