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Practical Points in Contribution Pricing

 

The previous example was simplistic and very few pricing decisions are that straightforward in practice. There are a number of additional practical points and factors which a business might wish to consider before accepting an offer based solely on the potential contribution a sale might achieve.

Some of these include:

The reduced price might be expected for all purchases

If a current customer requests a 50% reduction in price for additional purchases that might set a dangerous president. The customer might then want the reduced price for all future transactions whether were standard purchases or additional ones.

If all sales were then made for £25 instead of the normal £50 the business would not be able to cover direct costs and would make an overall loss. This position would not be sustainable in the long term.

Increased sales might result in additional fixed overhead costs

Situations can exist where catering for an additional order leads to increased fixed overhead costs. Employees who are taken on to produce the extra supplies may not be able to be dismissed the moment the order is satisfied.

Similarly, the budgeted levels of activity might be based on the business operating at full capacity. Any extra production might require the renting or purchase of additional premises and equipment.

Inviting competition to retaliate

The business’ competition might view their own loss of the extra work and the price quoted by the entity as an opportunity to reduce their prices in order to make them more competitive.

Thus, the status quo of the market might change whereby the agreement to sell items at a reduced price on one occasion then leads to prices falling generally. The only beneficiaries of such an event would be the customers. The business which made the additional contribution eventually losses other income as standard prices and the profit which they generate reduces.

Budgeted activity might not be achieved

Budgeted activity is rarely achieved, there is usually always some variation up or down on that which was estimated.

If the actual performance is lower than that which was forecasted, then the overheads (indirect costs) of the business would not have been covered in the manner which was predicted.

In such a scenario, the profit earned by extra contracts might be significantly less than that, which was calculated at the time the reduced price was announced.

 
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