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Definition: Incremental Cost Pricing
It is the method of pricing a product based on incremental cost. In this type of pricing, the selling price of a product is determined by the variable cost, and not kept according to the overall cost of creating the product. Incremental cost is the cost of creating additional products from the same setup (i.e. R&D, factory, machinery being same as used for other products), i.e. the fixed cost remains same, and the selling price of the product thus generated is based mainly on the variable cost.
For example, a company that has been making packets of biscuits, with 8 biscuits per packet, launches a new product, that is a 15-biscuits packet. The R&D, machinery, land on which the machinery (or factory) is remains same. So the fixed cost, like the rent of the land, the initial cost of setting up the machinery and that incurred in R&D of the biscuit remain same. The variable cost changes. This includes the cost of the extra volume of ingredients, bigger packets, extra oil/electricity used to run the machinery.
In the regular pricing method, the selling price of each product (each packet of biscuit) will include the distributed fixed costs (fixed cost per packet) + distributed variable cost + profit margin.
In the incremental cost pricing method, the selling price of the product will be based on only the latter two. This method is used only when the fixed overhead is being absorbed by existing product sales.
The advantage of incremental cost pricing is that it can be used to launch a new product with low cost so that it is readily accepted in the market, and also to open up a new customer base by reducing the price of an existing product. The disadvantage is that if not used judicially, the company may end up applying it to all products. The reduced prices may force the competitor to apply the same method as well. Thus, incremental cost pricing may become a norm. When all products are being sold using incremental cost pricing, it may be difficult to absorb the fixed cost overhead, resulting in the reduction of a company’s profitability. This may ultimately lead to perpetual losses, hence resulting in the failure of the product line or the company on the whole.
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