by John L. Daly and Craig Carrel
One of the great legends of college football was Woody Hayes, coach of the Ohio State Buckeyes from 1951 to 1978. Woodys Buckeye teams were famous for their running game. Three yards and a cloud of dust was the style of most Big Ten teams in those days. Hayes is often quoted as having said, There are three things that can happen when you throw a pass, and two of them are bad.
The same is true of product pricing. Three things can happen in pricing and two of them are bad. A companys reward for a price set too low is an unprofitable sale. Its reward for a price set too high is a lost sale that would have been profitable at a lower price. Only some place between these two numbers does the company have the opportunity to make both a sale and a profit.
The Competitive Advantage of Accurate Cost Information
While companies rarely price their products below cost intentionally, they often do so due to poor costing information. Traditional costing methods do a good job at telling the average cost of an average product sold to an average customer; but they do a poor job of identifying the specific costs related to a specific situation.
Cost, of course, is not the only issue in establishing price. The products value as perceived by the customer is another key factor. In fact, when a company has a superior value proposition or is the only one that does what it does, value is the most important factor in the pricing decision. However, value pricing falls apart in the face of real competition and cost becomes a more significant concern.
Traditional costing methods fail in many pricing situations because they arbitrarily allocate the indirect costs. Today, indirect costs such as rent, depreciation, utilities, and supervision are often a significant portion of the companys cost structure. While many people think such costs are unrelated to specific products, an analytical mind will quickly see cause and effect connections between products and the activities required to provide them to a customer.
Traditional costing methods fail in predictable ways. They over-allocate costs to high volume or easy-to-make products and under-allocate costs to difficult-to-make or low volume products. Thus, traditional methods bias pricing decisions towards the unprofitable dog products that a company would be perfectly willing to give to a competitor and against the money-making gravy products it would prefer to keep for itself. When superior costing information is available, a company has the ability to give the dogs to its competitors and keep the gravy.
While this is a simplistic view, in the real world many companies routinely under-price difficult or low volume work to the great satisfaction of their customers and overprice easy or high volume work to the great satisfaction of their competitors. Pricing policies based on average cost work well only when a company has nothing but average products. Today, because many companies produce a diverse portfolio of products using diverse processes, there may be few – if any – average products.
Activity-based costing (ABC) provides the tools necessary to understand indirect costs. In the early days of ABC, some writers proposed that a company identify the cost of every activity the company performed. Today, ABC practitioners know that it is not necessary to look at hundreds of categories of costs. Where companies once spent months performing an activity-based costing analysis, some companies now are able to produce an adequate analysis in as little as three days.
A company that understands five categories of costs will have a competitive advantage over a company that looks at traditional cost accountings three categories of cost (material, labor, and overhead). A company that looks at 12 categories of cost will have a competitive advantage over one that looks at seven. However, the law of diminishing returns applies. A company that looks at 20 categories of cost will not necessarily have an advantage over one that looks at twelve.
Categories of Cost at Team 1 Plastics, Inc.
Team 1 Plastics, Inc. in Albion, Michigan developed its first activity-based quoting model in 1998. Team 1 is a plastic injection molding company that specializes in lenses, light pipes, and other small precision plastic components primarily for automotive applications. Team 1s pricing model has evolved over the last 12 years and now examines 12 categories of cost.
Launch Costs One part of Team 1s model examines the cost to launch a new product. This includes quoting, engineering, layout, PPAP, selling costs, and other activities that occur before the company produces the first saleable unit of a product. Launch costs are a fixed cost and are completely independent of the number of units sold. Team 1s launch costs typically range from $5,000 to $15,000, depending on the nature of the product. For a high volume product, launch costs per piece may be trivial. However, for a low volume product, launch costs may be the most significant element of cost.
Complex products are more difficult to launch than simple products. Team 1s pricing model uses the number of critical product dimensions as a measure of complexity. The critical dimension count causes the companys pricing model to classify products as easy, medium, or hard, with corresponding different costs for each level. Product complexity also influences mold maintenance costs in the companys pricing model.
Set-up Costs Team 1s pricing model automatically calculates the production batch size of each product based on the companys production planning policies. This step-variable cost is very volume-sensitive and may represent a significant cost element for a low-volume product.
Volume Sensitivity The existence of fixed launch costs and set-up costs causes every product to have a characteristic relationship with volume.
Cost Volume Relationship All products in all industries have similar cost volume relationships.
Packaging The number of parts in a box is a key factor not considered in many cost models. Handling boxes from the molding machine to the customer dock can be a significant cost factor. Customers may want to use low box quantities to facilitate just-in-time production. However, it takes 10 times the handling for 10 boxes of 100 parts than for a single box of 1,000 parts.
Team 1s customers often supply returnable containers for their parts. The customers believe that packaging costs should be zero because they supplied the returnable containers. However, returnable containers involve significant handling, upkeep, and storage costs. A returnable container is cheaper than a box, but it is not free. The cost of shipping a product in a small returnable container can be a significant portion of the products cost. Since Team 1s activity-based quoting model allows it to quantify these costs, the company is often able to offer the customer cost-saving alternatives.
Profit Team 1s pricing model is unusual in that it places more emphasis on obtaining a return on assets rather than a return on sales. This approach implies that a fast paying customer will get a lower price than a slow paying customer. Because it has accurate costing information and an ABC cost model, Team 1 does not have to use cost factors to fudge its price. Instead, the company can quote the part accurately and only adjust the profit based upon its value proposition and competitive factors.
The company believes that its model has been an important factor in its profitable operation for the last decade. It allows Team 1 to translate costs into an accurate price and negotiate with customers so that the parts the company wins are profitable. The model is accurate regardless of how far from average factors such as volume, complexity, and packaging may be.
How Good is the Pricing Model?
All pricing models should reflect a combination of fixed, variable, and step-variable costs, which create a volume-dependent price. A good pricing model does not fail at extremely high or low volumes. Test the model by specifying a volume of a single unit. If the company is willing to produce this product, even though it would only sell one, then the model is probably a good one.
Astute customers know that there are smart vendors and dumb vendors when it comes to pricing. Smart vendors may be consistently the low bidder on high volume jobs, but very high-priced for low volume jobs. Dumb vendors quote similar prices, regardless of volume, and their lack of costing skills can drive them out of business, creating a possible supply interruption. Avoid being a dumb vendor!
Lower Your Average Quote While Increasing Your Profit
Surprisingly, pricing experts believe that companies who use activity-based costing are able to lower their average quoted price while still improving their profitability. Because companies with poor cost information tend to win the difficult/low volume quotes that they underbid, they usually conclude that they have to add fudge factors to obtain their target profit. These fudge factors have the effect of raising the companys average quoted price, while making the company competitive on even fewer bids.
The net result is the company with the best cost accountant wins!
John L. Daly, MBA, CPA, CMA, CPIM is a management consultant specializing in costing and pricing model development and is the author of Pricing for Profitability, published by Wiley & Sons. Daly will be presenting Executive Education, Inc.s Pricing for Profitability and Advanced Management Accounting seminars for the Minnesota Society of CPAs in Bloomington, Minn. on March 22 and 23, 2010.
Craig S. Carrel founded Team 1 Plastics with two partners more than 20 years ago in Albion, Mich. His focuses at Team 1 have been in the areas of sales and marketing, customer service, human resources, business management, and strategic planning. Carrel received his B.S. degree in chemical engineering from the University of Utah, and he currently serves on the universitys National Advisory Council.