From the economics point of view, the marginal cost pricing can be considered to be the strategy of setting the price equal to the additional expenses which is involved in manufacturing another product. With the help of this strategy, the business keeps the sales price reduced by encouraging the sales during the slack periods or simply to gain a huge amount of market share.
Marginal Cost Situations
There can be generally two situations where the marginal cost pricing strategy can be applied:
- When the company possesses a very small amount of capacity of unused products
- When the company is unable to sell at increased prices
In the first situation, the company is financially healthy and wishes to maximize the profits with some additional unit sales. The second situation is somewhat out of compulsion where the company is not able to increase the sales by any other means. In both the cases, the sales are intended to increase but not for the long term pricing strategy. The prices are set so low that it cannot offset the fixed costs of the business. The variable costs are however required to be created depending on the number of people working and the number of units produced.
Advantages of Marginal Cost Pricing
By using the marginal cost method, the following benefits can be observed:
- Profit Increase: Some additional profits can be earned in this method when the particular section of customers reacts to the prices in a very sensitive manner. The group of the people may not buy from the company if they have not involved in the marginal cost pricing.
- Accessory Sales: The marginal cost pricing will help in the situations where the product accessories and the services are bought by the customers in substantial margin. The technique can be applied in the ongoing basis to earn the profits from the future sales.
- Entry in Market: When a firm is willing to earn short term profits during the market entry, the marginal cost pricing can be applied. The acquisition of price sensitive customers can be done through this method.
Drawbacks of Marginal Costing
Though there are several benefits in this method, you can also find some disadvantages like:
- Market Price Ignorant: The marginal cost pricing generally ignores the market price. The prices are fixed at an absolute minimum point. The company could have gained more if the prices are set near to the market rates.
- Long Term Pricing: For the long term pricing, this method is not at all acceptable. The fixed expenses of the company are not captured in this particular method.
- Cost Focus: When the company frequently engages themselves in this particular pricing strategy, it can observe that the prices are kept lower and the transition to the high quality market niche is not possible.
The marginal cost pricing can therefore be useful in situations where the firms are possessing excessive capacity of production. The method will work well if the prices are set depending on the current market rates.