Pricing - Contribution pricing
Contribution pricing is very similar to marginal cost pricing. The direct cost of production for each product is calculated and price is then set at a higher level. The difference between the direct costs per unit and the price is called the contribution, so called because this is NOT PROFIT, but a 'contribution' to the unpaid indirect/fixed costs of production.
No one product will need to account for all the indirect costs, but each product sold will contribute a proportion to the payment of the firm's overall fixed costs.
For example, let's assume that Maze Green Yachts has indirect/fixed costs of $200 000 and faces the following situation:
|Product||Sales||Direct costs per unit ($)||Price ($)||Contribution per unit ($)||Total contribution ($)|
|21i||17||28 000||29 000||1 000||17 000|
|25i||18||33 000||36 000||3 000||54 000|
|32i||15||43 000||48 000||5 000||75 000|
|38i||11||62 000||66 000||4 000||44 000|
|45i *||11||80 000||88 000||8 000||88 000|
|Total contribution||$278 000|
* Note that the product number refers to the size of the yacht, so the larger the number, the larger the product.
Have a careful look at this data. Why do you think the contribution from each product is different? What factors might lead to these differences? Have a think about these issues and then follow the link below.
Since the indirect/fixed costs are only $200 000, Maze Green's contribution will cover these and leave a net profit of $78 000.
Advantages and disadvantages of contribution pricing
- Contribution pricing allows flexibility in the pricing of individual products - low volume or successful products can be priced to give a higher contribution to indirect costs
- Demand factors can be taken into account with contribution pricing
- Pricing can be linked with the nature/position of the product (N.B. Consider the link with product life cycle and the Boston Matrix - newly introduced products could even be priced with a negative contribution to boost demand and push them into their growth phase while cash cows could command a higher contribution)
- It may be difficult to allocate costs accurately or appropriately across the full product range and so difficult to assess the most appropriate contribution.
- If costs are difficult to allocate then this may lead to the pricing being inaccurate
- It may lead to an excessively product and cost-oriented approach and so not be sufficiently flexible to customer needs.