Price Isn’t Cost

The trend in American manufacturing has been toward more automation and fewer workers. This is clear by comparing industrial output over time to manufacturing employment:

Automation is an effort to reduce the amount of expensive or inefficient labor required to complete tasks. For manufacturing companies, it often represents a large upfront investment. This investment is made worthwhile by reducing long-term operating costs for the firm.

Automation, therefore, aims not only to reduce costs, but also to shift them from variable to fixed.

Once the investment is made, its cost no longer factors into the marginal cost of producing a product. Fixed costs are an important part of a go-or-no-go decision for a company at the onset of production, but should not factor into the price of a product going forward. Fixed costs are sunk costs.

Do Decreasing Costs Mean Decreasing Prices?

Variable costs are important to understand for pricing, but primarily only as a floor. A firm does not want to produce a product that sells for less than it costs to make (unless this is part of an long-term or product portfolio strategy to increase profit as a whole).

But only having a price floor is not much guidance. A floor may suggest that I not sell a product under $5 if its marginal costs are $5, but it does nothing to help me determine whether I should sell it at $10, $50, or $500.

This is one of the dangers of cost-plus pricing. The information that cost provides is either irrelevant (fixed cost) or insufficient (variable cost) to the pricing decision.

Let’s think back to the trend toward automation. If automation should reduce variable costs, by a cost-plus approach, prices necessarily should go down as well. If you are justifying the price of your product by the cost of making it, do not be surprised to face downward price pressure when your competitors and customers know that your variable costs are decreasing.

Lowered costs do not have to mean lowered prices, however, if a firm acts proactively in defining the value its products provide. This takes a dedication to understanding one’s customers and position in the marketplace, but can be the best way to defend prices above and beyond the effects of changing input costs.

Taking the Helm

Lowered costs can suggest lower prices, unless your company acts proactively to communicate and defend its value.

Value-based pricing, in short, means basing the price of your products on the value that they provide to customers, not on the cost to you to make them.

In this strategic worldview, investments in automation can lead to even increases in prices, if the firm is delivering more value to customers and can communicate that. Perhaps automation means that quality control will be improved, or that production can react faster to changes in demand.

Value-based pricing can take many forms in different industries, but at the core it represents a conceptual shift away from the company itself and to the existential purpose of a firm: serving customer needs profitably.

For US manufacturing, the lesson is to concentrate on the value that they bring to the marketplace. Lowering input costs can be an important component of raising profitability, but without a proactive strategy, a firm may be unable to capture such cost savings.

Cost-plus pricing relinquishes pricing leadership. Value-based pricing affirms pricing leadership.