In case of Marginal Cost Pricing we have to consider the incremental cost of production. Fixed cost is not taken into consideration. Marginal cost is the additional cost for producing additional unit of output. In this method the price is related to marginal cost.
The main difference between Full Cost Pricing and Marginal Cost Pricing is that in Marginal Cost Pricing the fixed cost component is not included. The Marginal Cost Pricing is useful in the short period whereas Full Cost Pricing is mainly for the long period. As long as the marginal cost is covered there is a sort of guarantee that the firm will not shut down.
Advantages of Marginal Cost Pricing
- Variable cost remains constant per unit of output and fixed costs remain constant in total during short period. Thus control over costs becomes more effective and easier. Standards can be set for variable costs, while Budgets can be established for fixed cost in order to exercise full control over the total activities.
- Marginal costing brings out contribution or profit margin per unit of output, and clearly brings out the effect of change in activity. It facilitates making policy decisions in a number of management problems, such as determining profitability of products, introducing a new product, discontinuing a product, fixing selling price, deciding whether to make or buy, utilising spare capacity, profit-planning, etc.
- The distinction between product cost and period cost helps easy understanding of marginal cost statements.
- Closing inventory of work-in-progress and finished goods are valued at marginal or variable cost only. This method leads to greater accuracy in arriving at profit as it eliminates any carry over of fixed costs of the previous period through inventory valuation.
- As a corollary to above, since fixed costs do not enter into product-cost, it eliminates the process of allocating, apportioning and absorbing overheads, and adjusting underand over-absorbed overheads. Therefore, the method is simpler to operate.
The firm generally follows Marginal Cost Pricing when it enters into a new market; the firm having unutilized capacity and that there is high degree of competition in the market.
Limitations of Marginal Cost Pricing
- This policy is useful only in the short-period and does not provide a long-run stable price policy.
- Under increasing cost conditions it may lead to higher price and under decreasing cost conditions it will lead to lower price.
- It may lead to frequent price changes which are not liked by the consumers. The buyers prefer stable prices and not erraticprice fluctuations.
It needs to be noted that the Marginal Cost Pricing provides the upper and lower limits of prices whereas Full Cost Pricing clings to the middle points. In fact while fixing the price both the theories should be taken into account as both the systems of pricing reinforce each other.
NB: Full Cost Pricing: In this method the producer calculates per unit cost of production and adds a margin of profit to it, which he considers fair and thereby arrives at a price which is acceptable to the consumer. In fixing the price, the firm calculates the average variable cost, adds to it the average fixed cost and to that adds the amount of fair profit. Fair profit is normally taken as 10% to 15% of the cost.