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Cost-based Pricing

Every company needs to calculate the costs of producing its products and services and to determine its profit margins based on these calculations. Needless to say, companies need to set the selling price over costs so that they can generate profit for their survival. Thus, a company must calculate all the cost elements affecting its products before determining the selling price.

Every company basically has three major cost components: fixed costs, variable costs, and total costs. Fixed costs are the cost elements that do not depend on production volume or are independent of outcomes, such as buildings, rent, machinery, and so on. These costs do not change in the short run and remain constant most of the time. Variable costs are the cost elements directly related to production volume and vary with the production output, such as the expenses of buying raw material for production, utilities, etc. The variable costs increase at a consistent rate, especially when a company starts increasing production capacity and producing more products. Total costs is a summation of fixed and variable costs (total costs = fixed costs + variable costs).

The company needs to set the unit price with this cost structure in mind. it needs to know how many products to sell to be able to pay its own costs before eventually making a profit. This is called break-even analysis. Break-even analysis is critical for a company in setting a markup price that reflects its sales targets and strategic goals. Break-even can be calculated for a specific price as follows:

The volume indicated by break-even analysis tells us how many units of products the company needs to sell in order to start making profit (profit = total revenue - total costs). In other words, all the losses and costs are paid before break-even point in order to start making profit. This is the point where total cost equals total revenue. This is also the point where the total cost curve intersects with the total revenue curve as pictured in Fig. 4.5.

Break-even point or the amount of product sale required to make a profit can vary greatly according to the selected price. If the company wants to reach break-even quantity earlier, it needs to increase prices, or vice versa. Thus, the break-even quantity can dramatically change the company’s pricing strategy.

Break-even pricing

Fig. 4.5 Break-even pricing

Once the company starts making a profit, the next question is: how can it maximize its profits under similar cost structures? The company needs to calculate marginal costs (the costs of producing one additional unit) to see the level at which it can reduce its own production costs in order to find a profit-maximizing price level. Marginal costs generally show an early downward slope followed by a rising slope. At the beginning, the company’s production costs generally reduce along the way as it learns how to effectively produce the products. That shows itself as a downward-sloping marginal costs line. In order to keep up with demand, the company needs to increase production capacity, for example, by hiring more workers. At some point, hiring one additional worker decreases production as it becomes difficult to organize employees to reach efficient production levels. This eventually causes an increase in marginal costs, which is depicted as a linear increase in the marginal costs curve in Fig. 4.6(a). This phenomenon is conceptualized as diminishing returns.

As discussed earlier, the marginal revenue curve is a downward-sloping line similar to the demand curve (Fig. 4.1), and the intersection of marginal revenue and marginal cost indicates the price and cost level where the company maximizes its profits. This can also be seen in Fig. 4.6(b) where total revenue exceeds the total costs line. The figure also indicates the

Marginal cost and marginal revenue company’s profit and loss zones. Thus, the company should operate at the right cost and price combination to remain profitable

Fig. 4.6 Marginal cost and marginal revenue company’s profit and loss zones. Thus, the company should operate at the right cost and price combination to remain profitable.

The cost structure is also influenced by the market structure. In monopolistic markets, a company potentially has substantial control over the market price of its product, and profit maximization can easily be achieved at the expense of consumers. However, in oligopolistic markets, price control is under the influence of competitors and sometimes is shared among a few producers in the same market. Thus, the companies in oligopolistic markets have moderate to substantial control of market prices and hence profit levels. On the other hand, in perfectly competitive markets, no company in the market has control over market prices and the market itself determines the price (see Fig. 4.2). In these markets, profits will be divided up according to the number of companies in the market.

 
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