Cost Analysis for Pricing Decisions

Costs That Matter for Pricing

Module 1 introduced cost concepts; this lesson applies them specifically to pricing decisions. The key question for any cost is: does this cost change as a result of the pricing decision I'm making? Costs that change are relevant; costs that don't change are sunk and should be ignored for this decision.

This sounds obvious but is frequently violated in practice. Managers include 'fully allocated overhead' in pricing calculations, treating fixed costs as if they varied per unit. They reject profitable deals because prices don't cover 'full cost.' They price new products based on development costs that are already sunk regardless of price. These errors leave money on the table.

Variable Costs: The True Floor

Variable costs—costs that change with each unit produced or sold—establish your absolute price floor. These include direct materials (the physical inputs in your product), direct labor (wages for production workers, if truly variable), variable manufacturing overhead (utilities, supplies that scale with production), variable selling costs (commissions, transaction fees, credit card processing), and fulfillment costs (shipping, packaging, handling).

Selling below variable cost means you lose money on every transaction. Unlike fixed cost shortfalls, which might be recovered through volume, variable cost shortfalls compound—the more you sell, the more you lose. Never price below variable cost unless you're liquidating inventory to exit.

Fixed Costs: Strategic but Not Transaction-Relevant

Fixed costs—rent, salaries, depreciation, R&D, administrative overhead—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.

Consider a simple example. Your product has $60 variable cost per unit. Fixed costs are $3 million per year. You're evaluating whether to accept a large order at $75 per unit—below your normal $100 price. Should you take it?

The $75 price generates $15 contribution per unit. This contribution helps cover fixed costs and generates profit. Refusing the order doesn't make the fixed costs go away—it just means you have $15 less contribution toward covering them. Unless the order displaces higher-contribution business (opportunity cost), you should take it.

The exception is when you're capacity-constrained. If accepting this order means refusing a $100 order, the relevant cost is the $40 contribution you'd forgo—not the fixed costs.

Contribution Margin Analysis

Contribution margin—price minus variable costs—is the essential metric for most pricing decisions. It tells you how much each unit contributes toward covering fixed costs and generating profit.

Contribution margin analysis enables clear thinking about pricing trade-offs:

Scenario

Analysis Question

Decision Rule

Accept low-price order?

Is contribution margin positive?

Yes if no capacity constraint or opportunity cost

Compare products

Which generates more total contribution?

Margin × volume, not just margin %

Evaluate discount request

What volume increase offsets margin loss?

Break-even volume change calculation

Assess customer profitability

Contribution minus cost-to-serve?

May need activity-based costing

The Break-Even Volume Change Calculation

When considering price changes, calculate the break-even volume change—how much volume must change to maintain current profit. This provides a reality check on pricing moves.

The formula for a price increase: Break-even volume change % = -ΔPrice% ÷ (CM% + ΔPrice%)

Where ΔPrice% is the price change percentage and CM% is the current contribution margin percentage.

Case Study: Break-Even Calculation Example Current situation: $100 price, $60 variable cost, 40% contribution margin. You're considering a 10% price increase to $110. New contribution margin: ($110 - $60) ÷ $110 = 45.5%. Break-even volume change: -10% ÷ (40% + 10%) = -10% ÷ 50% = -20%. Interpretation: You can afford to lose up to 20% of volume and still maintain the same total profit. If you expect to lose less than 20%, the price increase improves profit. If you expect to lose more than 20%, the increase hurts profit. This calculation frames the decision: is 20% volume loss realistic? What does demand analysis suggest? What do sales teams expect? The break-even gives you a threshold to evaluate.

For a price decrease, the calculation shows how much volume must increase to maintain profit:

Break-even volume change % = -ΔPrice% ÷ (CM% + ΔPrice%)

With a negative price change, this yields a positive required volume change. For example, a 10% price cut with 40% contribution margin requires: -(-10%) ÷ (40% - 10%) = 10% ÷ 30% = +33% volume increase to break even.

Activity-Based Costing for Pricing

Traditional cost accounting often allocates overhead using simple volume measures like direct labor hours or machine hours. This can distort product and customer costs, leading to pricing decisions that destroy value.

Activity-based costing (ABC) traces costs to the activities that drive them, then assigns those activity costs to products and customers based on their actual consumption. The results often overturn conventional wisdom about profitability.

Product Cost Distortions

Simple products that flow through standard processes are often overcosted by traditional allocation—they get burdened with overhead driven by complex products. Complex products with special handling, custom features, and extensive support are often undercosted—their true complexity doesn't show up in simple allocation bases.

The pricing implication: simple products may be overpriced, losing share to competitors. Complex products may be underpriced, attracting business that destroys value.

Customer Cost Distortions

Similarly, low-maintenance customers who order standard products through standard channels are often subsidizing high-maintenance customers who demand special handling, extensive support, and customized service.

The pricing implication: you may be underpricing high-cost-to-serve customers while overcharging efficient customers who should receive better deals.

Case Study: ABC Reveals Hidden Truth: The Demanding Customer A B2B supplier segmented its customers by revenue, assuming large customers were most valuable. Activity-based analysis told a different story. The largest customer—$5 million annual revenue—required dedicated account management, expedited shipping on most orders, extensive technical support, custom reporting, and frequent small orders rather than consolidated purchasing. When ABC traced costs, this 'best' customer generated less profit than customers one-tenth its size. The supplier used this insight to reprice the relationship: implementing minimum order charges, charging for expedited shipping, and establishing service-level tiers. Some customers accepted new terms; others moved to competitors. But profitability increased as the true cost of serving demanding customers was finally recovered.

Key Takeaways

• Focus on relevant costs that change with the decision—ignore sunk costs and fixed overhead for transaction decisions
• Variable costs set the absolute price floor; selling below variable cost loses money on every unit
• Contribution margin is the essential metric—price minus variable costs, the amount each unit contributes
• Break-even volume change analysis provides a decision threshold for evaluating price changes
• Activity-based costing reveals true product and customer costs hidden by traditional allocation