Q&A - How can a business use contribution pricing?

Contribution pricing involves setting a price based on the variable cost of producing or buying a product. The aim is to ensure the selling price generates an acceptable contribution towards covering the fixed costs of the business.

Contribution pricing is closely linked to the important concept of break-even.

To explain this, take a look at this example for a single-product firm;

- The variable cost of producing each unit of a product is £25
- The business has annual fixed costs of £100,000
- It is expected that sales volumes of 10,000 can be achieved if the product is priced competitively
- The business has an objective of at least breaking even during the year

What selling price should be charged.

Contribution pricing would look at the data above to set a price which provides enough total contribution to cover the fixed costs of £100,000 (i.e. achieve break-even).

If sales volume is 10,000 in the year, then contribution per unit needs to be £10 in order to generate £100,000 of contribution.

If contribution per unit needs to be £10, then the selling price must be £35 (i.e. a selling price of £35 less variable cost per unit of £25).

A selling price set above £35 will enable the business to achieve a profit, although this depends on demand still being 10,000 units per year and fixed costs not proving higher than expected.

Contribution pricing is particularly useful for a business that wants to determine the price for a special order. However, a possible disadvantage is that the price set for each item is not competitive. It is always important to double-check the resulting price to ensure that the firm remains competitive.