The Role of Variable Costs

What is the role of variable cost in pricing?

This may be obvious from the post called “Fixed Costs are Irrelevant“, but I’ve had several conversations with people about variable costs recently, so I’ll spell it out explicitly.

It depends.  It depends on if you are able to set a different price for every customer or not.

In most if not all B2C business, the company sets a price and many people decide whether or not to purchase at that price.  There may be sales, there may be segmentation (I hope), and there may be versions.  But the common theme is that many customers see one of these prices and each one makes a purchase decision.   Presumably the lower the price, the more people who purchase.

In this B2C setting, variable costs are very important because you are maximizing your total gross profit, which is:  Profit = Qty * (Price – variable cost).  You are moving your price to influence the quantity sold and hopefully maximize profit.  The key takeaway is that variable costs matter a lot when determining the profit maximizing price.

However, in many B2B situations, some deals are negotiated independently.  The price one customer pays is not directly related to the price any other customer pays.  Our sales team is negotiating to get the customer to pay the most they are willing to pay, and the customer’s buyer is negotiating to get us to sell the item for the least we are willing to accept.

In this B2B setting, the only role our variable cost has is to contribute to the level for the least we are willing to accept.  We negotiate with a customer to see how much they are willing to pay, and then we make a decision on whether or not we want to accept that business.

This doesn’t mean we accept all business above variable costs.  There may be reasons not to.  Possibly our investors have margin expectations that we want to hit.  We may not want to devalue our product if the price gets out.  We may not want our channel to see such a low price.  Regardless, we certainly would not accept business below variable costs without some very good strategic reasons.

This is an interesting parallel to the role of fixed costs.  The role of fixed costs is only for us to use to decide whether or not we want to be in that specific business.  The role of variable costs, at least on negotiated deals, is to decide whether or not we want to accept a specific piece of business.

What are the roles of variable costs?  When many customers buy at the same price, variable costs are a key component in determining the profit maximizing price.  When we negotiate independent deals with customers, variable costs only help determine whether or not to accept the business.