Cost considerations - Marketing Management

If demand considerations effectively set the upper limits to price, then cost considerations determine the lower limits. Relevant up-to-date cost information is essential to formalize pricing strategy. Accurate information allows the pricing decision maker to identify costs on a specific basis directly related to each product, activity or customer. In this way, management is able to make informed decisions about pricing to target market segments.

Possible shapes of demand curves

Possible shapes of demand curves

Relevant cost information is information which is presented and analysed in such a way as to be pertinent and helpful to marketing decision making. In particular, the cost analysis should enable the marketer to distinguish between fixed and variable costs and the relationship between these and volume. The importance and use of the distinction between fixed and variable costs is illustrated by a breakeven chart.

Simple breakeven chart

Simple breakeven chart

Breakeven versus different prices

Breakeven versus different prices

Fixed costs are those that do not vary with levels of output, examples being rates, heating, lighting and security of premises and are represented by the horizontal fixed cost curve. Variable costs directly relate to production and sales and include labour and direct materials. Increases in output or sales lead to a proportional increase in these costs. Taken together, fixed and variable costs combine to give total costs. The remaining information contained in a breakeven chart is the revenue curve. This shows the total revenue that will accrue to the company at a given price-quantity combination.

The breakeven point is the point at which total revenue exactly matches the total costs, i.e. there is neither profit nor loss. This information on cost/revenue relationships is useful to the pricing decision maker e.g. when comparing breakeven points associated with different possible prices for a product. The effect of charging a higher price is to steepen the total revenue curve and as a consequence lower the breakeven quantity. The decision maker can then evaluate the effect of charging different prices in terms of what these different prices and breakeven points mean to the company. Specifically, the information in a breakeven chart includes: n profit (or losses) at varying levels of output;

  • breakeven point at varying prices;
  • effect on breakeven points and profits (or losses) if costs change.

Breakeven points can also be calculated using the following information:

Selling price per unit – variable cost per unit = contribution per unit

pakeven quantity = Unit contributionp

e.g. Selling price = £20
Variable costs = £10
Fixed costs = £50,000
Contribution = 20 – £10 = £10.
∴Breakeven quantity =50,000/10=5,000 units.

The notion of contribution is a valuable addition to the pricing decision. It illustrates that in the short run at least, it may be advantageous to sell a product at a price that is less than the full cost of producing it. The distinction between fixed costs and variable costs is particularly useful where a company is attempting to penetrate a market with a new product. It is also useful in times of recession where prices have to be cut to maintain demand. The essential issue is to cover variable costs as a minimum and have a clear understanding of the contribution to fixed costs and profits.

Although fixed, variable and total costs are of major importance to pricing decisions it is also useful to consider how these costs change with different volumes of output, i.e. economies of scale and experience curve effects that we considered earlier.

If a company has a downward sloping experience curve, i.e. costs fall as a function of production experience, then the company might then adopt an aggressive pricing strategy based on increasing volume through low prices. There are risks such as aggressive competitor reaction and the creation of a down-market image.

Although costs are just one of the inputs to pricing decisions, in many organizations they are given more emphasis than any other factors in setting prices. Cost-based pricing is criticized, but it is still a widely used approach. Before looking at cost-based and other approaches to pricing along with their respective merits, we need to look at the final key input to pricing decisions: competitors.

All rights reserved © 2018 Wisdom IT Services India Pvt. Ltd Protection Status

Marketing Management Topics