Marginal cost pricing (contribution pricing)

1. Fixed cost – things a business pays for no matter how much they produce. (Rent/mortgage bank interest) • Variable cost – change with how much is produced. When there is no production this should be 0. (raw materials sometimes labor • Direct cost – similar to variable cost but is used to talk about a specific products cost of manufacturing • Indirect cost – close to fixed costs in that they don’t necessary account for the production of a given product • Contribution how much a sale of a product brings in to help pay fixed costs

2. Marginal cost pricing (contribution pricing) • The marginal cost is how much more it will cost to produce one more unit of something. • This deals with how much contribution a product makes to paying for fixed or indirect costs. • Subtract the direct or variable costs from the sales price of a unit to find the contribution.

3. Cost to make a book (per book) • Material 4.5 • Indirect cost 2.9 • Direct labor 4.1 • Total cost Per book 11.5 • Find the marginal cost of producing another book • If we charge 12 dollars for the book what contribution does the book make to pay indirect costs?

4. Full cost pricing – the pricing system is used to distribute the fixed costs of a business between all products a business produces. • Helps find break even point • It is simple because it only uses one criteria • Advantages of full cost pricing • Simple • Departments are accountable for the resources they use compared to contribution • Allocating costs is easy • Disadvantages • Is considered the least accurate method of appropriating costs • It can give misleading information if you change the criteria that will make a products contribution look better. (garbage in garbage out) • Obviously some departments will not like this way because some will look worse than others

5. Lets go with Chris’s business factory and he has $3000 worth of fixed costs every month

6. Fill in the chart below using first appropriation cost equally then by floor space

7. Absorption cost pricing is an extension of cost pricing in that it accounts for how much of the indirect costs a department uses. • It uses more than one criteria to determine what costs should be allocated to what department • This should be in theory more fair to the departments when figuring out contribution and finally profit. • Go back to Chris’s factory and add in the following costs • Rent 8000 • Marketing 2000 • Depreciation 2000

9. Advantages of absorption costing • Good for companies with many different products • Helps managers to understand the cost of their department • Makes it more fair for each department • Profitability can be easier understood • Disadvantages of absorption costing • Not all costs can be easily divided • More time consuming • Not practical in small firms • Indirect costs still need to be paid even if no production takes place

10. Predatory/ destroyer pricing • Is when a firm sets prices extremely low to get rid of the competitors. This can be an effective long term strategy to gain market share in future even though profits are hurt in the short term. • It is illegal in most western countries but most businesses can find ways around the laws with creative bookkeeping. • Is considered unethical by some • Limit pricing or pre-emptive pricing is when a business sets their prices just low enough so that it keeps competitors from entering the market. Creates a barrier of entry when one would otherwise not exist • Going rate pricing is simply charging the same as others in the industry for similar products

11. Price discrimination is when the same (usually service) is sold for a different price. Ex. Hairdressers, theme parks • During peak seasons businesses will raise their prices because customers have less price elasticity during these times. • Also on certain days of the week some businesses will offer deals. (half price food on Tuesdays) Three conditions that need to be met to achieve successful price discrimination • Must have some form of monopoly to work well. In a highly competitive industry it is not wise. • Consumers must have different levels of price elasticity • Markets must be kept separate so that switching does not take place. • Transfer pricing is when a business charges itself different prices within divisions to reduce profits which will reduce tax bills.

12. Loss leader pricing places like a supermarket may sell a product below cost in order to attract customers to the store in order to get them to buy other products that they make a profit on. They tend to advertise heavily the loss product in order to attract attention. Ex. Sony/Nintendo • Psychological pricing when a company sells something for 4.99 rather than 5 or 4.39 for one or 13.17 for 3. These are meant to trick the buyer that they are paying a lower price. • Promotional pricing – Charging a low price in order to attract customers (build market share) and build brand loyalty. Also if a business has a large stock of something they may use a promotional pricing scheme to clear them. Usually only a short term pricing scheme that can be easily copied by rivals. • Discount pricing is similar but used at the end of a products life cycle as an extension strategy.