Marginal cost pricing strategies are difficult to implement, but generally yield better results than full cost pricing. They are characterized by a market-facing approach that tries to estimate and influence demand for a product. The business sets production targets and bases pricing on what it costs to produce additional units at that point. Full cost pricing is inward-looking. It is characterized by a focus on the product, and how much it costs to make it. Businesses set prices by using the full cost of making the products at the set production volume. Such a strategy does not maximize profits.
Setting Production Volume
Both full and marginal cost pricing strategies must first set a level of production. Using full cost pricing, a manager estimates demand based on past production and market estimates. With full cost pricing, the costs do not vary greatly if production is slightly higher or lower. The manager sets the production level to a volume of products that he knows he can sell. For marginal cost pricing, a manager takes into account the higher demand caused by a lower price. He sets a higher level of production because, in his calculation, his costs are much lower when he produces more. He correctly assumes that he can sell more product due to the lower cost.
Following a full cost pricing strategy, a manager adds together all the costs related to manufacturing the product. He knows his level of production and he can easily calculate his total costs. A marginal cost is more difficult to establish, because there are no set costs to add together. The manager usually estimates the marginal cost based on subtracting the fixed costs from the total costs. He may review the production level to make sure it reflects the real demand anticipated for the product at the marginal cost. The marginal cost pricing strategy is only as good as the marginal cost estimate.
Setting the Price
Businesses using either strategy must make sure they establish pricing that covers their costs and leaves an adequate profit. For full cost pricing, a manager will add a margin to the full cost to cover overhead and generate the desired profit. For marginal cost pricing, a business may maximize profit by calculating the price needed to cover the marginal cost. It will then set a higher price, at a level that it estimates is the highest a customer will pay for the product, taking into consideration competitors' pricing and market price levels.
The business using a full cost pricing strategy will reliably make the calculated profit. The business using marginal cost pricing will have set a higher production level because it expected to be able to offer a lower price and stimulate demand. As a result, its costs are lower. If its estimates were correct, it will be able to set its pricing just below the full cost pricing of its competitor and sell more product, either generating more profit or generating the same profit while taking over market share. The marginal cost pricing strategy leads to better performance with a higher risk.