The marginal cost-plus pricing approach considers variable costs of production. It is a useful method for businesses with a large proportion of variable costs.
It is a simple and easy method to practice. Businesses can set the desired markup on top of the variable costs. However, this method is not suitable for all types of businesses as it ignores market competition and other external market conditions.
Let us discuss what is marginal cost-plus pricing and its uses.
Marginal Cost-Plus Pricing – Definition
It is a method that determines the selling price of a product by adding a margin to the variable costs of production. It means this method only considers variable costs of production.
A business adds a fixed percentage of markup to the variable costs incurred. It hopes to cover the proportion of fixed costs as well as administrative costs of business from the added markup.
It is in line with the proponents of marginal cost practitioners. A business that can recover marginal costs can remain competitive in the market.
A business incurs two main types of costs; variable and fixed. It is important to mention variable costs that are different from the fixed costs here. This method only considers variable costs of production.
Variable Costs
These costs change with the changing level of production. Common examples of variable costs include raw material, direct labor, and other direct costs.
Fixed Costs
These costs do not change irrespective of the changing production levels. These costs are also called sunk costs as a business cannot recover these costs once incurred. Common examples include production facility setup, rent, and permanent fixtures.
Marginal Cost-Plus Pricing Formula
The formula to calculate the marginal cost-plus prices can be used with a little variation of the normal cost-plus method.
It can be adjusted for the variable costs as:
Selling Price = Variable Cost × (1+markup)
How Does Marginal Cost-Plus Pricing Work?
Marginal cost-plus pricing is similar to calculating product contribution margin. The contribution margin is the selling price of a product less its variable costs of production.
A company calculates the variable costs of production first. It can then calculate variable cost per unit by dividing the total variable costs by the number of units produced.
A company adds a percentage of a markup over the variable cost of production. This approach is intended to generate sufficient profits that can cover fixed costs of production as well as provide profits.
The common practice of calculating a selling price is to consider fixed and variable costs. A cost-plus approach then adds a markup on top of that number. It gives a company the required profit after covering all costs of production.
The variable cost-plus method is preferred by businesses with a larger proportion of variable production costs. It means for businesses with highly customized production features and sophisticated technologies in use, this method can work well.
Steps to Calculate Marginal Cost-Plus Prices
Unlike the traditional cost-plus method, marginal cost-plus pricing requires calculating variable costs and fixed costs of production separately. If a business knows its contribution margin, its calculation will be easier for this process.
Step 01
The first step is to calculate the total variable costs of production. A company can separate its fixed and variable costs in this step.
Step 02
The second step is to calculate the variable cost per unit. If the business knows its contribution margin, it can directly use the contribution margin as well.
Step 03
Finally, the company can add a fixed percentage of a markup over its variable cost per unit. It will give you the required selling price per unit.
As with any other costing method, this method can also use a dollar amount of markup instead of a percentage. For example, a company can add $10 over its variable costs (say $ 15 per unit) to set a selling price of $25.
Example
Let us consider a working example to understand the marginal cost-plus pricing.
Suppose a company ABC produces electronic items. One of its items has the following cost data available.
- Direct Material = $ 25
- Direct Labor = $ 10
- Direct Energy = $ 5
- Total Fixed Costs = $ 500,000
ABC company intends to add a 40% markup in the marginal cost-plus pricing method.
Variable cost of production = $ 25 + $ 15 + $ 5 = $ 40.
Selling Price = Variable Cost × (1+markup)
Selling Price = $ 40 × (1+ 40%) = $ 56
ABC company can now determine its sales break-even point for recovering its fixed costs.
Required units = fixed costs / (selling price – variable costs)
Required Units = $ 500,000 / (56 – 40) = 35,714 units
It means ABC company needs to sell 35,714 units to cover its fixed costs on top of its variable costs. The company can adjust its markup according to its production capacity. For instance, it can set the markup up to 60% to lower the required units to 20,833.
When to Use Marginal Cost-Plus Pricing?
The first factor is an obvious one to consider if your business has a larger proportion of variable costs as compared to fixed costs. However, the calculation may not be simple.
If you are certain that adding a percentage or fixed markup to the variable costs will cover the fixed costs as well, this method suits your pricing strategy. You can add the desired markup on variable cost per unit.
If a business sets up a large production facility, it will have a large proportion of fixed costs. However, it may have excessive production capacity as well. If a business can fulfill that excess capacity to maximize its revenues, it can also use this method.
Conversely, once a business calculates the selling price through this method, it can analyze the production capacity requirements. As discussed in our example above, this method will provide a sales break-even point.
The business can then either adjust its markup or increase the production capacity to recover fixed costs. Similarly, if the business is already selling sufficient units, it can reduce the markup to remain competitive.
When Marginal Cost-Plus Pricing Should Not be Used?
An obvious case to avoid using this method is where fixed costs have a higher proportion as compared to variable costs.
Businesses with large production facilities and sophisticated technologies will have large fixed costs. Thus, it will be inappropriate to use this costing method to set a selling price.
This approach is also risky for businesses in a highly competitive market. This costing approach ignores the market competition. It also does not consider the factor of customers’ willingness to pay a certain selling price.
For small businesses with limited production capacity, this method may not offer the right selling price as well. The business would not be in a position to increase the production capacity to achieve the desired sales that can cover fixed costs.
Advantages of Marginal Cost-Plus Pricing
The marginal cost-plus pricing method comes with its pros and cons. A business should analyze different factors such as production capacity, the proportion of fixed costs, market competition, and so on.
Useful in Market Penetration
Many businesses use this method as a short-term costing method. They set lower selling prices that cover only variable costs to attract price-sensitive customers. It can help a business enter into a new market or a new business to penetrate an existing market.
Help in Utilizing Full Capacity
This method helps a business calculate the break-even point for sales. The business has a motivation to utilize its full production capacity to recover fixed costs as well as generate profits.
Competitive Pricing
If a business does not have a significant proportion of fixed costs, this method can help a business in setting up competitive prices. It is particularly important for businesses in a highly competitive market and where customers are more price-sensitive.
Simple and Easy Method
The marginal cost-plus pricing method is a simple costing method. It is a widely used and easily understood method. Managers and other stakeholders can easily adopt this method.
Flexible Pricing Approach
As this method directly derives the selling price from variable costs, it remains flexible if input raw material prices increase. The business adds a markup percentage over its variable costs that means its profit does not affect when input costs increase.
Disadvantages of Marginal Cost-Plus Pricing
Like any other costing method, this approach also offers some disadvantages.
Ignores Market Competition
This method only considers internal pricing factors. Precisely, it considers only variable costs of production. It does not consider the market competition and selling prices in the market. It can prove a costly mistake for a business.
Not Suitable for All Businesses
Businesses with a large proportion of fixed costs per unit should not use this method. Also, businesses that are highly sensitive to market competition should not adopt this method.
Not Suitable for the Long Term
This method is useful in the short-term such as for market penetration approaches. However, later with increased prices, it may not offer the same advantage to the business.
