Rethinking Cost and Price

Most of us accept that if we go to a convenience store to buy groceries late at night, the price of many of the items will be more than if we bought them at a major grocery chain during regular hours. Yet when it comes to operating our businesses, many of us are not convinced that cost has no bearing on price.

When we buy something and we pay more than we want, we may complain that the cost could not have been all that much. In truth, we are really indicating we are offended by our assessment of the seller’s greed. We are using cost as a baseline indicator of where we think a more equitable price should be. We simply do not like to admit we are willing to pay for the incremental value this specific product or service brings us. In this case, we are conflicted by an assessment of fairness based on cost and a reality that we are paying for the benefit of convenience.

So it is easy to understand why cost-plus pricing is the most common approach to price setting in practice today. It just seems fair. And it is relatively easy to determine. Further, we well comprehend that cost has everything to do with profitability. And profit is why most of us are in business so we spend a fair amount of time and energy managing and tracking our costs.

Making sure we are not selling below cost is a smart action to take. It tells us where we are not competing well. It tells us where we are spending too much on time and materials. And it can help us consider the least we are willing to accept for our products or services. Yes, as good business people we must study our costs and margins.

We can even consider it as a determination of our willingness to be in a specific customer segment, to produce a particular product, or to serve a certain customer. But, we must not confuse this activity as a price setting exercise.

Often consultants will discuss setting a floor price. Sometimes it will be referred to as determining the bottom of a “pricing envelope”. This is an exercise of determining the lower limit of a product or service’s price-range we will offer to a market. Let’s be clear though, this is not about setting a cost-based price.

A cost-based price is not a price we ever want to offer the market. It has nothing to do with either what the market will pay based on perceived value or how our offer is viewed relative to competitive offers. Our potential customers are thinking about themselves. What benefits will they get relative to what they are going to spend? Will our price be cheaper than the other offer?

Further when we dig into cost, the whole matter of spreading fixed overhead becomes very messy. As my graduate school cost accounting professor said when she wrapped-up a very long and tedious semester, “No cost accounting approach is accurate, but it is better than nothing.”

It is very easy to get sucked into the vortex of which costs are most appropriate to apply. It is also easy to spend our energy determining which version of margins we will use. Do we use gross margins, contribution margins, net margins, etceteras?

The activities of understanding costs and margins are internally introspective at best. They do not address the “willingness to pay” of our would-be customers. Alternatively, we should think about our bottom-price as the lowest price we will quote into a given market.

Our bottom-price can be based upon the lowest price in which our product or service has sold thus far. Ideally, this lowest price was given to our largest customer or for our largest transaction; e.g. the customer who bought the largest quantity of units or spent the most money at any one time.

The lowest price could also be based upon a contract which guarantees our “best customer” the best price – a “most favored customer” clause. But, we should have figured out the lowest price before we introduced it into a contract.

In summary, a cost-based price is not an indication of what we should charge for our products or services. It provides an understanding of when it is no longer viable to sell our products to certain customers or market segments. As such, it is an important activity that every organization must undertake. But, if we want to improve our margins and drive sales revenue, we must focus our efforts upon creating an understanding of what our prospects will pay for our offerings. And we must understand this with a solid grounding in the price our customer can pay to get that need fulfilled elsewhere. Yes, cost-based pricing is almost a natural instinct due to our sense of fairness and the ease in which we can generate numbers. But, if we study our own behavior when it comes to our willingness to pay for things beyond the cost of the goods, e.g. convenience, then we know we too should be able to add value to our products and services and our costs are irrelevant to our customers.