Marginal cost-plus pricing An obvious alternative to full cost-plus pricing and one that featured in the discussion of the pros and cons of the latter, is marginal cost-plus. A number of its virtues (and one of its vices) have already been mentioned in that discussion and thus require no further amplification. However, in view of the apparent superiority of the marginalist approach in the literature, and the (often uncritical) support it commands, it behoves us to preface our own positive remarks about its usefulness in certain aspects of the pricing decision with a healthily cynical caveat: Direct costing (marginal costing) emerged during the 1930s. It is ironic that it is more popular now, in a period of prosperity, capacity utilization, and expansion even outwardly ill-suited to many of its underlying assump-tions. Depression period ad hoc business thinking logically was influenced by the existence of idle capacity of plant, equipment and labor. At least 15 per cent of the work force was usually unemployed: furthermore, labor unions had not yet reached their present strength, and employers had greater flexibility in hiring, lay offs, setting standards, cost control, etc. Fewer capital assets were committed to each worker and, from the point of view of the individual enterprise, insolvencies and quick changes in ownership of capital assets at distress prices had decreased dollar costs of investment per worker below the years immediately preceding. Brand identifications, markets and selling prices were less differentiated, on the whole and in many more markets than today intense price competition prevailed. Compare our current economic situation: little idle capacity in manpower or machines, a high and increasing ratio of machinery to labor cost, powerful trade unions, more restrictive labor laws and relatively inflexible labor costs, and rising costs of fixed asset replacement and management and administrative personnel. The special characteristics of the depression economy made it possible for management to emphasize variable costs and frequently neglect fixed cost in pricing decisions without apparent adverse consequences. In an economy of idle capacity, incremental costs tend to be small, and certain costs may not increase at all until capacity is absorbed. Graphically, the fixed cost plateaus were much longer relative to the existing operating levels of many businesses. However, as plant and equipment were replaced and as capacity was fully utilized on regular product lines, costs that appeared to be constant eventually became variable. Continuing an ostensibly 'logical' short-run policy into the long run would have been highly destructive. The peculiar problems of the depression gave direct costing a pragmatic justification that obscured its theoretical fallacies. The continuation - and even expansion - of the concept to a changed economic and technical environment is an excellent example of a cultural lag Herson and Hertz (1981), p. 231) In the absence of precise data, best estimates of market demand at various prices in excess of variable cost are used to construct a series of profit lines on a PV chart. These lines are then joined to give a 'contribution curve', the highest point of which will indicate the selling price that makes the largest contribution to profits. Example 5 The variable cost of product X is £10 per unit, and the manufacturer estimates demand for X as follows: Within the volume range of 7,000 to 12,000 units, fixed costs are expected to remain unchanged at £40,000. From these data, a table can be prepared to enable the relevant points on the PV chart to be plotted and the contribution curve to be drawn: The contribution curve (Figure 11.8) would appear to confirm the figures in the table; a price of £17 maximizes profit. It would be better to extend the table and chart with some basic sensitivity analysis: by expanding the data to include estimated demand at intermediate points between £16 and 117 and £18, we can determine whether point C really is optimal, or whether this point lies some slight distance - and selling price - to the right or left. Sizer acknowledges the problems associated with single-figure estimates, and suggests the inclusion in the model, where possible, of the likely range of demand at each selling price. A similar chart can be constructed, joining all the lower and upper range points across the various profit lines; a visual inspection of the different contribution curves indicated by these limits should refine the analysis. A further refinement can be introduced by providing a probability distribution of sales demand for the various price levels, and calculating an expected value for profit at each of these to support the earlier contribution curve approach. Obviously, it is axiomatic in all quantitative disciplines that the quality of the output from a process can be no better than that of the input, and in view of the approximate nature of demand estimates, however statistically refined, the selling prices indicated by such analyses can themselves only be regarded as approximations. However, notwithstanding the overriding importance of market circumstances, which will subordinate all other considerations, Sizer's model provides a useful starting point in the search for profit maximization. The second situation in which the marginal costing approach to pricing can be particularly appropriate is where alternative products are competing for a scarce or limited resource. Here, profits will only be maximized where the total contribution from the limiting factor is maximized. The calculation follows easily from a computation of the contribution that each alternative product makes from each unit of the scarce resource. Where there is more than one limiting factor, the calculation is more complicated and calls for the use of linear programming or graphical analysis, but the principle remains simple - to maximize the contribution from the scarce resources. Obviously, contribution is a function of selling price and variable cost, and it is the former that we are interested in determining, in such a way that it satisfies the principle outlined above. Example 6 will illustrate how marginal costing can help in this situation.