Internal Factors Affecting Price
Understanding Your Cost Structure
Costs matter enormously for pricing—but not in the simplistic 'cost-plus' sense that many practitioners apply. You need to understand which costs are relevant for which decisions, how costs behave at different volumes, and the difference between accounting costs and economic costs relevant to pricing decisions.
Variable Costs: Your Absolute Floor
Variable costs change in direct proportion to volume. Each additional unit you produce or sell incurs incremental variable costs: raw materials, direct labor, packaging, shipping, sales commissions, transaction fees. These costs establish your absolute price floor—selling below variable cost means losing money on every transaction with no possibility of making it up on volume.
But even variable costs require careful analysis. Some 'variable' costs are actually step-fixed—constant within a range but jumping at certain thresholds. Shipping costs might be constant up to a truckload, then step up when you need a second truck. Production labor might be fixed within a shift but require overtime premiums or additional shifts at higher volumes.
Fixed Costs: Relevant for Strategy, Not Transactions
Fixed costs don't change with volume in the short run: rent, salaried staff, depreciation, research and development, administrative overhead. These costs must ultimately be covered for the business to survive, but they're not relevant to individual pricing decisions because they don't change based on whether you make a particular sale.
This is a crucial insight that many managers miss. A product that covers its variable costs and contributes something toward fixed costs is worth selling, even if it doesn't achieve 'full cost recovery.' The fixed costs exist regardless—refusing a sale that would contribute toward them just means lower contribution overall.
The exception is capacity constraints. When you're operating at full capacity, accepting a low-margin sale means refusing a potentially higher-margin opportunity. In this case, the relevant cost is the opportunity cost of capacity, not the accounting cost of fixed overhead.
| Cost Type | Examples | Behavior | Pricing Implication |
|---|---|---|---|
| Direct Variable | Materials, packaging, commissions | Changes per unit | Absolute price floor |
| Indirect Variable | Shipping, processing, support | Changes with volume | Include in minimum price |
| Step-Fixed | Warehouse, shifts, supervision | Fixed within ranges | Consider for volume deals |
| Fixed | Rent, salaries, R&D, depreciation | Constant short-term | Ignore for transaction decisions |
The Contribution Margin Framework
For most pricing decisions, contribution margin is the essential metric. Contribution margin equals price minus variable costs—the amount each unit contributes toward covering fixed costs and generating profit.
Contribution margin analysis enables clear thinking about pricing trade-offs:
- A product with positive contribution margin is worth selling, assuming no capacity constraints
- When comparing products, higher contribution margin percentage isn't always better—total contribution (margin × volume) matters
- Discounts should be evaluated in contribution margin terms: what volume increase is required to offset the margin reduction?
- Customer profitability depends on contribution generated minus cost-to-serve The contribution margin framework also reveals pricing flexibility. A product with 60% contribution margin can sustain significant price competition before becoming unprofitable. A product with 15% contribution margin has much less room to maneuver—even modest price pressure threatens viability.
Activity-Based Costing and True Cost-to-Serve
Traditional cost accounting often allocates overhead using simple volume measures like direct labor hours or machine hours. This can badly distort product and customer profitability, leading to pricing decisions that destroy value.
Activity-based costing (ABC) traces costs to the activities that actually drive them. The results often overturn conventional wisdom:
- 'Profitable' large customers may actually be unprofitable when you account for the demanding service, special handling, and management attention they require
- 'Marginal' small customers may be highly profitable because they order standard products, require minimal support, and pay list price
- 'Premium' custom products may generate less profit than standard products when you account for engineering, small-batch manufacturing, and extended support
- Channels that appear equivalent on gross margin may differ dramatically on cost-to-serve
Case Study: The ABC Revelation: When Profitable Wasn't A specialty chemicals manufacturer prided itself on custom formulation services. Custom products commanded price premiums of 30-50% over standard formulations, and management viewed this business as the company's profit engine. Activity-based cost analysis revealed the opposite: when accounting for application engineering, custom R&D, small-batch production, specialized quality testing, and extensive technical support, custom products actually earned lower margins than standards. The largest custom accounts—the 'most valuable' relationships—were among the least profitable customers overall. The insight led to three changes: repricing custom work to reflect true costs, investing in standardizing popular custom formulations, and shifting sales emphasis toward high-volume standard products. Within two years, profitability increased 40% without significant revenue growth.
Aligning Price with Business Objectives
Your pricing must serve your broader business objectives. Different objectives require fundamentally different pricing approaches, and confusion about objectives leads to incoherent pricing.
Profit Maximization
Pricing for maximum profit means finding the price point where margin times volume is highest. This requires understanding demand elasticity—how volume responds to price changes. It's rarely the highest possible price (which sacrifices too much volume) or the lowest profitable price (which sacrifices margin). The optimal point depends on the shape of your demand curve.
Revenue Maximization
Sometimes growing revenue matters more than current profitability—when market share drives future economics through network effects, learning curves, or switching costs. Revenue maximization typically means pricing lower than the profit-maximizing point to capture more volume. It requires confidence that future profits will justify current margin sacrifice.
Market Penetration
Penetration pricing aggressively sacrifices margin to build market share rapidly. It works when demand is highly price-elastic, when strong learning effects reduce costs over time, when network effects make early share valuable, and when you have the resources to sustain losses during the investment phase.
Market Skimming
Skimming prices high initially to capture early adopters' willingness to pay, then gradually reduces prices to reach broader markets. It works when genuine innovation justifies early premiums, when competitors can't quickly match your offering, and when customers don't resent early buyers paying more.
Survival
In crisis situations—demand collapse, liquidity emergency, competitive attack—survival becomes the objective. Survival pricing covers variable costs to generate cash, accepting contribution toward fixed costs even if inadequate for long-term sustainability. This is a temporary measure while addressing underlying problems, not a strategy.
Key Takeaways
- Variable costs set the absolute price floor; fixed costs are relevant for strategy, not transaction decisions
- Contribution margin—price minus variable costs—is the essential metric for most pricing decisions
- Activity-based costing often reveals that 'profitable' products and customers are actually unprofitable when true costs are traced
- Pricing objectives (profit max, revenue max, penetration, skimming) require fundamentally different approaches