One of the most compelling questions faced by every business is “how to appropriately price products and/or services?” The simple answer, of course, is to sell at a profit—to charge more than it costs.
However, the question that inevitably follows is “Will the customer be willing to pay that price?” Indeed, quite often the customer dictates the price that a business can charge. We certainly see this often in the world of bid and quote business, as well as those occasions when the customer desires to purchase a high volume of a given product or service. From these situations comes the terminology, price-based costing. In other words, your costs are dictated by the price. (In fact, the customer generally doesn’t care about your costs; they simply want their needs served at a specific price point.)
Too often, when prices are imposed by your customers, you are susceptible to developing a myopic focus on revenue—and a case of negligence regarding your costs. Fundamentally, you may fall into the assumption that if the cash register is ringing, you are making a profit. That failure to understand and keep a focus on costs has led to the demise of many businesses, both small and large. Usually, the first hint of this problem takes the form of one or more large customers who enjoy preferential pricing, while most other customers pay at a higher rate. These large customers tend to get larger yet, demanding more and more of the resources of the organization. Smaller customers subsidize the lack of profitability of the big guys, but gradually find themselves neglected or squeezed out of the picture. It is generally only when this has happened that it becomes clear that the big guys are not profitable customers—and haven’t been for a long time. And by this time, it’s often too late!
Consider, for instance, Vlasic Foods International who became enamored with the opportunity to expand their pickle sales through Wal-Mart. The giant retailer dictated a price point of $2.97 for a gallon jar of pickles—and Vlasic, focusing only on the likelihood of an incredible revenue increase, jumped at the opportunity. The anticipated revenue growth came about, as Wal-Mart sold an average of 240,000 gallons of pickles each week! However, as the sales of Vlasic pickles shifted to Wal-Mart, other retailers selling at a higher price point for Vlasic’s 8 ounce and 16 ounce jars saw their sales go nearly to zero. These profitable products disappeared as Wal-Mart sales grew. As Vlasic’s top-line soared, their bottom-line vanished. When Vlasic ultimately requested a price increase to $3.49 per gallon, Wal-Mart threatened to no longer carry any Vlasic product. Sadly, the story played out in January 2001, as Vlasic filed for protection under Chapter 11 of the U.S. bankruptcy laws.
Are there advantages to price-based costing? Clearly, knowing what the market will bear is essential and should not be ignored. A careful assessment of where the competition is priced, as well as face-to-face discussion with prospective customers will help zero in on the price range that will allow you to sell your product or service. Recognizing that the market will not support the price you had hoped to enjoy is not necessarily a bad thing, either. This information can help you decide where to compete (and where not to), or it can provide the impetus for innovation, lean initiatives, and cost reductions. Either outcome is good for your business!
That said, it is essential to understand your costs of doing business, especially direct or variable costs, which are often shown as cost of goods sold or COGS on the P&L. However, monthly financial statements aggregate both revenue and COGS, and that typically is insufficient to truly understand your direct costs. A more useful analysis will show costs by customer—and by product . This baseline cost analysis allows for a mark-up to your pricing. This is cost-based pricing.
So, should a business use cost-based pricing instead of price-based costing? NO! This should not be seen as an either-or proposition. Strong viable businesses do both. They learn what their price range must be in order to generate sales, while having a strong handle on their direct costs. They also recognize that it is critical to manage overhead costs, keeping a close eye on any elements of cost growth in those areas.
Understanding the market implications of your pricing decisions as well as the costs associated with those decisions is important. However, it is equally important to recognize that these decisions, while based on quantitative data, also require a healthy dose of managerial judgment. This should include the perspectives of salesmen, accountants, and executives. Pricing should ultimately be the fruit of careful thought, analysis, and collaboration.
(Full cost accounting allocates company overhead into COGS. However, for purposes of this article, the intention is fundamentally to understand direct costs and the contribution margin generated by your sales of a given product and/or specific customer. That margin contributes to paying for your overhead—and ultimately to creating a bottom-line profit.)