Some Thoughts on Decision Costs for Pricing

It was time for some scheduled maintenance on my car and I needed something to entertain myself while I waited in my auto dealership’s customer waiting lounge.  The mechanic’s work would only require about an hour so I didn’t need to fill a whole lot of time.  As I glanced at my bookshelf, I noticed a rather thin, soft-covered book sandwiched in between its larger, hard-covered neighbors.  It looked the right size for something that might occupy my wait time.  Pulling it from the shelf, I saw that it was a book I had purchased two decades ago by an author you’ve heard me mention in my writings, presentations, and podcasts on more than one occasion: namely, Dr. Aflred R. Oxenfeldt. 

The title of the book is “Decision Economics: Some Guidelines for Leaders” and it is a concise, 100-page summary of the key economic concepts that Oxenfeldt believes business decision makers must understand and apply if they are to make effective, well-reasoned decisions.  As a little background for any of you unfamiliar with the late Dr. Oxenfeldt, he was an international authority in the field of price setting and anti-trust.  He served as Principal Economist on the War Production Board during World War II and was a long-time economic consultant to government and business.  After serving as the chairman of the economics department at Hofstra University he spent three decades as a full professor of business at the Graduate School of Business of Columbia University.  His many books include “Industrial Pricing and Market Practices,” “Pricing for Marketing Executives,” and one I’ve cited on many occasions; “Cost Benefit Analysis for Executive Decision Making.”

Nearly a quarter of the book is dedicated to the subject of “Costs.”  Being an economist, he spends the bulk of that section emphasizing that decision costs are not the same as costs calculated and recorded by accountants and they are definitely not those product or service cost calculations that include overhead and other indirect costs.  Decision costs are incremental costs – those costs that will change as the result of the decision under consideration.  His words reminded me a great deal of the arguments I’ve heard over the years from my “lean accounting” and “throughput costing” friends who believe the assignment of non-direct costs to specific products or services is not only a waste of time, but a practice that misleads decision makers.

Oxenfeldt then added a paragraph that highlighted the one area in which the simple “decision costs are incremental costs” rule should not be taken literally.  He wrote: “Unfortunately, economists have mainly espoused the value of decision costing in the context of ‘marginal pricing.’  They point out, correctly, that the relevant costs for decisions to produce output are incremental costs.  This notion is very relevant and helpful for regulatory bodies dealing with public utility rates.  However, that concept can be destructive in unregulated markets, especially where overhead costs are high.  The damage results from the false assumption that firms should base their prices on decision costs.  Firms that base their prices on decision costs can, and generally do, depress prices and eliminate profits and cause numerous failures.”

In the following paragraph he added: “The chief benefits of decision costing are found in other applications, namely, in dealing with the addition or deletion of activities.  These include vertical integration, ‘make or buy’ decisions, the addition of new products, new product’s features, entry into new geographic markets, etc.”

Pricing decisions are different than “one off” decisions like make/buy, drop/add, special order, or capital investment decisions.  Pricing decisions require a more nuanced and comprehensive view of what costs are the appropriate decision costs.

First of all, prices should be based on the market, not cost.  Cost doesn’t determine price; it determines whether or not a seller wants to sell a product or service at the market price.  Rolling up costs (whether they be prime costs only or fully-loaded, causality-based costs) and adding a target margin is just a means of “fishing” for an acceptable price in situations where competitor’s prices are unknown.

Second, pricing decisions are seldom sequential.  Organizations will often have numerous quotes outstanding at any point in time so cost estimates are made at a point where the base on which to measure incremental cost is unknown.  An organization with published list prices will, in effect, have thousands of quotes outstanding at the same time. 

Third, costs are either linear variable or step variable.  There are such things as sunk costs, but there is no such thing as a fixed cost.  Costs have a time dimension.  In the short run, some costs may remain fixed, but in the long run, all costs are variable. 

Fourth, many expenses as measured by historical, financial accounting information do not reflect the economic performance of the organization.  Some expenses, like depreciation expense, are not expenses at all, but arbitrary assignments of irrelevant sunk costs to future financial periods.  Other real expenses, like the cost of capital and the cost of capital preservation are omitted altogether.  Some investments are treated as expenses and some ongoing expenses critical to sustaining the organization go unrecorded because they were temporarily deferred until future accounting periods. Finally, some expenses are made to make up for the failure to make required expenditures in previous periods.  In short, using expenses recorded in financial statements when measuring decisions costs is problematic, at best.

The question is, “What costs should be considered when measuring the value a particular product, service, customer, product line, or market brings to an organization?”  In the long run, core business – sales of the organization’s usual products or services sold under normal market conditions – must cover all of the costs that category of business causes the organization to incur if it is to be profitable.  That’s because core business is what sustains the organization over the long run – a period of time when all costs are variable. On the other hand, special orders – atypical products or services or those sold under abnormal market conditions – may only need to cover the incremental costs they cause.  The organization does not rely of special orders to remain profitable over the long run.  Core business is the organizations “meat and potatoes” while special orders are its “dessert.”

In measuring the value of the various sub-sets of the business - whether it be individual products, customers, markets, or any other segments – those costs required to sustain the business over the long term must be assigned by following the law of causality.  One of Hicks’ Laws of Pricing applies; namely; “Over time, a company will get a lot of business when it doesn’t charge a customer for the work it does for them, but it won’t get much business when it charges customers for work it doesn’t do for them.”  Causality links the cost of the organization to the products and services it sells in a way that reflects the consumption by those outputs of the organization’s resources.  If its sales price doesn’t cover the cost of those resources, the organization is likely to gain more sales of those items and, in turn, incur more costs that their price won’t cover.  On the other hand, if it attempts to recover the costs of resources unrelated to its output it is not very likely to win that business. Competitor prices will be much lower.

There are, of course, other circumstances that must be considered when deciding what cost is appropriate for a particular pricing decision.  For example, strategic pricing decisions – losing money on some products or product lines so an organization has enough volume of make “a killing” on the balance of its business – requires an organization consider both incremental and fully-loaded costs.  The purpose of this short article, however, is not to cover all pricing situations.  Its purpose is to dispel the ideas that either incremental costs or fully-loaded, causality-based costs are the decision cost that must be used in pricing.  In truth, it depends on the specific pricing decision at hand and requires that that decision be “framed” appropriately.

As the distinguished economist John Maurice Clark stated a hundred years ago, “Most of this controversy will disappear if we carry our study far enough to recognize that there are different kinds of problems for which we need information about costs, and that the particular information we need differs from one problem to another.”  As both Drs. Oxenfeldt and Clark would attest, believing that incremental costs are appropriate for all costing decisions is just as sophomoric as believing that fully-loaded, causality-based costs are always appropriate.

Finding “an” answer doesn’t mean you’ve found “the” answer.  As Vaclav Havel advised, “Follow the man who seeks the truth; run from the man who has found it.”