Marginal pricing is a method of pricing, also regarded as the variable cost or contribution method consists of applying cost-volume-profit analysis when making price decisions. By applying marginal prices, the company sets prices to maximize its contribution to profit and fixed costs (T. Lucey 2003, s. 383).
Future costs and revenues are those which will be used to determine the price. All previous expenses are unavoidable, these are sunk costs. With short-term decisions, marginal prices may increase price flexibility and profits (T. Lucey 2003, s. 383).
Marginal prices should be considered as a short-term or defined approach that can be used because the company is in a special situation, for example, it has vacancies on the plane. Ultimately, if a company should be profitable, all costs have to be covered by sales revenues (E. McLaney, P. Atrill 2008, s. 421).
Advantages of marginal pricing
During marginal cost pricing, the prices are never made uncompetitive as a result of larger fixed costs. The order will not be rejected because the current price is less than the average cost. Prices established on variable costs can be flexible because variable costs are controllable in the short-run (M. Govindarajan 2007, s. 130).
"Secondly, marginal pricing helps a businessman to pursue a far more aggressive pricing policy than full-cost pricing. An aggressive price policy will increase the sale and possibly reduce marginal cost through increased physical productivity and lower input prices. Thirdly, marginal pricing is more helpful to fix price over the life cycle of the product that requires short-run marginal cost and separable fixed cost data relevant to each stage of the cycle. Fourthly, marginal cost pricing is more useful than full cost pricing because of the prevalence of multi-product, multi-process and multi-market firms that makes the absorption of fixed costs into products costs difficult" (M. Govindarajan 2007, s. 130).
Rules of marginal pricing
Marginal pricing rules may also be significant for variables related to marketing strategy management. Typical product goes through the so-called product life cycle. At each stage, it will require data of marginal costs and also separate period costs significant to the exact stage in the cycle to be able to make correct pricing decisions (T. Lucey 2003, s. 383):
Practical example of marginal pricing
"A typical example of its application in practice is where hotel chains cater for full-price business during the week and offer the spare capacity at weekends at some price above marginal cost, but less than normal price, thus increasing profits. This process is known as price discrimination and enables the firm to sell at different prices in different markets. A further example of marginal pricing the familiar one where a firm is experiencing reduced demand and obtains the best possible price above marginal cost in order to provide some contribution to fixed costs"(T. Lucey 2003, s. 383).
Limitations of Marginal pricing
Marginal pricing has its limitations which should be taken into account when considering it as a pricing strategy:
- It is based on the assumption that the demand for a product is relatively inelastic and that prices can be adjusted without significantly affecting the level of demand. This is not always the case, and in some markets, the demand is highly elastic and changes in prices can have a major effect on total sales and profitability.
- Marginal pricing does not take into account the fixed costs associated with producing a product or service, which can have a significant impact on the overall profitability of a business.
- Marginal pricing does not take into account external factors such as competitor prices, consumer sentiment and market trends, which can all have a significant impact on pricing decisions.
- Marginal pricing can also lead to a situation where costs are not covered and prices are too low, resulting in a loss of profit.
The other approaches related to marginal pricing are as follows:
- Price Skimming – in this approach, the company sets a high initial price when introducing an innovation or product to the market, and then reduces it over time as the product becomes more widely adopted.
- Penetration Pricing – this approach involves setting a low initial price to attract more customers to the product and then increasing it when the demand for the product increases.
- Price Discrimination – this approach involves setting different prices for different customer segments, based on factors such as customer income or location.
- Dynamic Pricing – this approach involves setting prices based on real-time data such as market demand, competition, or current events.
In summary, marginal pricing is a pricing approach that involves setting prices to maximize contribution to profits and fixed costs. Other related approaches include price skimming, penetration pricing, price discrimination, and dynamic pricing.
- Govindarajan M. (2007), Marketing Management, Prentice - Hall of India, New Delhi, s. 130
- Hague D.C. (2018), Pricing in Business, Routledge, New York
- Hahne R.L., Aliff G.E. (2019), Accounting for Public Utilities, Matthew Bender & Company, New York
- Lucey T. (2003), Management Accounting, Continuum, London, s. 383
- McLaney E., Atrill P. (2008), Accounting, Pearson Education Limited, Harlow, s. 421).
Author: Radosław Cieślik