What costs should be considered when making pricing decisions?

A bakery case
A bakery sells 10,000 breads per month, although its installed capacity is 20,000 units. Each bread is sold for $2, with a variable cost of $1 per unit, including raw materials and packaging. Monthly fixed costs — rent, utilities, and salaries — total $7,000.

The income statement shows revenues of $20,000, variable costs of $10,000, and a gross contribution of $10,000. After subtracting fixed costs, profit before taxes is $3,000. If total unit cost is calculated — including both variable and fixed costs — it amounts to $1.70 per bread.

One day, a hotel calls to order 5,000 breads at a price of $1.40 per unit. This order does not affect regular sales. Even though the offered price is below the total cost of $1.70, the analysis shows that the gross contribution increases by $2,000. Since fixed costs do not change, profit increases by the same amount. Therefore, accepting the order is beneficial.

The reason is that the $1.40 price covers the $1.00 variable cost, leaving an additional contribution. Since fixed costs do not increase, that contribution turns directly into profit. This case shows that fixed costs should never be treated as variable, nor divided across units, because doing so leads to bad decisions.

When capacity is exceeded
Now imagine the hotel orders 15,000 breads, exceeding the monthly production capacity. In this case, two extra employees are needed, increasing fixed costs by $7,000.

Even though the gross contribution rises to $16,000, fixed costs also rise, reducing profit by $1,000. The additional contribution wasn’t enough to cover the new fixed costs, so the order ended up being a loss for the business.

Which costs to consider
The key is to consider only the costs that change when the number of units sold changes. These are incremental costs. All variable costs are incremental, since each additional unit sold generates an additional cost. However, not all fixed costs are incremental. Only those that arise due to an increase in installed capacity count as incremental.

The structure of an incremental cost analysis is very different from an accounting view. That’s why an accounting income statement should never be used to make pricing decisions. It’s essential to isolate revenues and costs generated by selling additional units.

Any initiative that generates positive incremental profit should be accepted. In the first example, incremental revenues were $7,000, with variable costs of $5,000, leaving an incremental profit of $2,000. Since it’s positive, the order should be accepted.

In the second case, incremental revenues were $21,000, with variable costs of $15,000, generating a gross contribution of $6,000. However, with additional fixed costs of $7,000, incremental profit was negative: –$1,000. In this case, the order must be rejected.

Strategic use of incremental costs
It’s important to clarify that incremental costs are not used to set prices, but to evaluate the profitability of prices previously defined based on perceived value. They are especially useful for defining the minimum prices of the lowest-end solutions in the portfolio and for determining the room for maneuver when facing competitive threats.

The right way to react to those threats will be addressed later.