Online Exclusive: Smart Pricing
In the global economy-where quality is a given, service is expected and the customer is king-price is everything. Yet pricing is often the most difficult task a manager must perform. It is so difficult that most managers rely on a cost-plus approach. Others simply throw up their hands and guess, and some even invoke trial and error-in essence, throw it against the wall and see what sticks.
By now, the marketing gurus are screaming that there is more to selling than just price-such as quality, service and personal relationships. While those are important marketing elements, globalization has standardized quality (ISO) and service (JIT), thereby increasing the value of good pricing. Unfortunately, "good pricing" often means low prices.
The dinnerware and pottery industries that were once family-owned and relationship-driven learned this lesson. They were forced to compete in a global market where service and quality are expected and low prices are demanded. They had to adapt their production operations and their pricing methods to this global reality. Good service and personal relationships did not insulate them from pricing pressures.
However, a low price doesn't have to mean low profits. What it does mean is smart pricing. Smart pricing reflects your unique capabilities and meets your sales and profit goals. It is one of the few areas where you can create a competitive edge. To generate a smart price, you must understand the five elements inherent in the pricing decision: your goals, costs, volume, product mix and competition.
GoalsBefore setting a price, you should determine what you want the price to achieve. For example, to project an image of a premiere producer, the price could be set high. People, even business people, associate high prices with top-notch organizations. The same is true on the other side of the spectrum-if you publish the lowest price, your company will be viewed as the low-cost producer.
The goals stated above require only broad directional approaches. However, objectives are quantitative-they require a little more analytical effort. Objectives define specific levels of performance, which are expressed in dollars, percent, volume or market shares. Additionally, objectives can be micro and macro in nature. For instance, at the micro level, Wal-Mart has a small per-item profit objective compared to Sak's Fifth Avenue, but at the macro level, the return on investment for these objectives is similar.
CostsTo many managers, pricing is a two-step process-cost-plus. It is easy to see why they like this abbreviated approach. Both the cost and the plus are within their control and completely known. This reduces risk and simplifies the calculation.
Costs are simply all the resources required to produce the product. They include direct labor, materials, energy, capital and overhead. The plus is the company's goals and objectives. Thus, with this model, price is simply the cost plus a pretax or gross profit margin.
The problem with cost-plus is that it assumes and ignores some very critical information. Let's look at a simple example-a pressed and fired clay ceramic that weighs 1 lb (see Table 1).
What are the assumptions in this example? First is the productivity of each operation in the process. For example, the press productivity is 240 pieces an hour. A labor rate is applied to that productivity to determine a cost per piece. Using a labor rate of $20 per hour, the cost per piece is $0.083 ($20/240=$0.083 per piece).
Second is scrap. The cost of the scrapped pieces must be added to the good pieces. This requires an assumed scrap rate. In this example, 5% was used.
Third is overhead. Overhead costs are those manufacturing costs that are not easily assigned to a particular item, such as taxes, supervision, depreciation, utilities, etc. These are grouped together and then applied to each item. The method of application depends on the product being made and the company making it. Overhead costs could be applied based on labor hours, materials used or total variable cost. Additionally, the rate of application must be determined by forecasting the volume to be produced.
The fourth assumption is the sales and general administrative (S&GA) expenses. Like overhead, S&GA expenses are mostly fixed. Here, S&GA was budgeted at $150,000 or $0.150 per unit based on a forecasted volume of one million units.
Finally, after all the costs are calculated, the profit objective of 10% is added to yield the final price of $1.00. This is the cost-plus approach.
Backtracking a little, the required gross profit to achieve the 10% pretax objective is 25%. Many companies prefer to use the gross profit percent as their objective reference. Their model would be manufacturing costs plus a gross profit objective, rather than total cost plus a pretax objective. By setting gross profit as their reference point, they eliminate the complexities of S&GA expenses in their pricing model.
The pricing example in Table 1 appears to be complete. As a business manager, you could easily adapt it to your product, your process and your productivity levels. However, while the prices generated by this model appear to be functional, in reality they may be dangerously dysfunctional because of the explicit and implicit volume assumptions.
VolumeMany of the assumptions illustrated in the foregoing example aren't really assumptions, but are historical averages or calculated projections. Productivity at the press is usually based on time studies or actual experience. Manufacturing and S&GA expenses are also based on sound historic precedents. Even scrap is more experience than assumption.
The real assumption in our pricing example is volume. Volume affects the rate at which we apply our fixed expenses and relies on the most unreliable of sources-the customer. To understand the impact of volume, let's look at a real-life example that had a tragic result.
Many years ago, I met the manager of a small ceramic company who was going through the pains of a bankruptcy. He expressed his bewilderment. His company was extremely efficient and a leading supplier of its product. Additionally, his accountant assured him that his pricing model (cost-plus) was the industry standard and that his profit objective was reasonable. So why was he faced with bankruptcy?
Even though his product earned a 60% incremental margin (a very healthy increment), the operation failed to earn a profit. He had missed the impact of volume-not just the obvious impact, but the hidden impact. When the volume diminished to the point of negative cash flows, bankruptcy ensued. Why didn't he see this?
Let's revisit the pricing example presented earlier. The volume assumption is inherent in three of the calculations. Can you identify them?
The first, and most obvious, is in our gross margin. The 25% we have built into the price must cover our sales and administrative expenses, which are essentially a fixed cost. They must be distributed to each item sold. To do that, we must assume a volume of sales. Using the S&GA budget of $150,000 and a volume assumption of one million units, the S&GA expense per unit is $0.150.
If the company fails to sell one million units, its profit declines in both dollars and percent because the fixed-dollar S&GA expense must be absorbed by fewer items. The point at which profit declines to zero is called the breakeven point. In this example, the breakeven point is 600,000 units ($150,000/$.25 per-unit gross profit).
But gross profit is not the only volume-dependent element in the model. Overhead is the second volume-related element because a substantial amount of that expense is fixed through taxes, depreciation, supervision, utilities, etc. At one million units, the overhead expense in this example was budgeted at $262,000 or $0.262 per unit. If the company fails to achieve its volume objective, the lower volume must absorb all of the overhead expenses, which lowers gross profit.
Volume is a double whammy-it not only affects our ability to absorb S&GA expenses, but it also lowers the gross profit needed to cover those expenses. Thus, the actual breakeven point increases from 600,000 to 804,688 units. An increase in the breakeven point is a bad thing.
Most pricing experts will yawn at this revelation. These are well-known effects, but what is less recognized is the third volume element-product mix. This is where that bankrupt ceramic company stumbled.
Product MixEach plant or organization has a capability-things that it does well. It is important that your company's pricing model reflect those process capabilities because they affect the product's ability to absorb fixed costs such as overhead and S&GA expenses.
To better understand how this works, let's change the size of the product being priced from 1 lb to 1 oz. The labor elements will not change, as it takes the same amount of time to set, inspect or press the 1-oz ceramic as it does to handle the 1-lb ceramic. The two areas where size would make a difference are materials and firing. Maintaining our gross profit objective and our overhead absorption rate, the pricing profile shown in Table 2 is developed.
The percentages are still very healthy. The scrap rate is still 5%, the manufacturing overhead applied is still 35%, and the gross profit is 25%. Even the projected volume is good-one million units.
However, selling one million of these items only generates $113,000 toward the overhead budget of $262,000, and only generates $108,000 toward the S&GA budget of $150,000. At one million units, the total sales will be $433,000, which generates a loss of $191,000. The smaller size effectively and drastically decreases the volume. This is the hidden volume effect.
Of course, you might argue that this is an unfair comparison. It's obvious that the company would make less money with only $433,000 in revenue. You might also argue that it would only be fair to keep the dollar volume equal. It is true that by changing the projection from one million units to one million dollars, the product will achieve the profit objectives. Unfortunately, this operation may not have the capacity to make one million dollars of this item. Let's look.
In the first pricing profile, press productivity was projected at approximately 240 pieces per hour. Operating two shifts yielded a net annual output of approximately one million items. In order to make one million dollars on this item, the unit output must increase 2.3 times, but adding a third shift will only increase unit output by a factor of 1.5. The three-shift revenue number is $649,500, which cuts the loss to $80,500-but it is still a loss, and there isn't sufficient capacity to reduce it further.
This is a common pricing problem that occurs in small, diversified shops. These companies often standardize their pricing model to an average. As the product mix deviates from that average, it can have a devastating impact on their bottom line. This is what happened to our bankrupt entrepreneur mentioned previously. His pricing model told him he should be making a profit, but he wasn't. He was producing at capacity, but losing money. He was trapped-he couldn't justify expanding the capacity of a losing operation, yet without that expansion, he was not capable of making a profit.
CompetitionIf smaller products can cause problems, then logic seems to
dictate that an increase in size would be beneficial. Let's revisit the example again, this time increasing the weight of the piece from 1 to 3 lbs. As before, handling will remain constant, and material and firing costs will be adjusted to reflect the new weight. The new calculation is shown in Table 3.
At one million units, revenue now equals $2,209,000 with a pretax income of $720,000. This is almost $500,000 more than the original targeted pretax income rate of 10% ($220,900) and $620,000 more than the original budgeted dollar income of $100,000. The actual gross profit dollars equal $870,000, which yields a gross margin of 39.4%, well above the targeted 25% objective. This item is a profit windfall and well within the capacity and capability of the plant.
This may appear good, but there is a problem. In a mature market, where growth is stagnant, technology is settled and price competition is fierce, a 40% gross margin invites competition. When this competition undercuts your quote, you might be mystified that they could sell so cheaply. After all, your pricing model indicates that the item is yielding only a 25% margin. You might think the competitor is more efficient when, in reality, they simply may be pricing smart.
What's interesting about this approach is how it seemingly reduces the interim profit goals but in reality increases the
bottom-line results. For instance, at one million units, the gross margin is only 19.1% but the pretax margin is still 10%. This yields a pretax profit of $165,000, which is 65% greater than the original budgeted amount of $100,000. In addition, the $1.654 price is more likely to get the order than the $2.209 price.
Strategic ImplicationsAs demonstrated in these examples, the most dangerous volume effect is the hidden risk of product mix. It lowers the price and encourages the purchase of items that are incapable of delivering profits. It also raises the price of and discourages the purchase of items that do deliver profits. Over time, customers will buy your low-profit products and decline to buy your high-profit products. They will leave you with a lot of losers, few winners and no windfalls.
By switching to a fixed-dollar approach rather than a fixed-rate model, the hidden volume effect of product mix is eliminated. This model requires that each item contribute a fixed number of dollars to the overhead, S&GA and the profit accounts, regardless of the value added in the plant. It eliminates the need to forecast volume before you price, which removes the risk associated with the volume effect. Each item is forced to carry its fair share of the fixed costs. Thus, every item is a winner, and the customers, through their purchases, will define what your company can do well. There will be no surprises, no slow profit declines and no bewildered bankruptcies.
Pricing is KeyIf you are consistently failing to make your profit goals, even with strong unit sales, the problem may not be in how you are making the products but how you are pricing them. Your competitors might not have more efficient operations-they may just have smarter pricing systems. If that is true, a small change in your pricing profile could put you back on the path to higher profits.
In the global economy, pricing is key. Smart pricing requires a complete understanding of your plant's capabilities, capacity and product mix. It reduces risk, enhances profitability and increases competitiveness. Smart pricing can be the difference between a profitable operation and a bankrupt one.