Fixed costs are irrelevant! (to pricing)

It’s true.  Your fixed costs are not relevant to your pricing decisions. 

Your price should be determined by how much your customers are willing to pay.  Their willingness to pay is driven by the amount of value they get for your product.  That value is determined by what else they would do with their money and the incremental benefit your product or service provides.  Their willingness to pay does not change if you have higher R&D costs.  Your fixed costs don’t matter.

Variable costs do matter.  What if a prospect’s willingness to pay is less than your variable costs?  Then don’t sell to him or her.  Sometimes, especially in a retail setting, you only get to set one price for many prospects with different willingnesses to pay.  In this case variable costs matter because you are trading off additional marginal profit per unit sold against the marginal profit of lost sales.  Marginal profit is price minus variable cost.  (OK, I’ve re-read and re-written this paragraph many times and still can’t make it easy to understand.  Trust me that variable costs are relevant when setting prices.)

Fixed costs DO matter, just not to pricing.  Fixed costs matter when you decide whether or not to get into a business. This may be easiest to understand by looking at a video game company.  EA spends millions of dollars to develop a new video game.  Those millions of dollars are fixed costs.  Should they spend that money on developing a new video game?  It all depends on how much profit they expect that game to generate.  They estimate the price they can get, the expected demand, and their variable costs.  Using simple math, they estimate how many profit dollars they can generate and compare that to the amount of the fixed costs.  Then they decide whether or not to invest the dollars into fixed costs.

Mistake:  Many companies calculate a “standard cost” by allocating their total manufacturing overhead (fixed costs) to individual products.  For example, if they have  $2M overhead and they forecast that will sell 1M units, then they allocate $2 of fixed costs to each unit.  This is OK for accounting purposes, but it can cause bad pricing/business decisions, especially for relatively low margin products.  For example, imagine this company with the $2 fixed costs allocated to each unit also has variable costs of only $0.10.  Their standard costs are $2.10 ($2 fixed costs plus $0.10 variable cost).  Now, a new piece of business comes in.  They can sell 100,000 incremental units if they are willing to sell them for $2.00.  Do they want it?  If they use their standard cost of $2.10 they would turn down this business.  However, if we look at the true variable cost of $0.10, it could be a great deal.  Allocating fixed costs to pricing and business decisions can lead us to bad decisions.

This blog may be complex, but it’s very important.  Let’s summarize:

Fixed costs should NOT be considered in pricing.  Fixed costs should be used to determine whether or not you want to be in a business.

Variable costs SHOULD be considered in pricing.  One place they are very important is in determining whether or not to accept a piece of incremental business.

The logic (and the hidden math) may be challenging, but trust me, don’t use your fixed costs while making pricing decisions.