Difficulty: Intermediate to Advanced. Prerequisites: cost behaviour, CVP analysis (Doc 1), cost allocation basics (Doc 2).
Pricing decisions require more than cost analysis: they demand consideration of competitors' likely responses, the distinction between short-run and long-run cost relevance, and the discipline to ignore sunk costs. Contribution analysis is the right tool for short-run decisions, but full-cost thinking matters in the long run. Strategic pricing also means anticipating whether competitors will accommodate or retaliate.
Contribution analysis (incremental cost analysis)
Evaluating a decision by comparing the additional revenue it generates against only the additional (variable/incremental) costs it creates. Fixed costs that do not change are excluded. In simple terms, focus on what changes.
Full cost approach
Allocating all costs, including fixed overhead, to products when setting prices or evaluating profitability. In simple terms, every product bears its "fair share" of all costs.
Accommodation (competitive response)
When incumbents maintain their current prices and allow a new entrant to capture some market share. The cost of accommodation is the lost contribution from customers who switch.
Retaliation (competitive response)
When incumbents cut prices to match or undercut the entrant, attempting to deny it customers. The cost of retaliation is the reduced margin on all existing customers.
Game theory (strategic interaction)
A framework for decisions where the outcome depends on what other decision-makers (competitors) do. Unlike decision theory (playing against nature), game theory involves players whose actions respond to yours.
Price leader
A firm whose pricing decisions influence the entire market. Competitors tend to follow the leader's price.
Marginal contribution
The contribution margin generated by one additional unit or customer. Equal to price minus variable (marginal) cost.
Incremental cost
The additional cost incurred from a specific decision or action, excluding costs that would exist regardless.
Sunk cost
A cost already incurred that cannot be recovered. Irrelevant for future decisions. The classic test: does this cost change depending on what we decide? If no, ignore it.
Ryanair announced service between Dublin and London (Luton) in 1986, directly competing with Aer Lingus and British Airways on a major route for the first time, at a fare of IR£98 versus the incumbents' IR£166.50.
Can Ryanair be profitable at £98? The analysis builds Ryanair's likely cost structure by adjusting the incumbents' costs for two advantages:
Greater staff efficiency: US airlines served 708 passengers per staff member vs BA's 483. Ryanair can achieve roughly 32% lower staff-related costs ((708-483)/708 = 0.32). Staff, selling, and handling costs are reduced by this factor.
Higher utilisation: incumbents operate at 60-70% seat utilisation. If Ryanair fills its planes at or near 100%, its fixed cost per passenger falls to about 65% of the incumbents' figure (cR = cBA x 0.65).
With both adjustments, Ryanair's total cost per passenger drops from 155.1 to roughly 94.4, making a £98 fare viable.
Incumbents' options:
Accommodation: keep fares at £166.50 and let Ryanair fill its 64,240 annual round-trip seats. Worst case for incumbents: all Ryanair passengers are stolen from them, costing 64,240 x £137.50 (marginal contribution) = £8.8M. Best case: Ryanair draws from sea-ferry passengers, and incumbents lose nothing.
Retaliation: cut fares to £98 across all 500,000 existing passengers. Worst case: no new passengers from ferries, cost = (166.5 - 98) x 500,000 = £34.3M. Best case: they fill 250,000 empty seats with ferry passengers at £69 contribution each (£17.3M gain), reducing the net cost to £17M.
Accommodation costs £0 to £8.8M. Retaliation costs £17M to £34.3M. Accommodation is far cheaper, so rational incumbents should accommodate, especially while Ryanair is small.
In industries with high fixed costs and low marginal costs, incumbents are tempted to retaliate because they can drop prices very low. But retaliation is unattractive when the entrant is small relative to the incumbent, because the incumbent must cut prices for its entire customer base to deny the entrant a small number of customers.
What actually happened: incumbents initially accommodated (dropped restricted fares from £99 to £95). When Ryanair expanded onto Aer Lingus's best routes, the flag carrier retaliated fiercely. Ryanair nearly collapsed in 1991, then reinvented itself as a true low-cost carrier modelled on Southwest Airlines and became one of the world's most profitable airlines by 1999.
Sheridan is a price leader in automobile carpeting (Product 104). Competitors dropped their price to $3.90, and Sheridan held at $5.20, losing market share (35% to 20%).
Should Sheridan drop to $3.90? Two approaches give contradictory answers:
Contribution analysis: at $3.90, unit CM = $2.24 on 150,000 yards = $335,850 total contribution. At $5.20, unit CM = $3.46 on 65,000 yards = $224,900. Contribution analysis says: price at $3.90. Breakeven indifference volume at $5.20: $335,850 / $3.46 = 97,000 yards. As long as Sheridan can sell more than 97,000 yards at $5.20, that price is better.
Full cost analysis: full cost per unit exceeds $3.90 at every volume level. At $3.90 the loss is $26,400; at $5.20 the loss is $10,335. Full cost says: $5.20 has the smaller loss.
The right answer requires game theory. Sheridan's pricing affects competitors' pricing.
If Sheridan drops to $3.90, competitors will match (they already did once). Demand for Product 104 depends on car sales, not carpet price, so price cuts cannot grow the total market. A price war benefits no one.
If Sheridan holds at $5.20, competitors are also better off at $5.20 (their total contribution is higher at $5.20 than at $3.90). As price leader, Sheridan can signal the higher price and wait for competitors to follow.
The payoff matrix shows (5.20, 5.20) is better for both Sheridan and competitors than (3.90, 3.90). Sheridan benefits from being the first mover (price leader) because competitors will follow its lead upward.
Takeaway: think strategically. Pricing decisions affect competitors' pricing. In a derived-demand market (carpets depend on car sales), price cuts cannot stimulate primary demand, only redistribute share.
Arguments for contribution metric: fixed costs are irrelevant in the short run; allocating them is arbitrary; economic theory supports it. Arguments for full cost metric: marginal-cost pricing does not make firms profitable long-term; fixed costs are variable in the long run; decisions have more long-run than short-run implications.
PWI sells machines that use steel rings. A new plastic ring has been developed that is four times more durable and cheaper to produce. PWI holds inventory of 25,192 finished steel rings plus raw steel sufficient for 34,500 more.
Are the existing inventories sunk costs? Yes. The special steel has no outside value (scrap value is zero). The resources committed to finished steel rings are already spent.
Short-run analysis:
25,000 steel rings in stock: incremental cost is zero (already produced). Contribution = (1,350 - 0) x 25,000/100 = $337,500. Far more profitable than selling the equivalent in plastic rings.
Next 34,500 steel rings from raw steel (summer production): raw material cost is zero (steel already owned, no alternative use). Labour is at 30% of normal wage (slack period, workers paid 70% anyway, only the incremental 30% matters). Variable OH = 80% of direct labour. Incremental cost per 100 = $106.11. Contribution per 100 = $1,350 - $106.11 = $1,243.89. Still far more profitable than plastic rings at $135.55 variable cost.
Future steel rings at full production: contribution per 100 = $674.40. Plastic rings contribution per 100 = $1,214.50, but volume is only 25% (plastic lasts four times longer). Annual contribution: steel $241,975 vs plastic $108,941. Steel is more profitable on a contribution basis even in the long run.
Full cost comparison: steel profit per 100 = $242.10; plastic profit per 100 = $1,070.35. But plastic volume is one-quarter. Annual profit: steel $86,866 vs plastic $96,010. On a full cost basis, plastic is slightly more profitable.
Recommendation:
Short run: sell the steel rings in stock, convert raw steel into rings during the summer (costs are sunk or near-zero), stop buying more steel, tell customers about plastic rings.
Long run: plastic will prevail (cheaper to make, lasts longer). Competitors will switch. The replacement ring market will shrink by 75%. Consider whether PWI should produce plastic rings or exit the ring business entirely.
The core lesson: sunk costs (inventory already on hand, steel already purchased) are irrelevant to future decisions. But long-run strategic thinking requires full-cost analysis and market foresight.
Merton manufactures two truck models (101 and 102) across four departments. Each department has limited machine-hour capacity. The case illustrates how to optimise the product mix when capacity is constrained across multiple departments.
The key principle: when multiple constraints exist, the optimal product mix maximises total contribution margin subject to all capacity constraints simultaneously. This typically requires linear programming rather than simple CM-per-unit-of-constraint ranking (which works only with a single binding constraint).
Students often treat the contribution analysis and full cost analysis as always contradictory. They are not. They answer different questions: contribution analysis is better for short-run, one-off decisions; full cost analysis is better for long-run, ongoing pricing. Know which question the exam is asking.
Students sometimes include sunk costs in incremental analysis. The test: does this cost change depending on our decision? If not, exclude it.
Students often forget to consider competitors' responses when recommending a price change. In oligopolistic markets, a price cut may be matched, eliminating any share gain.
Students sometimes confuse "accommodation" with doing nothing. Accommodation is a deliberate strategic choice: the incumbent decides that letting the entrant take some share is cheaper than retaliating.
Ryanair: be able to calculate the cost of accommodation vs retaliation for incumbents. Know the general lesson: retaliation is unattractive when the entrant is small.
Sheridan: expect a question that asks you to compare contribution analysis against full cost analysis and explain the contradiction. Know that game theory (anticipating competitor response) resolves it.
Precision Worldwide: identify sunk costs in a scenario and calculate incremental costs correctly. Be ready to compare short-run vs long-run profitability of two alternative products.
Know when to use contribution margin per unit of constraint vs simple CM per unit.
True or false: in the Ryanair case, retaliation is always cheaper for incumbents than accommodation. (False: accommodation costs at most £8.8M; retaliation costs £17M to £34.3M.)
Fill in the blank: Sheridan's pricing decision is best analysed using ______ because competitors respond to its prices. (game theory)
True or false: the steel inventory at Precision Worldwide has an incremental cost of zero because it is a sunk cost. (True for finished rings already in stock; partially true for raw steel, whose material cost is sunk but which requires incremental labour to convert.)
True or false: contribution analysis and full cost analysis always give the same pricing recommendation. (False)
Q: Ryanair plans 4 trips per day with a 44-seat turboprop, 365 days per year. What is its annual round-trip seat capacity?
A: 4 x 44 x 365 = 64,240 round-trip seats.
Q: Aer Lingus/BA carry 500,000 passengers at £166.50 with marginal costs of £29. If all 64,240 of Ryanair's passengers are stolen from incumbents, what is the cost of accommodation?
A: Lost marginal contribution per passenger = 166.50 - 29.00 = £137.50. Cost of accommodation = 64,240 x 137.50 = £8.83M.
Q: Sheridan's contribution at $3.90 on 150,000 yards is $335,850. What volume at $5.20 (CM = $3.46/yard) would generate the same total contribution?
A: $335,850 / $3.46 = 97,093 yards. Sheridan needs to sell roughly 97,000 yards at $5.20 to match the $3.90 outcome.
Q: PWI has 25,000 finished steel rings in inventory (sunk cost). Steel rings sell at $1,350 per hundred. What is the contribution from selling these rings?
A: Incremental cost is zero (inventory is sunk). Contribution = (1,350 - 0) x 25,000/100 = $337,500.
Q: In the long run, should PWI switch to plastic rings? Why?
A: Yes. Plastic rings are cheaper to produce and last four times longer. Competitors will adopt them, making steel rings uncompetitive. The replacement ring market will shrink by 75%. On a full-cost basis, plastic rings are already slightly more profitable. PWI should sell existing steel inventory, stop buying new steel, and transition to plastic.
This material draws on cost behaviour fundamentals (Doc 1) for contribution analysis and CVP. It connects to cost allocation (Doc 2) because accurate product costs are needed for pricing. It also connects to variance analysis and performance measurement (Doc 4), where the consequences of pricing and product-mix decisions show up in budget variances.
Related Terms / Search Tags
pricing strategy, contribution analysis, incremental cost, full cost pricing, marginal cost pricing, accommodation, retaliation, price war, game theory, strategic interaction, price leader, sunk cost, irrelevant cost, opportunity cost, capacity constraint, product mix, Ryanair, Aer Lingus, British Airways, Sheridan Carpet, Precision Worldwide, PWI, steel rings, plastic rings, Merton case, derived demand, cross-elasticity, competitive response