Costs may be classified as variable, fixed and semi-fixed. Take the case of an airline.
Costs may be classified as
variable, fixed and semi-fixed. Take the case of an airline. It may consider
the annual depreciation on an aircraft as a fixed cost. Taking the plane off
the ground to fly from one city to another incurs certain semi-fixed costs like
the fuel, the compensation of flight personnel, the airport fees and so on.
These costs are approximately the same for any given flight whether the plane
is empty, half-loaded or completely full of passengers. The variable costs of
the flight would include primarily the costs of food and beverage. They vary
directly with the number of passengers.
If fixed and semi-fixed costs
make up a larger portion of total costs, as in the airline example, pricing to
get maximum capacity utilization is crucial. Until the seller covers fixed
costs, money is lost. After fixed costs are covered, each incremental sale
contributes proportionally large amounts to profits.
If variable costs are a
relatively high percentage of total costs (which is quite likely in many
manufacturing firms), pricing to maximize unit contribution (i.e. the
difference between the unit variable cost and price) will be critical to
profitability. Under these cost conditions, the manufacturer would naturally
work to maximize unit prices and to reduce variable costs.
Above are two examples. In the
first one, the objective of the airline’s pricing strategy will be to generate
enough total revenue to cover its fixed costs and above that to get maximum
capacity utilization to make profits. In the second one, a manufacturer will
price to cover its high variable costs per unit and get enough contribution to
amortize fixed costs and make a profit.
Under certain conditions, firms
may elect to price at less than full cost. In conditions of capacity
underutilization, for instance, firms with high fixed costs may take business
at prices that cover variable costs and make some incremental contribution to
fixed costs (or overheads). The idea is to get through bad times, keep the
factory running and hold some critical team of managers, skilled technicians
Pricing temporarily at less than
full cost may also be used as a strategy to get a particularly large order. The
expectation is that by taking the business, the firm may be able to reduce its
unit costs and/or later raise its prices so as to make a profit on subsequent
orders. Taking business below cost with the hope of offsetting near-term losses
with longer-term profits may be a risky tactic, since there is no assurance
that the losses can be made up.
Pricing near or below cost may
also be done to gain a large market share. Generally pricing low to preempt
market share is predicted on the assumption that unit costs will come down
significantly as volume increases. This may happen through gaining
In fact, in many firms, a so-called experience or
learning curve is used to calculate what the effect will be of volume growth on
unit costs. To a large extent, learning curve experience reduces the variable
cost component of unit costs. Labour gains in efficiency and purchases of
materials and parts in larger volumes all result in lower prices and
manufacturing process improvements produce cost savings.
Indeed, the fixed-cost component
of unit costs may also come down with volume increases. Larger plants may be
more cost efficient. Large-scale selling and advertising programs may also be
more cost efficient. If product sales are particularly sensitive to heavy
advertising, or the product requires widespread distribution or extensive field
service support, fixed marketing expenditures for these purposes must usually
be at a high level.
These so-called scale economies
come in certain cost categories depending on the product, the processes used to
manufacture it and the level of marketing spending required to be competitive.
If significant scale economies are achievable, some competitors may be willing
to price low enough to gain volume, thus preventing other competitors from
going down the learning curve and hoping to emerge as low-cost producers with
dominant market shares.
Product cost, then, is not a
simple ‘hard’ number. How cost is calculated for pricing purposes is a matter
of managerial judgment. It may be construed as full cost or as variable cost.
It may be the cost levels being experienced or experience curve estimates of
future costs. The interpretation of cost factors for pricing will depend
greatly on product/ market objectives.
Tags : MARKETING MANAGEMENT - Pricing Decisions
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