Basic Marketing: A Global Managerial Approach

Perreault−McCarthy: Basic
Marketing: A
Global−Managerial
Approach, 14/e

18. Price Setting in the
    Business World

Text © The McGraw−Hill

Companies, 2002

Price Setting in the Business World 519

in that period gives an estimate of the average cost per unit for the next year. If

the cost was $32,000 for all labor and materials and $30,000 for fixed overhead

expenses—such as selling expenses, rent, and manager salaries—then the total cost

is $62,000. If the company produced 40,000 items in that time period, the aver-

age cost is $62,000 divided by 40,000 units, or $1.55 per unit. To get the price,

the producer decides how much profit per unit to add to the average cost per unit.

If the company considers 45 cents a reasonable profit for each unit, it sets the new

price at $2.00. Exhibit 18-3A shows that this approach produces the desired

profit—if the company sells 40,000 units.

It’s always a useful input to pricing decisions to understand how costs operate at

different levels of output. Further, average-cost pricing is simple. But it can also be

dangerous. It’s easy to lose money with average-cost pricing. To see why, let’s fol-

low this example further.

First, remember that the average cost of $2.00 per unit was based on output

of 40,000 units. But if the firm is only able to produce and sell 20,000 units in

the next year, it may be in trouble. Twenty thousand units sold at $2.00 each

($1.55 cost plus 45 cents for expected profit) yield a total revenue of only

$40,000. The overhead is still fixed at $30,000, and the variable material and

labor cost drops by half to $16,000—for a total cost of $46,000. This means a

loss of $6,000, or 30 cents a unit. The method that was supposed to allow a profit

of 45 cents a unit actually causes a loss of 30 cents a unit! See Exhibit 18-3B.

The basic problem with the average-cost approach is that it doesn’t consider

cost variations at different levels of output. In a typical situation, costs are high

with low output, and then economies of scale set in—the average cost per unit

drops as the quantity produced increases. This is why mass production and mass

distribution often make sense. It’s also why it’s important to develop a better under-

standing of the different types of costs a marketing manager should consider when

setting a price.

Exhibit 18-3 Results of Average-Cost Pricing

A. Calculation of Planned Profit if 40,000 B. Calculation of Actual Profit if Only 20,000

Items Are Sold Items Are Sold

Calculation of Costs: Calculation of Costs:

Fixed overhead expenses $30,000 Fixed overhead expenses $30,000

Labor and materials ($.80 a unit) 32,000 Labor and materials ($.80 a unit) 16,000

Total costs $62,000 Total costs $46,000

“Planned” profit 18,000

Total costs and planned profit $80,000

Calculation of Profit (or Loss): Calculation of Profit (or Loss):

Actual unit sales price ($2.00*) $80,000 Actual unit sales price ($2.00*) $40,000

Minus: total costs 62,000 Minus: total costs 46,000

Profit (loss) $18,000 Profit (loss) ($6,000)

Result: Result:

Planned profit of $18,000 is earned if 40,000 items are Planned profit of $18,000 is not earned. Instead, $6,000

sold at $2.00 each. loss results if 20,000 items are sold at $2.00 each.

*Calculation of “reasonable” price: Expected total costs and planned profit=$80,000= $2.00

Planned number of items to be sold 40,000

It does not make

allowances for cost

variations as output

changes