“Crap” Pricing

“Crap” means rock in Rumantsch the 4th national language of Switzerland

To set a product’s price is a difficult job. The manager doing the job is expected to consider many parameters for a successful price. He should include the expected demand in targeted market segments, competition, the products value, product cost and the expected profits from the product. This an easy list to write, but very difficult to deal with since each parameter influences the rest and since profit depends not only on price, but also the volume sold. How should prices be set?

What is Product Cost?

Many apparently believe that product cost is important to set a products price. Figure out what the product costs add, say, 20% and presto you have an apparently good price that ensures profit. Is a product cost developed in this way realistic? Does it give a manager good guidance for pricing? Is this guidance enough to generate a good price?
What do we know about the cost of any product? We do know the materials and component values. This cost can be easily identified in purchase prices and can be adjusted to reflect scrap rates during production. Although this part of a product’s cost can be identified there is no guarantee material and component purchase prices will not change. There is a need to monitor purchased material prices – especially since in most products materials cost is 40% and more of the price.
What about all the other costs we have; like factory personnel, sales and marketing, IT, human resources, top management, R&D etc. None of these have anything to do with our product directly. Even direct labour – those people and machines that actually produce the product – assemble the components to the final product – cannot really be allocated to a product’s cost. The amount produced and sold of any product, and the total produced and sold of all products varies from month to month. If all products should absorb all the cost we have a product cost that varies significantly and will take significant effort to calculate. Even if the data is available for marketing and sales, can they make use of it?
The rest of a businesses cost is even more difficult to allocate correctly to products. It seems to me that product costs, even if some version of them can be calculated, are probably a major source of error. Potentially at least these errors can easily lead to lower profits.

Trimming the Product Line

Many reasons might be given to trim the product line. Products may be calculated to be unprofitable. They may be categorized as unprofitable because their volume is too low or the price in the marketed is less than the targeted return or even below the calculated product cost. Low volume may cause production to complain about the extra work in set-ups and lost capacity this causes – low volume products are a hassle to produce.
Should such products be eliminated from the product line?
Assume the product is sold at a price below the calculated full cost. By this calculation every extra item sold will add a small loss to the company’s profit and loss statement. If we are aware of the fact that any price above materials cost (or totally variable cost) contributes to the bottom line why do we use product cost for such a decision. Materials cost would be good enough for such decisions.
However, it is possible that your company has a real bottleneck in its production – it is loaded to the maximum. Should this be the case you would want your bottleneck to be used as effectively as possible – which products make the most money? Well, of those that must use the bottleneck machine gross margins (sales less materials cost) will vary. The highest margin divided by the time on the bottleneck machine indicates which products are most profitable. Textile and industrial fibres are a good example. Heavy yarns generally have a low margin but many kilos can be produced in an hour. Very fine (light) yarns are the opposite – they have high margins per kilo but not many kilos can be produced in an hour. In such a case (and only if we are talking about a bottleneck) the margin per unit of time on the bottleneck counts.
Before you eliminate one of the lesser products look and see if it can be produced on another (maybe less effective) machine that has capacity. If you can, then the product will contribute nicely to your bottom line.
The message is, think very carefully before you trim something from your product line – it may cost you profitability and profits.

Price, Cost and Value

Each customer perceives the value of your product differently. No customer will pay more than the price you quote. If every client perceives a different value there will be a distribution of possible prices in the market – from very high to low prices (based on customers’ perception of value). If you set your price somewhere in that distribution you will lose those customers for whom the quoted price is too high and many customers would pay significantly more, but certainly not if your quoted price is low (for them).
Clearly 1 price for all is not a good idea – you will have the scenario described above. A good pricing scheme will capture high prices from those that put a high value on your product and you will also capture all those people that perceive a much lower value. Capturing the spectrum is much more valuable than missing out on all those with a low value perception – they are often high in number.
It is clear that market segmentation is essential. Every segment should have its own price to capture the correct value. The prices in each segment must not cause prices in other segments to decline. If you can meet these criteria your profits will improve.

Service with the Product

Service that comes with the product can be the differentiator. An example could be prices according to lead-time. Some market segments may need a much shorter lead-time than others. This could easily be one way to price your products differently. In some industries customers regularly suffer an emergency demand for your product. If you have the ability to deliver within a very short time frame (say 25% of a normal lead-time) and you can do this without messing up your regular business, then you have an excellent opportunity for significant premiums – whenever an emergency occurs.
Don’t turn up your nose at emergencies. If 5% of your business is emergencies and you have 10% market share, then half of your business could be these emergencies at high prices. BUT only if you can deliver within the very short lead-time reliably!
The point is that service with your product can be one of the tools for market segmentation and justify significant price differentiation. The trick is to understand what the clients in each segment value and then  building the appropriate offers.



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