Cost-based pricing strategies use the cost of producing the product as a base. They may or may not include an additional profit. Marginal-cost pricing strategies aim recover not only the cost of making the product, but enough extra to make one more of the same product.
If a small business owner makes three types of scented candle, she must decide on an appropriate price to charge for each candle before bringing the products to market. The most basic way to calculate a reasonable price for the candles is to calculate how much each candle costs to produce and then add a certain percentage as profit or do without a profit temporarily to break into the market. However, determining which costs to include is not always straightforward.
When calculating cost-based pricing, the business owner must decide whether to include only the costs directly associated with that specific product or all the costs of the business. Full-cost or fully distributed cost pricing includes a share of all business costs in the final price. In the case of the scented candle business, the rent on a table at a local Renaissance fair would be an example of a shared cost. In a full-cost pricing strategy, the table rent would be divided in three and assigned equally to each of the three types of candles to cover the cost.
Disadvantages of Full-Cost Pricing
Full-cost pricing may seem more logical than ignoring fixed costs as many businesses do. However, there is no logical connection between the decision to sell a particular product and a cost shared by all the products of the business. If the business owner stopped making one of her three scented candle varieties but kept making the other two, the rent on the table would remain the same. If she added four additional types of candles, the rent on the table would remain the same. Because the decision to make one particular type of candle has no effect on the cost of the table, including the cost of the table in the cost of the candle can cause it to be priced incorrectly for the market. Customers might be willing to pay only half as much for that particular candle, but three times as much for one of the others. Including the cost of the table might ensure that one of the candles doesn't sell at all.
In a marginal-cost pricing system, the cost of the product does not include fixed costs that are not specific to that product. The cost of the table rent is not considered part of the cost of the candle. Instead, the owner calculates the costs for producing that particular candle and then adds a margin equal to the cost of making one more candle. The margin can be used to help the business owner pay for the table rent if she chooses, but doesn't put an equal share of the rental cost on a candle that may prove less profitable.
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