A Practitioner’s Observations on Pricing

It has been suggested by one of our members that ”pricing” is one of the top 10 topics for most businesses in 2023. Another member commented that it has been a top 10 topic for decades. In my experience, pricing has always been a top 10 topic for businesses. Pricing is a complex, multi-dimensional process that includes market conditions, costs, investment usage, and many other factors. Unfortunately, many businesses continue to treat it as a simple process based on product or service cost and a targeted markup based on that cost. Here are some of my pricing related observations based on five decades working “in the trenches” with small to mid-sized organizations.

Too many organizations ignore the fact that the market, not cost, determines the price it can receive for its goods and services. When establishing a price, they simply estimate the cost and add a target markup. If they don’t think that price will win them the work, they will manipulate their cost estimates, often by violating the laws of physics, so that they can a charge price that they actually believe will enable them to attain their target margin. Instead of understanding that they are selling at a price that doesn’t meet their targets, they make themselves believe they will be earning that target and are then surprised when the bottom line doesn’t reflect that level of performance.

Speaking of costs, most organizations I’ve encountered haven’t a clue as to what their products or services actually cost them. They continue to rely on information from cost accounting systems that are not based on causality and fail to reflect the fundamental economics that underlie their operations. Even without manipulating their costs, their pricing decisions do not lead to the levels of profitability they anticipated. In several cases, I’ve seen companies whose inappropriate cost models actually caused them to fail.

Several of the companies I’ve helped develop causality-based cost model found that the product or contract they thought was “the jewel in their crown” was actually their biggest loser. Eliminating that product reduced their sales while increasing their profits considerably.

I’ve already mentioned that the market, not cost, determines the price an organization can receive for its goods and services. Although cost has nothing to do with the price, it has a lot to do with the pricing decision. It provides an organization with the information needed to determine if it wants to “play the game” at the market price. It is not, however, always the “fully absorbed” product or service cost that is relevant. Although I’ve seen many companies that hurt themselves by overusing the practice, there are situations where incremental cost is the relevant. Special, one-time orders are a common example. I’ve also seen companies use it effectively to create a supplemental, non-core business that uses capacity not required by its core business. In cases where incremental costs are relevant, it is important to be able to project those incremental costs; a process that is seldom performed accurately by using the traditional fixed vs. variable cost formula. Quality incremental cost information is best obtained by using a causality-based, predictive cost model that reflects actual cost behavior.

Another arena where causality-based, predictive cost models are critical is strategic pricing; pricing different product or service lines in a way that optimizes the overall profitability of the organization even if that means some product lines show marginal, or even negative, profits. Such strategies are designed to make the best use of the organizations fixed resources. The idea that General Motors would lose a little on Chevys so that it could make a killing on Cadillacs is an example of this strategy. So was the aerospace practice of breaking even on the original contract so it could mop up on the spare parts. Organizations whose products or services are non-inventoriable, like airlines, hotels, and telecoms, also rely on strategic pricing. They use sophisticated pricing models designed to make the most profitable use of their fixed, non-inventoriable investment. Any strategic pricing strategy requires that the organization be able to measure its total costs based on a variety of volume and mix scenarios – a process that is made possible by a causality-based, predictive cost model.

Most organizations use some measure based on percentage of sales to determine the price required to meet its financial performance objectives. Profit as a percentage of sales, gross margin percentage, or contribution percentage are the usual measures. Each of these has one fatal flaw. If the organization’s objective is to earn the best return on investment possible for its investors, why isn’t investment taken into account when measuring the value of each of the components that make up the organization’s business? I discussed this topic in detail in an earlier blog titled “Is Anything as a Percentage of Sales Meaningful?” so I won’t go deeply into it here. Some measure that takes investment into account is necessary to measure the true value of a product, service, customer, or any other sub-set of an organization’s business. Incorporating a cost of capital into the cost of a product or service would be ideal, but other simple measures, such as profit as a percentage of value added or as a percentage of internal cost would come closer to matching to organization’s overall financial objective.

A corollary to the percentage of sales measurement problem is the use of sales as a basis for commissions. Why would an organization pay commissions on work that could possibly erode company value? I’ve seen this happen time and again. A stamping company I once visiting went out of business after paying an agent a $500 thousand commission for a contract on which they lost over $3 million. One of our members related a situation where a retiring marketing executive maximized his final bonus by promising customers no future price increases and giving away extras as he went out the door costing the company over $100 thousand in revenue. Some measure based on the value of business being generated by the sale would be more appropriate. Many printers I’ve worked with recognized this problem and based the commissions they paid using a percentage of value added (sales less the substrate). Basing commissions on profitability or value added would be a preferable approach.

As I mentioned earlier, pricing is a complex, multi-dimensional process that includes market conditions, costs, investment usage, and many other factors. PACE’s eBooks on Customer Profitability provide further details on the subject as does the SMA “Revenue Management Fundamentals” that PACE developed for the Institute of Management Accountants.