It would be wrong to suggest that marginal pricing should never take place. It would also be naïve to suggest that it is not practised by many companies, in many sectors. Sometimes this is because they choose to do so, in other cases they may be forced into such a practice by competitors and by circumstances. It is, however,
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a pricing practice which is fraught with dangers, the most commonly quoted of which are outlined below.
The slippery slope
Good pricing requires discipline. Once management weaken their stance and accept that any price over variable cost is worthwhile because it provides ‘a contribution’, the floodgates can open. It can start as one contract in ‘unique’
circumstances that will not be repeated, or as one new product that will not be a substitute for others, or as one new customer whose business has been chased for years. These arguments may be valid in some circumstances, but once this kind of reasoning takes hold, it can become impossible to avoid that slippery slope which makes marginal pricing the norm. In these circumstances the breakeven chart takes on a very different shape as the whole sales line changes its slope, creating lower profitability and a higher breakeven point (Figure 8.4).
Fig. 8.4 How marginal pricing can affect the breakeven chart
Customer spread
It is often difficult to prevent information about special prices from spreading from one customer to another. The importance of this factor depends to a large extent on the visibility of pricing levels and the extent to which customers can make comparisons. This is often underestimated at the time when special price concessions are made. What was intended to be a unique price or discount for a major new customer can become the standard concession that eventually spreads to all customers of a particular type. It may not only be the customers who make the request – it may be sales people who manage different accounts and who want their own customers to have the same price concession as others, particularly if they are motivated and rewarded on volume rather than profit targets.
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Cost structure and pricing behaviour
Creeping fixed costs and complexity
A key argument in favour of marginal pricing is that the fixed cost base is already there and that any contribution of variable margin will go straight through to the bottom line. This impact can often be sensitive and transformational, as we saw in the earlier example. Once again, however, we must remember the limitations of the conventional definition of variable costs and appreciate that step increases in fixed costs will take place at a number of stages along the way.
This is perhaps the biggest danger of all in marginal pricing. A number of individual decisions may be taken on a separate basis, each of which seems to be justified on its own because it adds incrementally to the bottom line. Yet the cumulative impact of these decisions is to cause an increase in the step of fixed costs, because capacity is finally exhausted or because more complexity has gradually been created. The marginal approach to costing and pricing ignores this factor and this is a major reason why fixed costs are often allocated for the purposes of pricing and profitability assessment. There will be more about fixed cost allocation in the next chapter.
Despite all these dangers and reservations, and despite our emphasis on value pricing in earlier chapters, marginal pricing can and should be a valid strategy in certain circumstances. The ‘pro’ arguments are as follows.
Competitor attack
Marginal pricing can be used as a deliberate strategy to embarrass or weaken a competitor. In these circumstances there may be conflict with the laws and business regulations of certain countries and clearly such a strategy is valid only if it is legally acceptable. If we leave aside this factor and the ethical issues involved, there is no doubt that, in the right circumstances, marginal pricing can be a highly effective competitive weapon. The large player, perhaps with higher fixed and lower variable costs than competitors, can use its financial strength temporarily to drive prices down to levels that the smaller, weaker competitors cannot sustain, thus forcing them out of the market. On the other hand, in some markets the smaller player, with lower fixed costs and more flexible profit objectives, can use similar tactics to take business away from the market leader.
Competitor pressure and survival
It is possible that your business may be the one under attack. If you have competitors which are, for whatever reason, pricing marginally while providing equal value, you may have little choice but to follow suit. In the long term a business cannot deliver value by pricing its products on a marginal basis, but to achieve long-term objectives it is necessary to survive and sometimes marginal
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pricing is essential just to keep afloat. Any variable margin or contribution is better than nothing if you have a wage bill to cover, and sticking to a principled and consistent ‘value’ pricing strategy is no argument when the receivers move in.
In the long term you must hope and expect that this situation will change, otherwise there may be no future for your business in that market. If that change is unlikely to come about through external factors, it is vital to develop an effective new marketing strategy that makes your business less vulnerable to this kind of competitive price pressure. This would be likely to involve the strategies mentioned in Chapters 2 and 5 – the targeting of particular segments and the creation of differentiation through other elements of the marketing mix.
One-off opportunities
This is perhaps the most valid and acceptable use of marginal pricing. There might be a ‘one-off’ opportunity to use spare resources on activities which deliver contribution without jeopardizing the mainstream business. This would have to be in a separate segment with no links to mainstream business and with no likelihood that quality of products or service to existing customers would be adversely affected. There must also be no adverse impact on image, reputation or staff motivation. If all these demanding criteria are met, if the pay-off is worth the trouble and provided the activity is within core competences, marginally priced business can and should be accepted.
New segments
Sometimes marginal pricing can be a deliberate strategy that is aimed at particular segments with different characteristics to the main business. Typical examples would be companies that have a special pricing policy towards export markets, and consumer goods companies supplying to catering or industrial outlets as well as to retail customers.
However, though such a strategy can work and can provide valuable incremental profit for a period, it is unlikely to prove valid in the long term. At some stage there are likely to be resource constraints and new investments in capacity will have to be made. In these circumstances new fixed costs will be created and the ‘marginal’
business will have been the indirect cause, yet at marginal prices the profitability levels are unlikely to be sufficient to justify the investment. Management must be sure that such new segment business is priced at a level which has the long-term potential to be profitable in its own right, otherwise it should not become a major new source of business.
Cost structure and pricing behaviour