Pricing decisions affect whether a company will sell less of the product at a higher price or more of the product at a lower price. In either scenario, some costs remain the same (in total). Consequently, those costs do not affect the relative profitability of one price versus another. Only costs that rise or fall (in total) when prices change affect the relative profitability of different pricing strategies. We call these costs incremental because they represent the increment to costs (positive or negative) that results from the pricing decision.
Incremental costs are the costs associated with changes in pricing and sales. The distinction between incremental and nonincremental costs parallels closely, but not exactly, the more familiar distinction between variable and fixed costs. Variable costs, such as the costs of raw materials in a manufacturing process, are costs of doing business. Because pricing decisions affect the amount of business that a company does, variable costs are always incremental for pricing. In contrast, fixed costs, such as those for product design, advertising, and overhead, are costs of being in business. They are incremental when deciding whether a price will generate enough revenue to justify being in the business of selling a particular type of product or serving a particular type of customer. Because fixed costs are not affected by how much a company actually sells, most are not incremental when management must decide what price level to set for maximum profit.
Some fixed costs, however, are incremental for pricing decisions, and they must be appropriately identified. Incremental fixed costs are those that directly result from implementing a price change or from offering a version of the product at a different price level. For example, the fixed cost for a restaurant to print menus with new prices or for a public utility to gain regulatory approval of a rate increase would be incremental when deciding whether to make those changes. The fixed cost for an airline to advertise a new discount service or to upgrade its planes' interiors to offer a premium-priced service would be incremental when deciding whether to offer products at those price levels.
To further complicate matters, many costs are neither purely fixed nor purely variable. They are fixed over a range of sales but vary when sales go outside that range. The determination of whether such semifixed costs are incremental for a particular pricing decision is necessary to make that decision correctly. Consider, for example, the role of capital equipment costs when deciding whether to expand output. A manufacturer may be able to fill orders for up to 100 additional units each month without purchasing any new equipment simply by using the available equipment more extensively. Consequently, equipment costs are nonincremental when figuring the cost of producing up to 100 additional units. If the quantity of additional orders increased by 150 units each month, though, the factory would have to purchase additional equipment. The added cost of new equipment would then become incremental and relevant in deciding whether the company can profitably price low enough to attract that additional business.
To understand the importance of properly identifying incremental costs when making a pricing decision, consider the problem faced by the business manager of a symphony orchestra. The orchestra usually performs two Saturday evenings each month during the season with a new program for each performance. It incurs the following costs for each performance:
The orchestra's business manager is concerned about her very thin profit margin. She has currently set ticket prices at $10. If she could sell out the entire 1,100-seat hall, total revenues would be $11,000 and total costs $9,100, leaving a healthy $1,900 profit per performance. Unfortunately, the usual attendance is only 900 patrons, resulting in an average cost per ticket sold of $9.89, which is precariously close to the $10 admission price. With revenues of just $9,000 per performance and costs of $8,900, total profit per performance is a dismal $100.
The orchestra's business manager does not believe that a simple price increase would solve the problem. A higher price would simply reduce attendance more, leaving less revenue per performance than the orchestra earns now. Consequently, she is considering three proposals designed to increase profits by reaching out to new markets. Two of the proposals involve selling seats at discount prices. The three options are:
1. A “student rush” ticket priced at $4 and sold to college students one-half hour before the performance on a first-come, first-served basis. The manager estimates she could sell 200 such tickets to people who otherwise would not attend. Clearly, however, the price of these tickets would not cover even half the average cost per ticket.
2. A Sunday matinee repeat of the Saturday evening performance with tickets priced at $6. The manager expects she could sell 700 matinee tickets, but 150 of those would be to people who would otherwise have attended the higher-priced Saturday performance. Thus net patronage would increase by 550, but again the price of these tickets would not cover average cost per ticket.
3. A new series of concerts to be performed on the alternate Saturdays. The tickets would be priced at $10, and the manager expects that she would sell 800 tickets but that 100 tickets would be sold to people who would attend the new series instead of the old one. Thus net patronage would increase by 700.
Which, if any, of these proposals should the orchestra adopt? An analysis of the alternatives is shown in
. The revenue gain is clearly smallest for the student rush, the lowest-priced alternative designed to attract a fringe market, while the revenue gain is greatest for the new series, which attracts many more full-price patrons. Still, profitability depends on the incremental costs as well as the revenues of each proposal. For the student rush, neither rehearsal costs nor performance costs are incremental. They are irrelevant to the profitability of that proposal since they do not change regardless of whether this proposal is implemented. Only the variable per-patron costs are incremental, and therefore relevant, for the student-rush proposal. For the Sunday matinee, however, the performance cost and the per-patron cost are incremental and affect the profitability of that option. For the totally new series, all costs except overhead are incremental.
EXHIBIT 9-1 Analysis of Three Proposals for the Symphony Orchestra
To evaluate the profitability of each option, we subtract from revenues only those costs incremental to it. For the student rush, that means subtracting only the $200 of per-patron costs from the revenues, yielding a contribution to profit of $600. For the Sunday matinee, it means subtracting the performance cost and the variable per-patron costs for those additional patrons (550) who would not otherwise have attended any performance, yielding a profit contribution of $150. For the new series, it means subtracting the incremental rehearsal, performance, and per-patron costs, yielding a net loss of $200. Thus, the lowest priced option, which also happens to yield the least amount of additional revenue, is in fact the most profitable.
The setting out of alternatives, as in, clearly highlights the best option. In practice, opportunities are often missed because managers do not look at incremental costs, focusing instead on the average costs that are more readily available from accounting data. Note again that the orchestra's current average cost (total cost divided by the number of tickets sold) is $9.89 per patron and would drop to $8.27 per patron if the student-rush proposal were adopted. The student rush tickets, priced at $4 each, cover less than half the average cost per ticket. The manager who focuses on average cost would be misled into rejecting a profitable proposal in the mistaken belief that the price would be inadequate. Average cost includes costs that are not incremental and are therefore irrelevant to evaluating the proposed opportunity. The adequacy of any price can be ascertained only by looking at the incremental cost of sales and ignoring those costs that would be incurred anyway.
Although the orchestra example is hypothetical, the problem it illustrates is realistic. Scores of companies profit from products that they price below average cost when average cost includes fixed costs that are not true costs of sales.
• Packaged goods manufacturers often supply generic versions of their branded products at prices below average cost. They can do so profitably because they can produce them with little or no incremental costs of capital, shipping, and selling beyond those already incurred to produce their branded versions.
• A leading manufacturer of industrial cranes also does milling work for other companies whenever the firm's vertical turret lathes would not otherwise be used. The price for such work does not cover a proportionate share of the equipment cost. It is, however, profitable work since the equipment must be available to produce the firm's primary product. The equipment cost is, therefore, not incremental to the additional milling work.
• Airlines fly weekend flights that do not cover a proportionate share of capital costs for the plane and ground facilities. Those costs must be incurred to provide weekday service and so are irrelevant when judging whether weekend fares are adequate to justify this service. In fact, weekend fares often add incrementally more to profits precisely because they require no additional capital.
In each of these cases, the key to getting the business is having a low price. Yet one should never be deceived into thinking that low-price sales are necessarily low-profit sales. In some cases, they make a disproportionately large contribution to profit because they make a small incremental addition to costs.