A Different Perspective on Marginal Cost Pricing

I pulled up behind a Prius at a red light.

A sticker on its left rear bumper, in type too small to read unless you were within a car length or two, said:

“Sorry for driving so close in front of you.”

A different point of view on the tailgaters that clearly bug that vehicle owner!

A Different Point of View on Marginal Cost Pricing

A client’s pricing challenge that I recently helped with brought me back to a subject I wrote about years back: Marginal Cost Pricing.

That’s when a company seeks more volume by pricing just high enough to exceed their variable costs.

I’ve run across pricing experts who advocate doing so, but seldom do I see it as advisable. Why not? Because it assumes a perfectly competitive, commodity market. Few of us are in businesses like that.

The Proper Role of Costs as an Input to Pricing Decisions

At many companies, prices are a markup or multiple of costs, adjusted for competitive price levels. It’s flawed because this approach ignores value to the customer.  The first consideration in price decisions should be “What’s the price ‒ or range of prices ‒ at which my prospects and customers are willing to buy?” 

As a secondary factor in pricing decisions, covering your costs with enough left for a satisfactory pre-tax profit margin IS important.  You can think of it as a reality test for the prices you’re discovering in the marketplace.  This factor, along with generating enough volume, will affect your willingness to sell.

Covering Which Costs?  Variable vs. Fixed

In businesses selling standardized products and services, classical microeconomic theory suggests you can cut your prices to get incremental volume as long as the price is high enough to exceed your variable costs. That would provide a positive contribution toward amortizing your semi-fixed and fixed costs. This marginal cost pricing approach can indeed bring in incremental profit and raise total profit in the current period, IF the right circumstances are in place.

However, you have to first worry that using marginal cost pricing will create negative ripple effects. 

Unless the following conditions are true, marginal cost pricing won’t deliver its theoretical benefits and instead could create a profit drain that can last for years:

1. The demand curve is downward-sloping, i.e. a lower price will increase the quantity that customers want to buy.  This is common, but hardly universal.  For example, a provider of Lasik eye surgery in a developed country that offers the surgery for $49 will not likely see more demand than one at $999. $49 is too low for the service to be credible.
2. If it’s a seasonal or temporary pricing discount, the customer must have the flexibility to time their demand to when you want to supply.
3. You can’t do any better ‒ the price you’re considering is as high as the customer will pay, and you’ll lose the order if you don’t make the price concession the customer wants.
4. Your planned price concession will be invisible to your competitors — they cannot even infer that you've lowered your price — or your company isn't a significant enough player in your industry for your competitors to react and adjust their pricing downward accordingly.
5. All customers will get the same prices. Or, a customer-specific concession will be invisible to other customers who didn’t get a concession.  If your customers are retail or wholesale resellers, the one(s) who get the lower price mustn’t lower their resale prices as a result.  Or, if they do, they're too small a factor in the marketplace for other resellers to notice, or take their own prices down to match or undercut your channel partners.
6. The price that you offer or accept now, based on marginal cost pricing, won’t condition your customers to come back for yet another price concession now or in the future.  Or if they do, you can overcome their expectation that you’ll make another concession, and you’ll still get the order even when you don’t lower your price the next time.
7. Your sales personnel will be unaffected, now and in the future, by your price concession.  That is, even though you made a concession and indicated that you would accept a discounted price calculated on a marginal cost basis, it won’t affect how firmly and confidently they defend your company’s prices in subsequent interaction with customers.  Nor will your selling personnel have lower pricing expectations for future pricing decisions in which they have decision authority or input.
8. Your company’s shareholders, securities analysts (if your firm is publicly traded), and senior executives all agree that the goal is optimizing total profit dollars into the business ‒ without worrying about any negative effects on percentage-based income statement metrics such as margin rate, Return on Sales, etc.  Or, the transactions to which you'll apply a marginal pricing approach are too small to dilute your company's percentage-based financial measurements.

If all of those conditions aren’t present, I recommend thinking carefully about the wisdom of marginal cost pricing. 

In the two public companies where I worked, I cannot recall an instance where all those conditions held true. Ditto most of the privately held companies I’ve worked with.

Is marginal cost pricing really your best option? I usually see opportunities for companies to become more effective in attracting additional demand without cutting price. Make few if any pricing exceptions, and you’ll have more success in defending the worth of what you bring customers, the prices at which you offer to sell, and ongoing profits. 

If you sometimes face a pricing challenge like this one, let’s set time for a discussion. You can come away with clarity and a decision process that leads to better results with less risk.