Pricing Cost: What Motivates Mark-up and Break-Even Pricing

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  • 0:05 The Four Ps: Pricing
  • 0:48 Basic Costs
  • 1:17 Costs Per Unit
  • 4:10 Types of Pricing
  • 6:39 Lesson Summary
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Lesson Transcript
Instructor: Jennifer Lombardo
The marketing mix consists of the four Ps (product, place, promotion and price). The marketing manager has to decide what type of pricing strategy to use for the overall marketing plan. The options depend on how cost is determined.

Marketing Mix 4Ps: Pricing

How does a company decide on the price of a product or service? It might seem to be an easy task, but developing a pricing strategy can be very complicated. The marketing mix contains the four Ps (product, place, promotion and price). Price is the most flexible P in that it can be altered the quickest according to business needs. Some companies make the mistake of ignoring the demand for a product and just setting a price based on costs.

Whack-a-Wing is a fast food restaurant that's launching a new soup. The company must determine a price that the target market will feel is appropriate and fair and encourage a purchase. Let's look at some basic pricing terminology before we tackle Whack-a-Wing's dilemma.

Basic Costs

Cost has five terms that marketing managers must understand to develop an appropriate price for products and services. The first term is called variable cost, and it is a cost that varies with changes in the level of output. An example would be material, such as chicken for Whack-a-Wing's soup product. In contrast, fixed costs are costs that do not change with the level of output. An example of fixed costs would be Whack-a-Wing's office rent or executive salaries.

Costs Per Unit

In order to figure out the appropriate price, a starting point is to determine the cost per unit of product. This can be accomplished by finding the average variable cost (AVC), average total cost (ATC) and marginal cost (MC). Average variable cost (AVC) is the total variable cost divided by the quantity of output. Average total cost (ATC) is the total cost divided by the quantity of output. AFC (average fixed costs) is the fixed costs of production (FC) divided by the quantity (Q) of output produced (AFC = FC / Q). As the total number of goods produced increases, the average fixed cost decreases because the same amount of fixed costs is being spread over a larger number of units of output. AVC + AFC = ATC. This gives the company an idea of what costs are associated by producing one unit of product (one can of Whack-a-Wing soup).

An increase in the total number of goods produced leads to a decrease in the AFC
ATC AVC AFC Chart

Marginal cost (MC) is the change in total costs associated with a one-unit change in output. Marginal cost decreases initially and it is usually cheaper to produce products when quantity is increased. At some point, though, marginal cost will increase as diminishing returns will occur. This means that less output is produced for every additional dollar spent on variable output.

Formula for finding the average total cost
Average Total Cost Formula

Here is a very easy example of marginal cost and benefit. Let us say that you are given a plate of freshly baked chocolate chip cookies. Your cookie satisfaction level begins at zero. For every cookie you eat, you increase your marginal benefit score by +5. For a while, you are going to keep increasing by +5. At some point, you will grow tired of eating the cookies and reach a plateau. This is where marginal cost equals marginal benefit, so less output is reached (or a diminished return) or you're less happy with your cookies. When MC is less than AVC or AC, the incremental cost will cause a decrease in average costs. When MC is greater than AVC or ATC, then the average costs increase. When marginal cost equals marginal revenue, then profit maximization occurs, which means that any additional production of product will produce more profit. Costs are the basis for determining pricing, along with demand.

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