Fixation of Selling Price
Fixation of selling price is one of the important functions of management. Prices are generally determined by market conditions and other economic factors. Cost-Volume-Profit analysis assists the management in the fixation of selling prices under various circumstances.
Pricing under Normal Conditions
Under normal circumstances, the prices are based upon total cost of sales so as to cover both fixed as well as variable cost and in addition to this, provide for certain desired margin of profit. But prices can also be fixed on the basis of marginal cost by adding a sufficiently high margin to marginal cost so as to cover the fixed cost and profits. However, under other circumstances, products may have to be sold at a price below the total cost. In such circumstances, the prices should be fixed on the basis of marginal cost in such a manner so as to cover the marginal cost and contribute something towards the fixed expenses.
Selling Price below the Marginal Cost
Sometimes it may become necessary to reduce the selling prices to the level of marginal cost or even below the marginal cost. In the following circumstances, the selling price may be fixed even below the marginal cost:
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To introduce a new product in the market,
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To explore foreign markets,
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To eliminate the competitor from the market,
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To avoid the retrenchment of workers,
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To dispose off perishable products,
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To avoid extra losses by closing down the business,
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To dispose off surplus stocks,
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To utilize idle capacity.
Illustration
The marginal cost of a product is Rs.15 and fixed expenses amount to Rs.2,25,000. Selling price per unit is Rs.17 and 40,000 units can be sold at this price. Should the company sell the product or not?
Solution
Total marginal cost = 40,000 units @ Rs.15 per unit = Rs.6,00,000
Fixed cost = Rs.2,25,000
Total cost = Rs.8,25,000
Total cost per unit = Rs.8,25,000/Rs.40,000 = Rs.20,625
Even though the selling price of Rs.17 is below the total cost, yet it is advantageous to sell the product at the selling price of Rs.17 which is more than the marginal cost of Rs.15. This will reduce the loss on account of fixed expenses (if the product is discontinued) by Rs.80,000 as shown below:
Sales = 40,000 units @ Rs.17 per unit = Rs.6,80,000
Loss = Total Cost - Sales = Rs.8,25,000 - Rs.6,80,000 = Rs.1,45,000
Loss if the product is discontinued (fixed expenses) = Rs.2,25,000
Thus, loss of Rs.80,000 (i.e. Rs.2,25,000 - Rs.1,45,000) will be reduced if product is sold at Rs.17 per unit.
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