While I would like to avoid being cliché, pricing is often an under utilized and oft misunderstood strategy. So today I wanted to look at contribution margin-based pricing with you in my continued series of business related pieces.
What is contribution margin-based pricing? It is a is a pricing strategy which works without any mention of gross margin percentages. Many people are unfamiliar with it but I had the good fortune to have an amazing professor in college that saw the benefit at looking at intensely at pricing strategies that were not commonly utilized in the US at the time.
The main draw to the strategy is that it maximizes the profit derived from a company's assortment, based on the difference between a product's price and variable costs. You can calculate that by taking the product's contribution margin per unit. Then taking one's assumptions regarding the relationship between the product's price and the number of units that can be sold at that price you arrive at the product's contribution to total firm profit; This is a contribution to the operating income, which is maximized when a price is chosen that maximizes the Contribution Margin Per Unit X Number of Units Sold.
Depending on the level of employment of the strategy, a distinction is made between fixed and variable costs, which together result in the total cost.
We will look at that in just a moment.
However, first let us look at the required contribution, and how the cover can also be derived from the invoice. The contribution per unit sold is based on the net selling price minus variable costs.
Price – Variable Costs Per Unit = Contribution Margin Per Unit
The contribution does not take into account the fixed costs, i.e. the costs required to maintain the company. A contribution to cover occurs precisely when the sales revenue per unit is greater than the variable costs. The contribution to cover is thus the short-term price floor and is used precisely if it is to be decided whether:
Performance or foreign reference:
- Acceptance of additional orders
- General pricing policy
In order to reach the profit zone, either the price per unit must be increased or more customers gained through marketing measures in order to increase the net selling price than the total cost ( profit). Depending on the price policy, the price must either exceed the total cost, in the long term at least, or be higher than the contribution to cover; Aware that the short-term applies only to additional orders or the decision in pro/contra own performance. The contribution statement can also be used to inferred the operating result by making the sum over all units sold.
Unlike the commonly applied coverage contribution bill, this is used in connection with the Profit Center to figure out what coverage the Profit-Center bears in the general fixed costs for the company.
In many cases, the contribution statement still takes into account sales proceeds with which this profit center in particular works. In particular, this applies to pricing policy within market structure. So the net selling price is not set, but the gross selling price minus the cabling reductions like discounts.
Otherwise, the bill remains the same.
To put it simply, variable cost is the contribution to cover minus fixed cost, resulting in a profit/loss scenario per unit sold.