Marginal Pricing, Revisited

What is the proper role of costs as a consideration in pricing decisions?

At many companies, the relationship between prices and costs is all too simple. Prices are calculated as a markup or multiple of costs, and perhaps adjusted for competitors’ price levels. Since this approach ignores worth to the customer, the flaw is obvious.  So the first consideration in pricing decisions should be “What’s the price ‒ or range of prices ‒ at which my prospects and customers are willing to buy?”

As a secondary consideration in pricing decisions, covering your costs with enough left for a pre-tax profit margin is important.  You can think of it as one reality test for the prices you’re discovering in the marketplace.  This consideration, along with generating enough volume, will affect your willingness to sell, for a given period of time.  (More on the time factor and cost dynamics below.)

Covering Which Costs?  Variable vs. Fixed

Microeconomic theory will tell you to cut your prices to get incremental volume as long as the price is high enough to exceed your variable costs and thus provide a positive contribution toward amortizing your semi-fixed and fixed costs.  Called “marginal pricing,” this approach can indeed bring in incremental profit and raise total profit in the current period, all other things being equal.

The caveat is that all other things tend not to stay equal.  You have to be sure that using marginal pricing won’t create negative ripple effects in the present, or (as near as you can tell) in the future.

The conditions that must be present for marginal pricing to deliver its theoretical benefits would include:

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 not universal.  A provider of lasik eye surgery in a developed country offering the surgery for $49 will not likely see more demand than at a much higher price (some prices are too low to be credible).
2. You can’t do any better in the pricing negotiation ‒ this is the highest price the customer will pay, and you’ll lose the order if you don’t make the price concession the customer wants.
3. Any price concession that you give, based on marginal pricing, will be invisible to your competitors (i.e. 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 down accordingly.
4. All customers get the same prices, or any customer-specific concessions will remain invisible to other customers who didn’t get a concession.  If your customers are retail or wholesale resellers, the ones who get the lower price won’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 the new price level.
5. The price that you offer or accept now, based on marginal 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 again.
6. 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 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.
7. Your company’s shareholders, securities analysts if your firm is publicly traded, and senior executives all agree on the goal of optimizing total profit dollars into the business ‒ without worrying about any negative effects on percentage-based income statement metrics (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, you might pause and think carefully about the wisdom of marginal pricing.

Pricing environment matters.  In the two public companies where I worked, I cannot recall an instance where all those conditions held true.  Unless your pricing environment is more forgiving, consider your best estimate of full costs, at your best assumption about volume, when setting your pricing floors.  Make very few exceptions to this rule, 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.

The Time Factor & Cost Dynamics

An important note about covering your company’s costs….

At a given point in time, you need to treat your costs more or less as a given, and make sure your prices will cover costs and yield a profit. But over time, costs cannot be treated as a given. You have to be working to reduce them continually through quality and productivity initiatives, managing any increases in input costs, and redefining your product and service delivery to take out low-value and no-value costs.

What if the prices that more price-sensitive customers will pay are below your costs plus profit requirements?  If you cannot achieve higher prices, or cannot lower your costs through changes in product or service, or quality and productivity initiatives, then perhaps you should turn that price-sensitive business away.  If that drops your volume below what you need to make your profit math work, then you need another plan, or to think about exiting the category.