MANAGERIAL ECONOMICS » MARGINAL COST PRICING

In case of Marginal Cost Pricing we have to consider the incremental cost ofproduction. Fixed cost is not taken into consideration. Marginal cost is the additionalcost for producing additional unit of output. In this method the price is related tomarginal cost.

The main difference between Full Cost

Pricing and Marginal Cost Pricing is that in Marginal Cost Pricing the fixed costcomponent is not included. The Marginal Cost Pricing is useful in the short periodwhereas Full Cost Pricing is mainly for the long period. As long as the marginal cost iscovered there is a sort of guarantee that the firm will not shut down.

Advantages of Marginal Cost Pricing

1. Variable cost remains constant per unit of output and fixed costs remain constantin total during short period. Thus control over costs becomes more effective andeasier. Standards can be set for variable costs, while Budgets can be establishedfor fixed cost in order to exercise full control over the total activities.

2. Marginal costing brings out contribution or profit margin per unit of output, andclearly brings out the effect of change in activity. It facilitates making policydecisions in a number of management problems, such as determining profitabilityof products, introducing a new product, discontinuing a product, fixing selling price,deciding whether to make or buy, utilising spare capacity, profit-planning, etc.

3. The distinction between product cost and period cost helps easy understanding ofmarginal cost statements.

4. Closing inventory of work-in-progress and finished goods are valued at marginalor variable cost only. This method leads to greater accuracy in arriving at profit asit eliminates any carry over of fixed costs of the previous period through inventoryvaluation.

5. As a corollary to above, since fixed costs do not enter into product-cost, iteliminates the process of allocating, apportioning and absorbing overheads, andadjusting underand over-absorbed overheads. Therefore, the method is simpler tooperate.

The firm generally follows Marginal Cost Pricing when it enters into a newmarket; the firm having unutilized capacity and that there is high degree ofcompetition in the market.

Limitations of Marginal Cost Pricing

1. This policy is useful only in the short-period and does not provide a long-run stableprice policy.

2. Under increasing cost conditions it may lead to higher price and under decreasingcost conditions it will lead to lower price.

3. It may lead to frequent price changes which are not liked by the consumers. Thebuyers prefer stable prices and not erraticprice fluctuations.

It needs to be noted that the Marginal Cost Pricing provides the upper andlower limits of prices whereas Full Cost Pricing clings to the middle points. In factwhile fixing the price both the theories should be taken into account as both thesystems of pricing reinforce each other.

NB: Full Cost Pricing: In this method the producer calculates per unit cost ofproduction and adds a margin of profit to it, which he considers fair and therebyarrives at a price which is acceptable to the consumer. In fixing the price, the firmcalculates the average variable cost, adds to it the average fixed cost and to that addsthe amount of fair profit. Fair profit is normally taken as 10% to 15% of the cost.