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What is Marginal Cost Pricing of Production?
Marginal cost pricing is a particular practice of setting the price for a product or service with a marginal slightly higher than a variable cost of production. Essentially, marginal cost is determined by the knowledge of the variable cost of production and the margin added by a company. Marginal cost is often presented as a short-term price-setting method. It occurs when a company has a small number of unused units. Besides, the marginal cost is also used when a firm finds itself unable to set a higher price for a product or service.
There are several key elements to consider when it comes to the marginal cost of production. Essentially, the phenomenon is regarded as the change in the total production cost originating from making one additional product unit. The key purpose of analyzing the marginal cost of production is to distinguish when a can get economies of scale to optimize the entire show and overall operations. In profit-making, it is possible when the marginal cost of producing one particular unit is lower than the current price per unit.
The key takeaways from the marginal cost phenomenon can be illustrated in several ways. First, the marginal cost is a crucial concept in managerial accounting. It helps optimize production. Second, a business can maximize profits by output to the point when the marginal cost equals marginal revenue. Third, the fixed costs are constant within the scope of production levels. Essentially, higher production costs lead to lower fixed costs per unit.
Advantages and Disadvantages of Marginal Cost Pricing
While it comes to particular benefits and challenges of the marginal cost of production, it is crucial to focus on several key angles. In terms of the pros, there are the following aspects to mention:
- Increased profits. It is crucial to understand that some customers are extremely sensitive to price changes. However, because of the marginal cost of pricing, companies can consider the interests of such consumers. When such a thing happens, businesses earn additional profits through marginal cost. It shows that marginal cost pricing can be beneficial when customers respond to various prices.
- Additional entry to markets.As a short-term strategy, the marginal cost of pricing can help create better entry points for needs. However, there is a potential to backfire in the scenario. Namely, when entering a new market with marginal cost, the company is more likely to get price-sensitive clients. Such consumers can easily leave a business if the price changes unfavorably.
- Increased sales volumes. If consumers are willing to purchase products within a robust margin, marginal cost pricing can help sell a product individually and gain profits later. The marginal cost of production shows when it is possible to increase the sales volumes.
In contrast to the potential benefits of the phenomenon, one can speak about correlating disadavantes. These include the following:
- Bad for long-term cases. The marginal cost of production is a short-term strategy. It means that it is unacceptable for long-term cases correlating to prices. If used in the long run, marginal costs do not capture a firm’s fixed costs.
- Market prices.The phenomenon works with the prices set at an absolute minimum. Essentially, there can be situations when a company focuses on marginal costs while avoiding market prices. As a result, a lack of focus on market prices can lead to a company's inability to evaluate the existing market conditions properly.
- Marginal customers. As mentioned above, the marginal cost of production leads to marginal prices and marginal customers responding to such prices. It creates conditions where any price rise can go against the company and repel the customers.
- Focus on costs. The constant emphasis on marginal cost pricing creates an environment in which a firm needs to hold down costs to generate profits continually. Such situations do not work well for businesses, especially if a company wants to switch to a higher-quality market.
Keeping the pros and cons of the marginal cost of production in mind, it is apparent that the strategy benefits when used properly. Companies appealing to the phenomenon should not solely rely on it. Instead, one should understand the difference between short-term and long-term pricing.
Examples of the Marginal Cost of Production
There are several elements to consider when it comes to understanding the functionality of the marginal cost of production. First, the production cost takes into account fixed and variable costs. To illustrate, one can present an example of a company producing umbrellas. For instance, a company pays $1.5 in plastic and fabric for every produced umbrella. These two materials correlate to the variable costs. The umbrella factor also adds $1,000 of fixed costs per month, including the cost of labor or pay for utilities.
Essentially, if you make 1000 umbrellas per month, each umbrella incurs $1 of fixed costs. Keeping that in mind, the total cost per umbrella produced will be $2.5. Suppose the company boosted its production and produced 2000 umbrellas per month for the next step. At this point, the total cost of production will drop to $2. Keeping that in mind, increasing production will lead to marginal costs. However, if the company won’t be able to handle additional units of production, adding any fixed costs will be included in the marginal cost of production.
The marginal cost of production is a short-term pricing strategy that considers fixed costs and variable costs. It is important when a company wants to boost production and add units. There are particular pros and cons of marginal cost, and it all depends on how the phenomenon is used to determine whether the concept will be advantageous or not.
How to Calculate Marginal Cost?
To calculate the marginal cost, it is necessary to divide the change in the total cost by the change in the number of units. Besides, it can be important to calculate the average price per unit.
Can Marginal Cost be Negative?
The only possible scenario for a marginal cost to be negative can occur if there is a decrease in the total cost. However, it does not happen in an environment with limited resources and scarcity.