Cost-Oriented Pricing: A Realistic Solution to a Complicated Problem

Abstract

Most businessmen know that the optimum price is that at which marginal cost equals marginal revenue. At least, that is the optimal price if we are profit maximizers. But in practice, such a rule has nominal pragmatic value. First, it implies that we know the marginal cost and marginal revenue curves of the products we are offering. In many businesses, adequate cost data do not exist. This is particularly true when new products and the extension of existing products are concerned, and when the problems of overhead allocation and burdens are considered., To argue that such data should be available, or must be available, in order to reach informed decisions begs the point. The fact is that very often such data simply are not available when needed. A knowledge of the marginal revenue curve implies a knowledge of the demand curve. And if the typical firm has trouble obtaining adequate cost information, the problems associated with collecting adequate demand information are several times more complex. Finally, it is not clear that firms are, in fact, profit maximizers. By observation it is clear that many firms fail to follow policies consistent with profit maximization. Most firms set sales quotas or cost targets on departments or divisions. Salesmen are given sales quotas and rewarded on the basis of sales performance. Managers who are evaluated on profits are typically given target profit levels. They are rarely (if ever) rewarded on the basis of how close they come to the theoretical maximum level. Of course, the reason most firms fail to act as profit maximizers is that most firms are unable to do so. As suggested above, such action implies a knowledge of data that are simply not available to most businesses. The predominant pricing goal observed in American industry is that of profit satisfaction. That is, prices are set so that a satisfactory level of profit (or return on investment) is anticipated. Such a price is based almost solely on cost.