Do managers really understand Marginality rule?
Setting prices as per the level where marginal revenue is equal to marginal cost is called marginality rule. However, there is evidence produced by some researchers that most of the organizations do not follow marginality rules rather they follow different pricing methods and strategies based on different market conditions.
Even though Marginal rule isn’t suited for every organization, but it is very crucial for startups and companies with potential growth. Both, startups and early stage growth companies have to be aware of marginality since fast growth lead to investment in fixed assets, therefore their fixed cost will go up together with growth, that’s ok, it should be like that but you have to price it, every manager or senior leader should be aware that increase in fixed cost either facility or direct IT cost should be allocated to their cost of revenue on income statement. If by any chance they allocate the cost but not to include those components in their pricing, whatever you are selling, service or product, your net profit always will be understated by allocation on income statement. To prevent the scenario of losing the profit your fixed cost has to be part of your future selling price to prevent significant increase of your marginal cost over marginal revenue when you add additional unit to your product or service you provide. The biggest illusion to trap the lead in forming the prices without looking into marginality is:
· How to know when to invest in fixed cost
· How to know when increase in volume require investment in fixed cost
· Not knowing their actual cost of the business
· Trapped into illusion that every increase in production volume will bring higher profit.
· Not be aware of net profitability.
· Not understanding impact on cash flow
· Misallocation of the cost in between overhead and cost of revenue
I would say the points above are common mistakes made by leadership but very symptomatic to start up and companies growing faster than they could sustain with their knowledge and experience, it is very important to understand your priced backlog, so you could appropriately budget your year, not to mentioned importance of setting and understanding market conditions to be included in future pricing.
If you want to ease your Budget/Forecast process, first look into your pricing models and make sure your pricing supports your fixed cost and variable cost projections.
Every aspect of your financial report will be impacted if you do not know your own price.
Your KCR Team
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