Many organizations set the price for their products or services using the standard Cost Plus process. The question they are asking themselves is “What is the best product we can offer our customers?” With the answer to this in mind they then determine the cost, add profit and this gives them the price that they wish to sell at. It sounds reasonable, is simple to apply and loved by cost accountants throughout the world. But have companies that embrace this methodology considered the law of unintended consequences and what its effect will be on an organization embracing this methodology? One of the pillars that this methodology stands on is that the lowest price is the best price. (That might come as a bit of a shock to companies like Ferrari, Tiffany, Apple and many others.) There are many problems with this assumption. First and foremost, competing based on price will get you into a cycle of continually reducing cost. While reducing unnecessary costs is a good thing, if it is the basis of your pricing strategy you have set a lower limit to your possible costs – once you get to zero cost you cannot go any lower… and you probably went bankrupt before you got to that point. In reality there is an absolute minimum cost that must be covered for raw materials, people, machines and other resources. Any further price reductions must come from the profit margin.
The next biggest problem is that it actively discourages innovation both in products and in processes. Like it or not, innovation is messy and often expensive at first but without innovation an organization will just continue down the same path while their competition blazes new trails for your industry. After a while you end up as just another Me2 company (See my earlier posting – Are you a Me2 Company?)
Other potential issues would be decreased employee morale (affected by raises, bonuses, cost cutting…), Supplier issues (cost cutting, quality issues, more attention to more profitable customers…), customer issues (pricing, lead time, quality issues…) plus many other potentials. While this sounds like a lot of doom and gloom they are all possible or even probable unintended consequences of a low price methodology. Probably all or even most of these will not show up depending on corporate culture, management attention and many other factors but they are possible and require a great deal of work (which means cost) to control.
So are there any other options? Believers in Value Proposition suggest that turning the process on its head will also turn many of the issues upside down. They suggest that organizations should first determine what customers would value (notice I did not say want) then determine the price the customer would be willing to pay for that value. This in turn gives you the cost you can incur to provide this value which can then be used in the development process to determine the product that will deliver the value desired. Note that this is a looping process because value desired always changes with time and as existing desires are met. In the end it’s not about what product we have to sell to the customer, it’s about what product we need to provide value to the customer! Moving away from a low cost model to a value add model opens up all types of possibilities to grow the business by increasing sales and profit. People will pay more for unique products that directly address specific values.
Will the Law of Unintended Consequence come into play in this scenario as well? Absolutely, but in this case many of the consequences will be positive. Among them could be higher employee morale, a more innovative organization, supplier and customer relations that resemble partnerships, higher profit and better long term organizational viability.
I look forward to seeing any comments people have on pricing – low cost model or value proposition model. Which do you prefer and why?