Fixed Cost 200,000

Break-even Output = ——————— = ———— = 8,000

Contribution 25

Contribution pricing methods can be a very useful means of assessing the performance of a business, allowing management to measure and compare the contribution made by all of the various products the firm produces. Some products may make a negative contribution – that is, variable costs may exceed the selling price – in which case, total profit may be increased by halting their production. However, sometimes firms may deliberately produce and sell a product generating a negative contribution as a loss-leader, in order to encourage interest in other products in the range. Closing down the production of such a product could damage sales of the other products, and reduce their contribution as well. For example, the Mini car is a popular make which car-dealers like to display in their showrooms to attract people in to browse – and hopefully to buy. However, for many years the production of the Mini resulted in a loss for its manufacturer.

Similarly, a product may make a negative contribution if it is a relatively new, competitively priced item, in the launch or growth stage of its life cycle.

Marginal cost pricing. The addition to total cost resulting from the production of an additional unit of output is known as the marginal cost. A decision to expand output by one or more units will be based on an assumption that unit price will be at least sufficient to cover marginal costs, such that the total profit earned on all previous units is not reduced. Sometimes firms will price just above marginal cost in order to use up spare capacity and ensure that at least a small contribution to fixed costs is made. For example, consider an airline selling flights to New York. Whether the plane flies full or half-empty, it will incur the same fixed costs for fuel, flight crew, and staff. Suppose 80% of seats at the standard fare are sold, yielding a reasonable profit on the flight. In an attempt to fill the plane, the airline can offer remaining seats at bargain prices. The marginal cost of each additional passenger will be small – just the cost of additional administration and on-board refreshments. As long as the fare price more than covers these small additional costs, the airline will be able to add to its profit.

Problems with cost-based pricing

Cost-based pricing strategies make no allowance for the market and what people are already paying for similar products. Once a mark-up for profit has been added on top of allocated costs per unit, the product price may be too expensive compared to rival products and the firm will find it difficult to make sales. In the short run, therefore, a firm may be forced to cut price and take a loss in order to fight off competition.

4.3. Market-Based Pricing Demand based pricing

Market- or demand-based pricing strategies tend to involve pricing products at ‘what the market will bear’. That is, producers will price high if consumer demand is high. For example, high prices are often charged for unique products, like rock festivals and designer clothes, because demand will normally outstrip supply.

Instead of reflecting what the product costs to produce, demand-based pricing asks: ‘At what price will this product sell?’ In adopting this approach, firms will need to carry out careful market research to find out what consumers are willing to pay, and also study the pricing policies of their competitors. Only then will they be able to produce a good or service with the right design and quality to fit the market, and at the right cost to yield a profit.

• Market skimming. This strategy, also known as price creaming, is often used when there is little competition in a market. It involves charging a high price for a new product to yield a high initial profit from consumers who are willing to pay extra because the product is new and unique. As competitors enter the market, prices are reduced to encourage the market to expand. Market skimming is a practice often observed in markets for audio and video products. For example, Sony and Phillips were the first manufacturers to release compact disc players in the UK during the mid-1980s. Initially, the players were priced at £500 or more. By 1995, there existed a bewildering variety of CD players, some priced as low as £50.

• Penetration pricing. This strategy is used by firms trying to gain a foothold in a new market. It is a high-risk, high-cost strategy that tends to be confined to large firms who supply mass markets. Penetration pricing involves setting product price low to encourage consumers to try the product and to build sales. This will also encourage retailers and wholesalers to stock the product and in doing so reduce their demand for competitors’ goods and services. In addition, the firm may boost sales by lowering price if demand is price-elastic. Cutting price tends to increase total sales revenue if demand is price-elastic. However, in markets where the supply side is very competitive, a price war may develop among rival firms. Any rise in sales from price cuts may be short-lived, as rival firms slash prices in an attempt to retain their market shares. It is often said that only the consumer wins in a price war.

• Expansion pricing. This is similar to penetration pricing. Product prices are set low to encourage consumers to buy. As demand increases, the firm is able to raise its level of output and take advantage of economies of scale, which will lower the average cost of producing each unit. Lower average costs can either be passed on to consumers as lower prices, or, if prices are held steady, the lower costs will increase the firm's profit margins.

• Price discrimination. This is used when a firm is able to charge different prices to different groups of consumers. For example, British Rail has different prices for peak and off-peak travel. Similarly, British Telecom charges different rates for telephone calls made at peak and off-peak times. Price discrimination is only possible when consumers are unable to undercut higher prices by reselling the product from low-price markets to higher-priced ones. Thus, it is often possible to charge different prices for the same product or service in different regions of the country or world, if the cost of sending the product elsewhere more than offsets any saving in price between areas.