Contribution margin-based pricing

Contribution margin-based pricing (German:Deckungsbeitrag) is a pricing strategy which works without any mention of gross margin percentages. It maximizes the profit derived from a company's assortment, based on the difference between a product's price and variable costs (the product's contribution margin per unit), and on one’s assumptions regarding the relationship between the product’s price and the number of units that can be sold at that price. The product's contribution to total firm profit (i.e., to operating income) is maximized when a price is chosen that maximizes the 'Contribution Margin Per Unit X Number of Units Sold'.

Contribution margin per unit is the difference between the price of a product and the sum of the variable costs of one unit of that product. Variable costs are all costs that will increase with greater unit sales of a product or decrease with fewer unit sales (i.e., leaving out fixed costs, which are costs that will not change with sales level over an assumed possible range of sales levels). Examples of variable costs are raw materials, direct labor (if such costs vary with sales levels), and sales commissions.

The contribution margin per unit of each product multiplied by units sold equals the contribution to profit from sales of that product.

The total of Contributions to Profit from all a firm’s products minus the firm’s fixed costs equals the firm’s profit (more precisely, operating income).

To express the above in mathematical format:

Therefore, using the simplified example of a single-product firm, a firm would maximize profit by determining the price that maximizes contribution to profit (i.e., contribution margin per unit multiplied by the number of units sold), since the fixed costs that will next be subtracted will, by definition, be a constant regardless of the number of units sold.

Assuming an inverse relationship between price and units sold (i.e., sales volume), as is the case for most products since a lower price will generally induce higher unit sales, the firm would assume likely unit sales levels at various price levels, calculate the contribution margin per unit for the product at each of those price levels, multiply the number of units by the corresponding Contribution Margin Per Unit at that price level and choose the highest result (i.e., the highest Contribution to Profit) to maximize profit.

The relative contribution margin refers to the use of a production factor that is required for the generation of the contribution margin:

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