Variable-Margin Pricing

Variable-Margin Pricing

 

Most industrial firms sell a line of products rather than jus a single product. Very few firms attempt to earn the same profit margin on each product in the line. Most firms price their products to generate a satisfactory return on their whole line, not on each product in the line. This variable-margin pricing policy permits maximum competition on individual products. The profits from the most efficiently produced and “successfully priced” items often are used to offset the losses or the lower profit margins of the inefficiently produced items.

 

Recently, during a research project at a printed circuit manufacturer, one of the authors traced overhead for 188,000 boards consisting of about 4,000 designs. The overhead generated by the production was applied by the company to the boards on an equal basis; however, about 20 percent of the boards drove 80 percent of the overhead. As expected, the 20 percent consisted of the low-volume boards produced on small lots. Since the company based its prices on cost estimates, the high-volumes boards were significantly overpriced.

 

An understanding of the theory of variable-margin pricing is essential if buyers are to obtain the right price. Whenever possible, sellers use average profit margins for pricing orders because that is usually advantageous to them. In some cases, this practice results in prices that sophisticated buyers realize are too high, particularly when low-cost, efficiently produced items are being purchased. Invariably when average margins are used, prices considerably above fair prices result for large, long-term purchases. When dealing with large multiproduct  firms which utilize this pricing approach, a buyer also must know which of the items purchased is a high-margin item and which is a low-margin item. Such facts are learned by noting the differences in volumes, manufacturing skills, and costs of the various producers.

 

The following case illustrates the practical concepts of the preceding discussion. A large high-technology research firm successfully negotiated a $2.8 million annual contract for medical and scientific supplies. At the outset, the seller proposed that the contract be priced at cost plus the firm’s annual gross profit margin of 19 percent. After several hours of negotiation, the contract was priced at cost plus 6 percent profit margin. If the supply manager had not understood the concept of variable-margin pricing and not known which items the seller produced efficiency, the contract would have cost her company an additional $320,000.

 

In their search for optimum prices, component buyers are aided by analyzing the pricing methods of both full-line and specialty suppliers. Regrettably, only buyers from a few progressive firms actually make such in-depth analyses of the entire product line of the industries in which they do business. Instead, most buyers focus their analyses on one product at a time. Buyers are rewarded by directing their efforts toward the development of savings produced by recurring long-term cost reductions rather than focusing on savings from short-term cost reductions. In short, optimal pricing come to buyers who understand the pricing processes for complete product lines, in all firms, in all industries from which they buy.

 

In the long run, a firm must recover all of its costs or go out of business. In the long run, for any particular item, the price is roughly equal to the cost of the least efficient producer that is able to remain in business. In the short run, however, prices in the free, competitive segment of the economy are determined primarily by competition, that is, by supply and demand, not by costs.