Contribution Pricing

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Definition: Contribution Pricing

Contribution Pricing is a pricing strategy which maximizes the profit coming from a product. In Contribution Pricing, the price of the product is kept on the basis of its contribution to cover the fixed costs it incurs even if to a minimal level. Here the assumption lies in the difference between the product’s price and the number of items sold and the variable costs involved.

Formulae:

Price - Variable Costs/Unit = Contribution Margin/Unit

Contribution Margin/Unit x Units Sold = Product’s Contribution to Profit

Contributions to Profit From All Products – Firm’s Fixed Costs = Total Firm Profit

Relative Contribution = Product’s Contribution to profit / Production Factor

EXAMPLE

If a product is produced in let us say

Variable Costs : 10\$ per piece

Fixed Costs (Total): 100000\$

Demand (assumed): 10000 pieces

Now SP should contribute to fixed cost recovery too.

So it has to be above 10\$ for sure as variable cost is that much

Now if we keep price at 20\$.

It recovers 10\$ of variable costs and contributes 10\$ back to fixed costs.

for 10000 pieces it would be 10000*10\$=100000\$ which covers the fixed cost exactly.

Now any price above 20\$ will help company maximize profits.

Hence, this concludes the definition of Contribution Pricing along with its overview.

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