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Fixed, variable and total costs
Manufacturing costs, apart from being split into direct and indirect costs, can also be divided into fixed costs and variable costs. Fixed and variable costs are added together to calculate total costs in the following formula:
Total costs = Fixed costs + variable costs
Fixed costs are those costs, such as factory rental, capital eqipment repayments and permanent staff salaries, which at least in the short or medium term, remain unchanged regardless of the level of output achieved.
Variable costs are those costs, such as raw material purchases, wages and electricity, which vary directly according to the level of output achieved.
Once a company has achieved an output that generates sufficient revenue (or income from sales) to cover both the firm’s fixed and variable costs, it will have reached a breakeven point. At this point, total revenue is equal to total costs. Above breakeven, the only additional costs incurred should be variable costs; therefore, any price per unit that exceeds the variable costs, will yield a profit.
Marginal-cost pricing involves basing the price on the variable costs of producing a product, not on the total costs (i.e fixed and variable costs).
Obviously, the company cannot, within its local markets, sell some of its stock at normal prices and the rest at marginal-cost prices. All prices would have to be reduced with the result that a greater volume of output would be required to reach a breakeven point. The exporter can, however, take advantage of cost pricing in certain export markets becuase it would be difficult for the import to directly compare the export price with the domestic selling price – but the target markets should be sufficiently divorced from the company’s main markets to prevent price levels in the local markets being affected.
Marginal-cost pricing should only be considered when the profitable use of resources, such as an alternative market which may offer high price levels, or a more profitable product that could be manufactured at the same plant, can no longer be identified. It has obvious attractions for markets where lower income levels dictate lower prices or where foreign competition is such that a company cannot compete at normal price levels. However, it should relate only to short-term business aimed at disposing of temporary surpluses following the construction of new plant or a seasonal fall-off in other orders.
An example of marginal cost pricing
To illustrate the concept of marginal costing, let us use an example:
Assume there is a local company that produces backpacks. The firm has the capacity to produce 60 000 backpacks per year given the size of its factory and the number of machines it has available (these are large capital-intensive machines that cannot easily be increased in number without incurring long-term financing costs). The comapny, irrespective of whether it achieves any sales whatsoever has fixed costs amounting to R700 000 per year (including management and permanent staff salaries, factory rent, insurance costs and capital equipment repayments).
The variable cost of producing a single backpack for the domestic market, is R42 per unit. This covers materials, wages, electricity, yarns, dyes, etc. The variable cost for producing a single backpack for the export market is R59 per unit. The extra R17 covers international transportation, additional insurance, additional labelling, special packaging, import duties and the import agent’s commissions.
Currently the firm sells 45 000 units domestically. The breakeven cost per unit of these domestic sales are therefore:
Breakeven cost per unit = Total costs / total number of unit solds = (Fixed costs + variable costs) / total number of unit solds = (R700 000 + (R42 x 45 000 units)) / 45 000 = R2 590 000 / 45 000 units sold = R57.56 per unit
If this company now generates an export order for 10 000 units per annum, the breakeven cost of this export order will be calculated as follows:
Breakeven cost per unit = Total costs / total number of unit solds = (Fixed costs + (variable costs for domestic sales + variable costs for export sales)) / total number of unit solds = (R700 000 + ((R42 x 45 000 units) + (R59 x 10 000 units))) / 55 000 = (R700 000 + R1 890 000 + R590 000) / 55 000 = R3 180 000 / 55 000 = R57.82 per unit
Using marginal costing methods, however, the firm would ignore fixed costs for its export sales and would calculate the per unit price based on variable costs alone. This would be done as follows:
Breakeven cost per unit (Marginal costing method) = Total variable costs / total number of units sold = (Variable costs for domestic sales + variable costs for export sales) / total number of units sold = ((R42 x 45 000 units) + (R59 x R10 000)) / 55 000 units = (R1 890 000 + R590 000) / 55 000 = R2 480 000 / 55 000 = R45.09
Clearly, R45.09 per unit is a more competitive (breakeven) price than R57.82 and the marginal costing method thus allows many exporters to enter and compete in export markets which they otherwise would not be able to do because of selling prices that are simply too high.
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Marginal costing is generally not viewed favourably
Apart from the obvious disadvantage of lower profit generation, marginal-cost pricing may also be viewed by the government of the importing country as dumping. This is likely to be the case where the country concerned has competing industries which require protection from unfair competition. A company could then face the imposition of high countervailing duties by the government, in order to correct the imbalance in prices.
Dumping is the sale of a product in a foreign market at a price lower than that at which the same product is being sold in the exporting country’s domestic market.
From a national point of view, marginal-cost pricing is seen as contrary to a country’s overall export objectives because a commitment to exports is likely to be lacking. As soon as an opportunity to increase sales volumes in the domestic market arises, the exporting company is likely to shift its activities from the foreign market to the local market. This action gives rise to mistrust amongst foreign buyers of all other suppliers residing in the same country as being totally unreliable.