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How to set the wrong price, based on costs 1/3

How to set the wrong price, based on costs 1/3

I have been teaching strategy and strategic marketing for more than (alas!) thirty years, in the context of management education programs addressed to SMEs’ owners and managers, public officers, young graduates, and more …

Quite often, during the same programs, I run into the intrusion, in the finance and management accounting modules, of teachers (coming from the academic world or the professions, i.e. reputed CPAs!) who “explain” to the audience “how-to-set-prices”.

Too bad that, frequently, their suggested method refers to the regrettable and unfortunately widespread practice of setting prices based on the sum of three amounts: unit variable cost (this is important, but for other reasons), unit fixed cost (this doesn’t make sense) and desired unit margin (another nonsense!).

How is it possible that “otherwise” intelligent people (these teachers, and all the entrepreneurs and managers who adopt the so-called cost-plus pricing) could not see the absurdity and riskiness of that approach?

I therefore think that an attempt to dismantle the cost-plus (il)logic could be useful, drawing your attention to few aspects that seem obvious to most of us, but apparently are totally ignored by an incredible number of managers and a significant share of management accounting teachers (especially in Italy!) who are not sufficiently familiar with strategy.

The decision about the price level has a central role in marketing strategy … what does management accounting have to do with it?

I guess it’s evident to everybody that the buyer of any good or service makes his/her choices (among the available alternatives, and given specific needs) based on a more or less conscious comparison of the ratios between the perceived value of the various offers and their price.

From the perspective of a supplier who wants to create wealth for his/her company through the satisfaction of buyers’ needs, the relationships among the relevant factors can be summarized as shown in the following figure.

An organization's wealth engine
An organization’s wealth engine

It is clear that this conceptual model, that I challenge anybody to dispute, identifies real and “physiological” cause-effect relationships, and not purely theoretical assumptions or simple conventions. Beyond the obvious relationship between margins, revenues, and costs, and that equally obvious between volumes, price, and revenues:

• the volumes sold imply the existence of a market demand (no matter how generated) and the company’s ability to gain a share of it
• the acquisition of a demand’s share implies that the ratio between the value perceived by the market and the price paid is satisfactory and “competitive”, compared to the available alternatives
• the price level is inversely related, other things equal, to the willingness to buy, but it is often positively related – at the same time – to the perceived value
• the value perceived by the market depends, to a large extent, on the investments on resources (broadly speaking), and therefore on the costs incurred by the company to produce it
• the same company’s investments can contribute to the market’s expansion (for example, acquiring new consumers to the industry via communication campaigns), but the logic of acquiring a “slice” of the available “pie”, to the competitors’ detriment, remains applicable (no matter how the pie was generated).

Can we possibly see any “physiological” and cause-effect relationship between costs (or investments) and price? Certainly not: if costs have a direct impact on price, it is just because somebody decided – as we will see, incorrectly – in that way.

Nobody can deny that price is a significant variable for traditional management accounting, but the choice of the price level is evidently a matter of strategy, since it directly determines the type and level of the firm’s market position, and falls within the competence of marketers and company owners, certainly not of controllers or CPAs!

We should therefore ask ourselves on which grounds these guys pretend, and presume, to invade a field that is outside their competencies.

Next time we will see why it doesn’t make sense, in particular, to consider the fixed costs in our analysis.

Selected bibliography:
• These three posts on pricing are translated and adapted from G. Gandellini, “Come sbagliare i prezzi basandosi sui costi”, in G. Gandellini, D. Possati, M. Manzoni & A. Pace, Perfectum, Franco Angeli, Milano, 2005.
• Thomas T. Nagle, The Strategy & Tactics of Pricing: a Guide to Profitable Decision Making, Prentice Hall, 1987 (or later editions by the same author or co-author).

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