Contribution Margin Pricing
Contribution margin pricing is a pricing concept that is aimed at maximizing the profit that is achieved from an individual product, depending on the difference between the price of the product and the business person’s assumptions regarding the relationship between the price of the product and the number of units that can be put on sale at that price. It should be noted that the contribution of the product to total business profit i.e. operating income, is maximized when a price is chosen that can maximize the contribution margin per unit multiplied by the number of units sold.
In theory, Contribution per unit is the difference between the price and the sum of the costs of variables of one unit of the given product. Variable costs are all costs that will shoot up with greater unit sales of a product or fluctuation with fewer unit sales. When doing the calculation, fixed costs should not be included since they are costs that will not change with level of sales over an assumed possible range of sales levels. Variable costs include cost of raw materials, direct labor and commissions issued on sales.
The contribution to profit from sales of a product can be obtained through the multiplication of the units sold by the contribution margin per unit of each product. On the other hand, the total of contributions to profit from all a company’s products minus the company’s fixed costs equals the profit of the company, that is also known as the operating income. These calculations can also be represented on mathematical format.
The approach of contribution margin pricing can determine the price that maximizes profit only for an individual product, and only over a given time frame. When setting the price of each product, there are more aspects than profit-maximization that a business has to look into, especially if they have a wide range of products.
One of the factors that the business will need to consider is the impact of sales of other products of the company. The other aspect to be looked into when setting the price of each product is the strategic role of that particular product and others that are also contained in the product portfolio. It is also important to consider the plans of replacing or modifying the product while withholding distribution for some time.
When a business is setting the price of every product that it deals in, it is also ideal to consider the economies of scale and scope, and the effects of experience curves on costs. It would also be advisable to look into the long-term strategy for the product.
It is very important to know how to calculate the contribution margin pricing since it has enormous utility in the determination of the operating leverage of a company. It may look simple but has to be augmented with other financial metrics to be useful in the analysis of cost-volume profit. A practical application of the contribution margin pricing is in the manufacturing price for sustainable labor costing.
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