In the early years of my consulting work I picked up a client that had been losing money for two consecutive years and was experiencing severe cash flow problems. They were using cost plus pricing. What went wrong?
They didn’t define their production costs well. They had included some of their production costs in the operating expense category, consequently when they added the traditional industry profit margin to their production costs their prices were too low to cover their costs.
Lest you think this an aberration, I’ve worked with hundreds of companies over the years and most don’t know what their costs are. Why? There are a variety of reasons, some:
Don’t have a clear understanding of how to categorize costs.
Allocate overhead costs to production using subjective, irrelevant bases for the allocation.
Use standard costs which typically include ‘cushions’ to protect the production group from being criticized for cost overruns.
Indeed, one VP of production had included a 60% cushion in his standard costs and no one in finance knew it.
As if those weren’t enough reasons, Eliyahu Goldratt in his famous book, The Goal, shows that traditional cost accounting drives up operating costs rather than reducing them. His book, It’s Not Luck, demonstrated that the same is true for service organizations.
Finally, and most importantly, production costs have nothing to do with the value to the consumer. That’s true whether you’re selling B2B or B2C. Allow me to illustrate this point.
Cost/Value Not Related
Let’s say that I’m a milk producer. I buy milk from farmers, process it and distribute it through grocery stores. Let’s assume that it costs me $1.12 to produce a gallon of milk. Now, let’s look at the various markets available to me as a milk producer.
Young families will typically place great value on milk because it’s essential for the child’s development. The elderly also have a health issue, osteoporosis, that adds value to milk for them.
Many adults, whose children are grown and aren’t yet concerned about osteoporosis, value milk only if they enjoy it’s taste. For the others in this group, milk has little, if any, value.
For people who are lactose intolerant, milk has no value. Indeed, it’s a health risk for them.
As you can see, the fact that it costs me $1.12 to produce a gallon of milk has no relationship to the value customers place on it.
Hopefully this simple example along with the challenges in defining costs outlined above will be enough to dissuade you from cost plus pricing.