Two Ways of Setting Prices : Full Costing versus Incremental Costing

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The following is an illustration of the full costing and incremental costing methods. The Natural Company is selling 15,000 units of its product per year. The regular market price is $15.00 per unit. The variable costs are $5/unit for materials and $4/unit for labor, for a total of $9/unit. The fixed costs are $40,000 per year. The income statement reflecting the situation would appear as follows:

Suppose the company has the opportunity to sell an additional 3,000 units at $10.00 per unit to a foreign firm. (This is a special situation and will not have an adverse effect on the price of the product in the regular market.) If the Natural Company uses the full costing method to make its decision, the opportunity will be rejected, because the price of $10.00/unit does not cover the full cost of $11.67/unit ($175,000/15,000 = $11.67). By using the full costing method as a decision criterion, the company would actually be giving up $3,000 in additional profits.

If the incremental costing method is used, the opportunity will be accepted. The incremental costing method compares additional costs to be incurred with the additional revenues that will be received if the offer is accepted.

The difference between the two decision methods results from the treatment of fixed costs. The full costing method includes the fixed cost in the cost-per-unit calculation. The incremental cost method recognizes that no additional fixed costs will be incurred if additional units are produced. Therefore, fixed costs are not considered in the decision process.

The following is an income statement comparing the results of accepting and rejecting the foreign offer:

Note: An important factor in such a decision is a consideration of the effects of accepting the offer on regular market price. For purposes of illustration, this example specified that the regular market price would not be affected by the sale of extra units at a lower price. In the real world, however, if the additional sales were made in the regular market at the $10.00 price, it could depress the regular market price below $15.00. This would severely hamper operations in the future.

SOURCE: From Subhash C. Jain, International Marketing Management, 2nd ed. (Boston: PWS-KENT Publishing Company, 1987), Figure 16.1. © by Wadsworth, Inc. Permission granted by PWS-KENT Publishing Company, a division of Wadsworth, Inc.

Predatory pricing involves discrete, short-term cuts intended to financially weaken the competition rather than to expand the market. After the price cuts have produced their effect and competitors have been eliminated, prices are returned to oligopolistic levels. Penetration pricing involves setting prices below existing equilibrium levels in order to maximize unit volume. Lower prices increase total sales, and the firm using penetration pricing acquires a significant share of the market. Japanese companies have captured sizeable shares of the U.S. color TV and automobile markets by using penetration pricing strategies to their limit.

According to Robinson, there are essentially three pricing policies: standard worldwide pricing, dual pricing (domestic/ export), and market-differentiated pricing. 1 Any of these policies may, of course, include a discount system. (Depending on the priorities of foreign buyers, performance warranties, claims for services, payment in certain foreign currencies, or delivery within a specified time may take the place of a discount based on quantity, terms of payment, or purchase of associated goods or services.) In establishing a standard worldwide base price, management is most likely to use the full-cost pricing method, including an allowance for manufacturing overhead, general overhead, and selling expenses.

Dual pricing refers to the practice of quoting one price for the domestic market and a second price for exports. The latter is often the lower of the two. Various issues must be taken into consideration in establishing a dual pricing policy. For example, the export price cannot be set below the cost of production or else the firm may be subject to "antidumping" suits. Also, if the firm is exporting out of a country with a value-added tax (VAT) into a country that has no VAT, the tax on the exported product may be lower than the tax on the product sold domestically to the extent that the VAT is rebated by the exporting country.

The assumption underlying a market-differentiated pricing policy is that the head office knows enough about the target market to set the correct price for that market. The best approach in some circumstances is for headquarters to set a price floor and give local management full discretion to price above that point. A variation of this approach is to allow local management to set prices a certain percentage above or below a base price established by headquarters.

In some markets, the price an MNC can charge is restricted by the government. Some countries (such as Egypt), in order to protect the local small producer, set a floor price below which MNCs cannot sell their products. Some others (such as Japan), in order to accommodate local customers, set a maximum price above which the MNC cannot sell its products. The best advice that one can give to a newcomer in the international business game is to follow the leader and make sure that the cost structure allows for a respectable return on the invested capital.