Chapter 9
Costs

How Should They Affect Pricing Decisions?

In most companies, there is ongoing conflict between managers in charge of covering costs (finance and accounting) and managers in charge of satisfying customers (marketing and sales). Accounting texts warn against prices that fail to cover full costs, while marketing texts argue that customer willingness-to-pay must be the sole driver of prices. The conflict between these views wastes company resources and leads to pricing decisions that are imperfect compromises. Profitable pricing involves an integration of costs and customer value. To achieve that integration, however, requires letting go of misleading ideas and forming a common vision of what drives profitability.¹ In this chapter and in Chapter 10 on financial analysis, we explain when costs are relevant for pricing, how marketers should use costs in pricing decisions, and the role that finance should play in defining the price-volume trade-offs that marketers should use in evaluating pricing decisions.

The Role of Costs in Pricing

Costs should never determine price, but costs do play a critical role in formulating a pricing strategy. Pricing decisions are inexorably tied to decisions about sales levels, and sales involve costs of production, marketing, and administration. It is true that how much buyers will pay is unrelated to the seller’s cost, but it is also true that a seller’s decisions about which products to produce and in what quantities depend critically on their cost of production.

The mistake that cost-plus pricers make is not that they consider costs in their pricing, but that they select the quantities they will sell and the buyers they will serve before identifying the prices they can charge. They then try to impose cost-based prices that may be either more or less than what buyers will pay. In contrast, effective pricers make their decisions in exactly the opposite order. They first evaluate what buyers can be convinced to pay and only then choose quantities to produce and markets to serve.

Firms that price effectively decide what to produce and to whom to sell it by comparing the prices they can charge with the costs they must incur. Consequently, costs do affect the prices they charge. A low-cost producer can charge lower prices and sell more because it can profitably use low prices to attract more price-sensitive buyers. A higher-cost producer, on the other hand, cannot afford to underbid low-cost producers for the patronage of more price-sensitive buyers; it must target those buyers willing to pay a premium price. Similarly, changes in costs should cause producers to change their prices, not because that changes what buyers will pay, but because it changes the quantities that the firm can profitably supply and the buyers it can profitably serve. When the cost of jet fuel rises, most airlines are not naive enough to try passing on the fuel cost through a cost-plus formula while maintaining their previous schedules. But some airlines do raise their average revenue per mile. They do so by reducing the number of flights they offer in order to fill the remaining planes with more full-fare passengers. To make room for those passengers, they eliminate or reduce discount fares. Thus the cost increase for jet fuel affects the mix of prices offered, increasing the average price charged. However, that is the result of a strategic decision to reduce the number of flights and change the mix of passengers served, not the result of an attempt to charge higher prices for the same service to the same people.

Such decisions about quantities to sell and buyers to serve are an important part of pricing strategy for all firms and the most important part for many. In this chapter, we discuss how a proper understanding of costs enables one to make those decisions correctly. First, however, a word of encouragement: understanding costs is probably the most challenging aspect of pricing. You will probably not master these concepts on first reading this chapter. Your goal should be simply to understand the issues involved and the techniques for dealing with them. Mastery of the techniques will come with practice.

Determining Relevant Costs

One cannot price effectively without understanding costs. To understand one’s costs is not simply to know their amounts. Even the least effective pricers, those who mechanically apply cost-plus formulas, know how much they spend on labor, raw materials, and overhead. Managers who really understand their costs know more than cost levels; they know how their costs will change with the changes in sales that result from pricing decisions.

Not all costs are relevant for every pricing decision. A first step in pricing is to identify the relevant costs: those that actually determine the profit impact of the pricing decision. Our purpose in this section is to set forth the guidelines for identifying the relevant costs once they are measured. In principle, identifying the relevant costs for pricing decisions is actually fairly straightforward. They are the costs that are incremental (not average) and avoidable (not sunk). In practice, identifying costs that meet these criteria can be difficult. Consequently, we will explain each distinction in detail and illustrate it in the context of a practical pricing problem.

Why Incremental Costs?

Pricing decisions affect whether a company will sell less of the product at a higher price or more of the product at a lower price. In either scenario, some costs remain the same (in total). Consequently, those costs do not affect the relative profitability of one price versus another. Only costs that rise or fall (in total) when prices change affect the relative profitability of different pricing strategies. We call these costs incremental because they represent the increment to costs (positive or negative) that results from the pricing decision.

Incremental costs are the costs associated with changes in pricing and sales. The distinction between incremental and nonincremental costs parallels closely, but not exactly, the more familiar distinction between variable and fixed costs. Variable costs, such as the costs of raw materials in a manufacturing process, are costs of doing business. Because pricing decisions affect the amount of business that a company does, variable costs are always incremental for pricing. In contrast, fixed costs, such as those for product design, advertising, and overhead, are costs of being in business.² They are incremental when deciding whether a price will generate enough revenue to justify being in the business of selling a particular type of product or serving a particular type of customer. Because fixed costs are not affected by how much a company actually sells, most are not incremental when management must decide what price level to set for maximum profit.

Some fixed costs, however, are incremental for pricing decisions, and they must be appropriately identified. Incremental fixed costs are those that directly result from implementing a price change or from offering a version of the product at a different price level. For example, the fixed cost for a restaurant to print menus with new prices or for a public utility to gain regulatory approval of a rate increase would be incremental when deciding whether to make those changes. The fixed cost for an airline to advertise a new discount service or to upgrade its planes’ interiors to offer a premium-priced service would be incremental when deciding whether to offer products at those price levels.

To further complicate matters, many costs are neither purely fixed nor purely variable. They are fixed over a range of sales but vary when sales go outside that range. The determination of whether such semifixed costs are incremental for a particular pricing decision is necessary to make that decision correctly. Consider, for example, the role of capital equipment costs when deciding whether to expand output. A manufacturer may be able to fill orders for up to 100 additional units each month without purchasing any new equipment simply by using the available equipment more extensively. Consequently, equipment costs are nonincremental when figuring the cost of producing up to 100 additional units. If the quantity of additional orders increased by 150 units each month, though, the factory would have to purchase additional equipment. The added cost of new equipment would then become incremental and relevant in deciding whether the company can profitably price low enough to attract that additional business.

To understand the importance of properly identifying incremental costs when making a pricing decision, consider the problem faced by the business manager of a symphony orchestra. The orchestra usually performs two Saturday evenings each month during the season with a new program for each performance. It incurs the following costs for each performance:

The orchestra’s business manager is concerned about her very thin profit margin. She has currently set ticket prices at $10. If she could sell out the entire 1,100-seat hall, total revenues would be $11,000 and total costs $9,100, leaving a healthy $1,900 profit per performance.³ Unfortunately, the usual attendance is only 900 patrons, resulting in an average cost per ticket sold of $9.89, which is precariously close to the $10 admission price. With revenues of just $9,000 per performance and costs of $8,900, total profit per performance is a dismal $100.

The orchestra’s business manager does not believe that a simple price increase would solve the problem. A higher price would simply reduce attendance more, leaving less revenue per performance than the orchestra earns now. Consequently, she is considering three proposals designed to increase profits by reaching out to new markets. Two of the proposals involve selling seats at discount prices. The three options are:

1. A “student rush” ticket priced at $4 and sold to college students one-half hour before the performance on a first-come, first-served basis. The manager estimates she could sell 200 such tickets to people who otherwise would not attend. Clearly, however, the price of these tickets would not cover even half the average cost per ticket.

2. A Sunday matinee repeat of the Saturday evening performance with tickets priced at $6. The manager expects she could sell 700 matinee tickets, but 150 of those would be to people who would otherwise have attended the higher-priced Saturday performance. Thus net patronage would increase by 550, but again the price of these tickets would not cover average cost per ticket.

3. A new series of concerts to be performed on the alternate Saturdays. The tickets would be priced at $10, and the manager expects that she would sell 800 tickets but that 100 tickets would be sold to people who would attend the new series instead of the old one. Thus net patronage would increase by 700.

Which, if any, of these proposals should the orchestra adopt? An analysis of the alternatives is shown in Exhibit 9-1. The revenue gain is clearly smallest for the student rush, the lowest-priced alternative designed to attract

EXHIBIT 9-1 Analysis of Three Proposals for the Symphony Orchestra

a fringe market, while the revenue gain is greatest for the new series, which attracts many more full-price patrons. Still, profitability depends on the incremental costs as well as the revenues of each proposal. For the student rush, neither rehearsal costs nor performance costs are incremental. They are irrelevant to the profitability of that proposal since they do not change regardless of whether this proposal is implemented. Only the variable per-patron costs are incremental, and therefore relevant, for the student-rush proposal. For the Sunday matinee, however, the performance cost and the per-patron cost are incremental and affect the profitability of that option. For the totally new series, all costs except overhead are incremental.

To evaluate the profitability of each option, we subtract from revenues only those costs incremental to it. For the student rush, that means subtracting only the $200 of per-patron costs from the revenues, yielding a contribution to profit of $600. For the Sunday matinee, it means subtracting the performance cost and the variable per-patron costs for those additional patrons (550) who would not otherwise have attended any performance, yielding a profit contribution of $150. For the new series, it means subtracting the incremental rehearsal, performance, and per-patron costs, yielding a net loss of $200. Thus, the lowest priced option, which also happens to yield the least amount of additional revenue, is in fact the most profitable.

The setting out of alternatives, as in Exhibit 9-1, clearly highlights the best option. In practice, opportunities are often missed because managers do not look at incremental costs, focusing instead on the average costs that are more readily available from accounting data. Note again that the orchestra’s current average cost (total cost divided by the number of tickets sold) is $9.89 per patron and would drop to $8.27 per patron if the student-rush proposal were adopted. The student rush tickets, priced at $4 each, cover less than half the average cost per ticket. The manager who focuses on average cost would be misled into rejecting a profitable proposal in the mistaken belief that the price would be inadequate. Average cost includes costs that are not incremental and are therefore irrelevant to evaluating the proposed opportunity. The adequacy of any price can be ascertained only by looking at the incremental cost of sales and ignoring those costs that would be incurred anyway.

Although the orchestra example is hypothetical, the problem it illustrates is realistic. Scores of companies profit from products that they price below average cost when average cost includes fixed costs that are not true costs of sales.

• Packaged goods manufacturers often supply generic versions of their branded products at prices below average cost. They can do so profitably because they can produce them with little or no incremental costs of capital, shipping, and selling beyond those already incurred to produce their branded versions.
• A leading manufacturer of industrial cranes also does milling work for other companies whenever the firm’s vertical turret lathes would not otherwise be used. The price for such work does not cover a proportionate share of the equipment cost. It is, however, profitable work since the equipment must be available to produce the firm’s primary product. The equipment cost is, therefore, not incremental to the additional milling work.
• Airlines fly weekend flights that do not cover a proportionate share of capital costs for the plane and ground facilities. Those costs must be incurred to provide weekday service and so are irrelevant when judging whether weekend fares are adequate to justify this service. In fact, weekend fares often add incrementally more to profits precisely because they require no additional capital.

In each of these cases, the key to getting the business is having a low price. Yet one should never be deceived into thinking that low-price sales are necessarily low-profit sales. In some cases, they make a disproportionately large contribution to profit because they make a small incremental addition to costs.

Why Avoidable Costs?

The hardest principle for many business decision makers to accept is that only avoidable costs are relevant for pricing. Avoidable costs are those that either have not yet been incurred or can be reversed. The costs of selling a product, delivering it to the customer, and replacing the sold item in inventory are avoidable, as is the rental cost of buildings and equipment that are not covered by a long-term lease. The opposite of avoidable costs is sunk costs— those costs that a company is irreversibly committed to bear. For example, a company’s past expenditures on research and development are sunk costs since they cannot be changed regardless of any decisions made in the present. The rent on buildings and equipment within the term of a current lease is sunk, except to the extent that the firm can avoid the expense by subletting the property.⁴

The cost of assets that a firm owns may or may not be sunk. If an asset can be sold for an amount equal to its purchase price times the percentage of its remaining useful life, then none of its cost is sunk since the cost of the unused life can be entirely recovered through resale. Popular models of airplanes often retain their value in this way, making avoidable the entire cost of their depreciation from continued use. If an asset has no resale value, then its cost is entirely sunk even though it may have much useful life remaining. A neon sign depicting a company’s corporate logo may have much useful life remaining, but its cost is entirely sunk since no other company would care to buy it. Frequently, the cost of assets is partially avoidable and partially sunk. For example, a new truck could be resold for a substantial portion of its purchase price but would lose some market value immediately after purchase. The portion of the new price that could not be recaptured is sunk and should not be considered in pricing decisions. Only the decline in the resale value of the truck is an avoidable cost of using it.

From a practical standpoint, the easiest way to identify the avoidable cost is to recognize that the cost of making a sale is always the current cost resulting from the sale, not costs that occurred in the past. What, for example, is the cost for an oil company to sell a gallon of gasoline at one of its company-owned stations? One might be inclined to say that it is the cost of the oil used to make the gasoline plus the cost of refining and distribution. Unfortunately, that view could lead refiners to make some costly pricing mistakes. Most oil company managers realize that the relevant cost for pricing gasoline is not the historical cost of buying oil and producing a gallon of gasoline, but rather the future cost of replacing the inventory when sales are made. Even LIFO (last-in, first-out) accounting can be misleading for companies that are drawing down large inventories. To account accurately for the effect of a sale on profitability, managers should adopt NIFO (next-in, first-out) accounting for managerial decision making.⁵

The distinction between the historical cost of acquisition and the future cost of replacement is merely academic when supply costs are stable. It becomes very practical when costs rise or fall.⁶ When the price of crude oil rises, companies quickly raise prices, long before any gasoline made from the more expensive crude reaches the pump. Politicians and consumer advocates label this practice “price gouging,” since companies with large inventories of gasoline increase their reported profits by selling their gasoline at much higher prices than they paid to produce it. So what is the real incremental cost to the company of selling a gallon of gasoline?

Each gallon of gasoline sold requires the purchase of crude oil at the new, higher price for the company to maintain its gasoline inventory. If that price is not covered by revenue from sales of gasoline, the company suffers reduced cash flow from every sale. Even though the sales appear profitable from a historical cost standpoint, the company must adding to its working capital (by borrowing money or by retaining a larger portion of its earnings) to pay the new, higher cost of crude oil. Consequently the real “cash” cost of making a sale rises immediately by an amount equal to the increase in the replacement cost of crude oil.

What happens when crude oil prices decline? If a company with large inventories held its prices high until all inventories were sold, it would be undercut by any company with smaller inventories that could profitably take advantage of the lower cost of crude oil to gain market share. The company would see its sales, profits, and cash flow decline. Again, the intelligent company bases its prices on the replacement cost, not the historical cost, of its inventory. In historical terms, it reports a loss. However, that loss corresponds to an equal reduction in the cost of replacing its inventories with cheaper crude oil. Since the company simply reduces its operating capital by the amount of the reported loss, its cash flow remains unaffected by that “loss.”

Unfortunately, even levelheaded businesspeople often let sunk costs sneak into their decision making, resulting in pricing mistakes that squander profits. The case of a small midwestern publisher of esoteric books illustrates this risk. The publisher customarily priced a book at $20 per copy, which included a $4 contribution to overhead and profit. The firm printed 2,000 copies of each book on the first run and normally sold less than half in the first year. The remaining copies were added to inventory. The company was moderately profitable until the year when, due to a substantial increase in interest rates, the $4 contribution per book could no longer fully cover the interest cost of its working capital.

Recognizing a problem, the managers called in a pricing consultant to show them how to improve the profitability of their prices in order to cover their increased costs. They did not expect the consultant’s recommendation that they instead run a half-price sale on all their slow-moving titles. The publisher’s business manager pointed out that half price would not even cover the cost of goods sold. He explained to the consultant, “Our problem is that our prices are not currently adequate to cover our overhead. I fail to see how cutting our prices even lower—eliminating the gross margin we now have so that we cannot even cover the cost of production—is a solution to our problem.”

The business manager’s logic was quite compelling, but his argument was based on the fallacy of looking at sunk costs of production as a guide to pricing rather than looking at the avoidable cost of holding inventory. No doubt, the firm regretted having printed many of the books in its warehouse, but since the production cost of those books was no longer avoidable regardless of the pricing strategy adopted, and since the firm did not plan to replace them, historical production costs were irrelevant to any pricing decision.⁷ What was relevant was the avoidable cost of working capital required to hold the books in inventory.

If, by cutting prices and selling the books sooner instead of later, the publisher could save more in interest than it lost from a price cut, then price-cutting clearly would increase profit even while reducing revenue below the cost of goods sold. In this case, the publisher could ultimately sell all books for $20 if it held them long enough. By selling some books immediately for $10, however, the company could avoid the interest cost of holding them until it could get the higher price. Exhibit 9-2 shows the cumulative interest cost of holding a book in inventory, given that it could be sold immediately for $10 and that the cost of capital at the time was 18 percent. Since the interest cost of holding a book longer than four years exceeds the proposed $10 price cut, any book for which the firm held more than four years of inventory could be sold more profitably now at half price than later at full price.⁸

The error made by the business manager was understandable. It is a common mistake among people who think about pricing problems in terms of a traditional income statement.

Avoiding Misleading Accounting

Unfortunately, accounting statements can often be misleading. One must approach them with care when making pricing decisions. Let us further examine the publisher’s error presented above, and others, to better understand the pitfalls of accounting data and how to deal with them. By accounting convention, an income statement follows this form:

This can lead managers to think about pricing sequentially, as a set of hurdles to be overcome in order. First managers try to get over the gross profit hurdle by maximizing their sales revenue and minimizing the cost of goods sold. Then they navigate the second hurdle by minimizing selling expenses, depreciation, and overhead to maximize the operating profit. Similarly, they minimize their interest expense to clear the pretax profit hurdle and minimize their taxes to reach their ultimate goal of a large, positive net profit. They imagine that by doing their best to maximize income at each step, they will surely then reach their goal of a maximum bottom line.

Unfortunately, the road to a profitable bottom line is not so straight. Profitable pricing often calls for sacrificing gross profit in order to reduce expenses further down the line. The publisher in our last example could report a much healthier gross profit by refusing to sell any book for less than $20, but only by bearing interest expenses that would exceed the extra gross profit, leaving an even smaller pretax profit. Moreover, interest is not the only cost that can be reduced profitably by trading off sales revenue. Discount sales through direct mail often save selling expenses that substantially exceed a reduction in sales revenue. While such discounts depress gross profit, the greater savings in selling expenses produce a net increase in operating profit. Discounting for a sale prior to the date of an inventory tax may also save more on tax payments than the revenue loss.

Effective pricing cannot be done in steps. It requires that one approach the problem holistically, looking for each trade-off between higher prices and higher costs, and cutting gross profit whenever necessary to cut expenses by even more. The best way to avoid being misled by a traditional income statement is to develop a managerial costing system independent of the system used for financial reporting,⁹ as follows:

The value of this reorganization is that it first focuses attention on costs that are incremental and avoidable and only later looks at costs that are nonincremental and sunk for the pricing decision. In this analysis, maximizing the profit contribution of a pricing decision is the same as maximizing the net profit, since the fixed or sunk costs subtracted from the profit contribution are not influenced by the pricing decisions and since income taxes are determined by the pretax profit rather than by unit sales.

One could not do such a cost analysis simply by reorganizing the numbers on a traditional income statement. The traditional income statement reports quarterly or annual totals. For pricing, we are not concerned with the cost of all units produced in a period; we are concerned only with the cost of the units that will be affected by the decision to be made. Thus, the relevant cost to consider when evaluating a price reduction is the cost of the additional units that the firm expects to sell because of the price cut. The relevant cost to consider when evaluating a price increase is the avoided cost of units that the firm will not produce because sales will be reduced by the price rise. For any managerial decision, including pricing decisions, it is important to isolate and consider only the costs that affect the profitability of that decision.

Estimating Relevant Costs

The essence of incremental costing is to measure the cost incurred because a product is sold, or not incurred because it is not sold. We cannot delve into all the details of setting up a useful managerial accounting system here. For our purposes, it will suffice to caution that there are four common errors that managers frequently make when attempting to develop useful estimates of true costs.

1. Beware of averaging total variable costs to estimate the cost of a single unit. The average of variable costs is often an adequate indicator of the incremental cost per unit, but it can be dangerously misleading in those cases where the incremental cost per unit is not constant. The relevant incremental cost for pricing is the actual incremental cost of the particular units affected by a pricing decision, which is not necessarily equal to average variable cost. Consider the following example:

A company is currently producing 1,100 units per day, incurring a total materials cost of $4,400 per day and labor costs of $9,200 per day. The labor costs consist of $8,000 in regular pay and $1,200 in overtime pay per day. Labor and materials are the only two costs that change when the firm makes small changes in output. What then is the relevant cost for pricing? One might be tempted to answer that the relevant cost is the sum of the labor and materials costs ($13,600) divided by total output (1,100 units), or approximately $12.36 per unit. Such a calculation would lead to serious underpricing when demand is strong, since the real incremental cost of producing the last units is much higher than the average cost. A price increase, for example, could eliminate only sales that are now produced on overtime at a cost substantially above the average.

What is the cost of producing the last units, those that might not be sold if the product’s price was raised? It may be reasonable to assume that materials costs are approximately the same for all units, so that average materials cost is a good measure of the incremental materials cost for the last units. Thus a good estimate of the relevant materials cost is $4 per unit ($4,400/1,100). We know, however, that labor costs are not the same for all units. The company must pay time-and-a-half for overtime, which are the labor hours that could be eliminated if price is increased and if less of the product is sold. Even if workers are equally productive during overtime and regular hours, producing approximately 100 units per day during overtime hours, the labor cost is $12 per unit ($1,200/100), resulting in a labor and materials cost for the last 100 units of $16 each, substantially above the $12.36 average cost.¹⁰

2. Beware of accounting depreciation formulas. The relevant depreciation expense that should be used for all managerial decision making is the change in the current value of assets. Depreciation of assets is usually calculated in a number of different ways depending on the intended use of the data. For reporting to the Internal Revenue Service, depreciation is accelerated to minimize tax liability. For standard financial reporting, rates of depreciation are estimated as accurately as possible but are applied to historical costs.¹¹ For pricing and any other managerial decision-making, however, depreciation expenses should be based on forecasts of the actual decline in the current market value of assets as a result of their use.

Failure to accurately measure depreciation expenses can severely distort an analysis of pricing options. For example, the author of one marketing textbook wrote that a particular airline could price low on routes where its older planes were fully depreciated, but had to price high on routes where new planes were generating large depreciation charges. Such pricing would be quite senseless. Old planes obviously have a market value regardless of their book value. The decline in that market value should either be paid for by passengers who fly on those planes, or the planes should be sold. Similarly, if the market value of new planes does not really depreciate as quickly as the financial statements indicate, excessive depreciation expenses could make revenues appear inadequate to justify what are actually profitable new investments. The relevant depreciation expense for pricing is the true decline in an asset’s resale value.

3. Beware of treating a single cost as either all relevant or all irrelevant for pricing. A single cost on the firm’s books may have two separate components—one incremental and the other not, or one avoidable and the other sunk—that must be distinguished. Such a cost must be divided into the portion that is relevant for pricing and the portion that is not. Even incremental labor costs are often not entirely unavoidable (see “Peak Pricing: An Application of Incremental Costing” on next page).

In past recessions, some steel producers found when they considered laying off high-seniority employees that the avoidable portion of their labor costs was only a small part of their total labor costs. Their union contracts committed them to pay senior employees much of their wages even when these employees were laid off. Consequently, those companies found that the prices they needed to cover their incremental, avoidable costs were actually quite low, justifying continued operations at some mills even though those operations produced substantial losses when all costs were considered.

4. Beware of overlooking opportunity costs. Opportunity cost is the contribution that a firm forgoes when it uses assets for one purpose rather than another. Opportunity costs are relevant costs for pricing even though they do not appear on financial statements. They should be assigned hard numbers in any managerial accounting system, and pricers should incorporate them into their analyses as

they would any other cost. In the earlier example of the book publisher, the cost of capital required to maintain the firm’s inventory was the cost of borrowed funds (18 percent). It, therefore, generated an explicit interest expense on the firm’s income statement. A proper analysis of the publisher’s problem would have been no different had we assumed that the inventory was financed entirely with internally generated funds. Those internally generated funds do not create an interest expense on the publisher’s income statement, but they do have alternative uses. Internally generated funds that are used to finance inventories could have been used to purchase an interest-bearing note or could have been invested in some profitable sideline business such as printing stationery. The interest income that could have been earned from the best of these alternatives is an incremental, avoidable cost of using internally generated funds, just as the interest paid explicitly is an incremental, avoidable cost of using borrowed funds.

The same argument would apply when costing the use of a manufacturing facility, a railroad right-of-way, or the seat capacity of an airline. The historical cost of those assets is entirely irrelevant and potentially a very misleading guide to pricing. There is often, however, a current cost of using those assets that is very relevant. That cost occurs whenever capacity used either could be used to make and sell some other product, or could be rented or sold to some other company. Even though the historical cost is sunk, the relevant cost of using those assets is positive whenever there are competing profitable uses. That opportunity cost is the contribution that must be forgone if the assets are not sold or used to produce the alternative product or service. It can easily exceed not only the historical cost but also even the replacement cost of the capacity.

Even if a company has current excess capacity but there is some probability that future business might have to be turned away, the capacity should be assigned an opportunity cost for pricing. Airlines, for example, stop selling discounted seats for a particular flight long before the flight is full. The opportunity cost of selling a discounted seat is near zero only if that seat would otherwise certainly be empty at flight time. As a plane’s capacity fills, however, the probability increases that selling a discounted seat will require turning away a passenger who would have paid full fare on the day of the flight. The probability of such a passenger wanting the seat, times the contribution that would be earned at full price, is the opportunity cost of selling a discounted seat in advance.

Obviously, moving beyond these costing principles to estimating the true cost of a sale is not easy. Too often, however, managers shrink from the task

because of the cost and complexity of measuring true costs on an ongoing basis. Usually, in our experience, it is possible to get much closer to true costs by doing even a simple point-in-time study of cost drivers. We have, for example, worked with a company that charged every item produced the same amount for paint, even though some items were produced in large lots and others in small lots. By doing a simple statistical regression, using prior year data, paint purchases by color as a function of production of that color product, and average lot size, we rationally reallocated paint costs to reflect the higher costs of small batches. In other cases, we have relied on cost drivers as subjective as a plant foreman’s judgment about the relative difficulty of making different types of products. Are such judgments highly accurate? Probably not. That is not a reason to avoid making them if that is the best you can do with the time and money available. It is better to make pricing decisions based on rough approximations of the true costs of products or services than on precise accounting of costs that are sure to be, at best, irrelevant and, at worst, highly misleading.

Activity-Based Costing

Activity-based costing (ABC) provides more realistic estimates of how support costs change with increments in sales volume.¹² For example, traditional cost accounting systems use bases like direct labor and machine hours to allocate to products the expenses of support activities. Instead, ABC segregates support expenditures by activities, and then assigns those expenditures based on the drivers of the activities and how they are linked to product sales volume. Some applications of ABC have allowed firms to estimate not just manufacturing costs, but also costs to serve different customers. ABC enables managers to identify the characteristics or drivers that cause some customers to be more expensive or less expensive to serve. Robert Kaplan¹³ identified the following differences in characteristics of high cost-to-serve versus low cost-to-serve customers:

ABC extends incremental costing to cost categories that are neither fixed nor variable, but are semifixed costs. For example, these may be costs associated with order entry personnel, or shipping personnel, that are incurred in less frequent outlays or lumps, but nonetheless change with larger changes in volume. ABC allocates these semifixed costs according to activity drivers, usually related to transactions associated with the function—for example, the number of orders received by the order entry department, or the number of shipments shipped by the shipping department. ABC is especially valuable in refining the manager’s estimate of the true cost-to-serve an incoming customer order.

Percent Contribution Margin and Pricing Strategy

There are three benefits to determining the true unit cost of a product or service for pricing. First, it is a necessary first step toward controlling costs. The best way to control variable costs is not necessarily appropriate for controlling fixed costs. Second, it enables management to determine the minimum price at which the firm can profitably accept incremental business that will not affect the pricing of its other sales. Third, and most important for our purposes, it enables management to determine the contribution margin for each product sold, which, as will be seen in Chapter 10 on financial analysis, is essential for making informed, profitable pricing decisions.

The percent contribution margin is the share of price that adds to profit or reduces losses. It is not the return on sales, which is used by financial analysts to compare the performance of different companies in the same industry. The return on sales indicates the average profit as a percentage of the price after accounting for all costs. Our concern, however, is not with the average, but with the added profit resulting from an additional sale. Even when variable costs are constant, the added profit from a sale exceeds the average profit because some costs are fixed or sunk. The share of the price that adds to profit, the contribution margin, is everything above the share required to cover the incremental variable cost of the sale.

When variable cost is constant for all units affected by a particular pricing decision, it is proper to calculate the percent contribution margin from aggregate sales data. After calculating the sales revenue and total contribution margin resulting from a change in sales, one can calculate the percent contribution margin, or %CM, as follows:

When variable costs are not constant for all units (for example, when the units affected by a price change are produced on overtime), it is important to calculate a dollar contribution margin per unit for just the units affected by the price change. The dollar contribution margin per unit, $CM, is simply

where variable cost is the cost per unit of only those units affected by the price change and includes only those costs that are avoidable. With the dollar contribution margin, one can calculate the percent contribution margin without being misled when variable costs are not constant. The formula for this calculation of the percent contribution margin is

which gives the percent contribution margin in decimal form.

The size of the contribution as a percentage of the price has important strategic implications. First, the percent contribution margin is a measure of the leverage between a firm’s sales volume and its profit. It indicates the importance of sales volume as a marketing objective. To illustrate, look at Exhibit 9-3. A company sells two products, each with the same net profit on sales, but with substantially different contribution margins. A company using full-cost pricing would, therefore, treat them the same. However, the actual effect of a price change for these two products would be radically different because of their varying cost structures (see Exhibit 9-3).

Product A has high variable costs equal to 80 percent of its price. Its percent contribution margin is, therefore, 20 percent. Product B has low variable costs equal to 20 percent of its product’s price. Its percent contribution margin is therefore 80 percent. Although at current sales volumes each product earns the same net profit, the effect on each of a change in sales volume is dramatically different. For product A, only $0.20 of every additional sales dollar increases profit or reduces losses. For product B, that figure is $0.80.

EXHIBIT 9-3 Effect of Contribution Margin on Break-Even Sales Changes

The lower part of Exhibit 9-3 illustrates the impact of this difference on pricing decisions. In order for product A, with its relatively small percent contribution margin, to profit from a 5 percent price cut, its sales must increase by more than 33 percent, compared with only 6.7 percent for product B with its larger percent contribution margin. To profit from a 10 percent price cut, product A’s sales must increase by more than 100 percent, compared with only 14.3 percent for product B. Clearly, this company cannot justify a strategy of low pricing to build volume for product A nearly as easily as it can for product B. The opposite conclusion follows for price increases. Product A can afford to lose many more sales than product B and still profit from higher prices. Consequently, it is much easier to justify a premium price strategy for product A than for product B.

Second, the percent contribution margin is an indicator of the firm’s ability to compete against competitors. If a competitor believes it has a substantially higher percent contribution margin than you do, then it is likely that the competitor will engage in price discounting to drive sales volume because of the leverage between sales volume and profit. On the other hand, knowing that you have comparable or higher percent contribution margins than your competitor provides some assurance that you have the ability to retaliate and counterattack opportunistic moves by competitors who attempt to lure customers with price discounting.

Third, the percent contribution margin is a measure of the extent to which you can use segmentation pricing to serve and penetrate multiple market segments. Segmentation pricing means setting different prices for different market segments, each of which has a different cost to serve and different level of price sensitivity. For a given product, the greater your percent contribution margin, the more flexibility you have to set higher prices for some customer segments and lower prices for other segments. This enables you to serve not only customers who are willing to pay premium prices but also customers that are price sensitive and only willing to pay lower prices. Many companies strategically design their cost structure to ensure that their variable costs remain low so they can maintain a high percent contribution margin, which enables them to penetrate many market segments of varying price sensitivities. They support these penetration strategies with high fixed costs that enable them to drive product volume through investments in advertising, sales promotions, price discounting, and intensive distribution systems.

Managing Costs in Transfer Pricing

A frequently overlooked opportunity to use costs as a source of advantage in pricing occurs when the company can manage the structure of the prices of its upstream suppliers. These upstream suppliers might be independent companies or independent divisions of the same company that set the prices of products that pass between them. This situation, known as transfer pricing, represents one of the most common reasons why independent companies and

EXHIBIT 9-4 Inefficiencies in Transfer Pricing

divisions are sometimes less price competitive and profitable than their vertically integrated competitors.

Exhibit 9-4 illustrates this often-overlooked opportunity. Independent Manufacturing, Inc. sells its product for $2 per unit in a highly competitive market. To manufacture the product, it buys different parts from two suppliers, Alpha and Beta, at a total cost per unit of $1.20. The parts purchased from Alpha cost $0.30 and those from Beta cost $0.90.

Independent Manufacturing conducts a pricing analysis to determine whether any changes in its pricing might be justified. It determines that its contribution margin (price minus variable cost) is $0.60, or 30 percent of its price.¹⁴ It then calculates the effect of a 10 percent price change in either direction. For a 10 percent price cut to be profitable, Independent must gain at least 50 percent more sales (Chapter 10 presents the formulas for performing these calculations). For a 10 percent price increase to be profitable, Independent can afford to forgo no more than 25 percent of its sales.

Independent’s managers conclude that there is no way that they can possibly gain from a price cut, since their sales will surely not increase by more than 50 percent. On the other hand, they are intrigued by the possibility of a price increase. They feel sure that the inevitable decline would be far less than 25 percent if they could get their major competitors to follow them in the increase.

As Independent’s management considers how to communicate to the industry the desirability of a general price increase, one of its major competitors, Integrated Manufacturing, Inc. announces its own 10 percent price cut. Independent’s management is stunned. How could Integrated possibly justify such a move? Integrated’s product is technically identical to Independent’s, involving all the same parts and production processes, and Integrated is a company with a market share equal to Independent’s. The only difference between the two companies is that Integrated recently began manufacturing its own parts.

That difference, however, is crucial to this story (see Exhibit 9-5). Assume that Integrated currently has all the same costs of producing parts as Independent’s suppliers, Alpha and Beta, and expects to earn a profit from those operations. It also has the same costs of assembling those parts

EXHIBIT 9-5 Efficiency from Cost Integration

($0.20 incremental labor plus $0.40 fixed per unit). Moreover, Integrated enjoys no additional economies of logistical integration. Despite these similarities, the two companies have radically different cost structures, which respond quite differently to changes in volume and which cause the two companies to experience price changes differently. Integrated has no variable materials cost corresponding to Independent’s variable materials cost of $1.20 per unit. Instead, it incurs additional fixed costs of $0.60 per unit ($0.20 plus $0.40) and incremental variable costs of only $0.40 per unit ($0.05 plus $0.35).

This difference in cost structure between Integrated (high fixed and low variable) and Independent (low fixed and high variable) gives Integrated a much higher contribution margin per unit than Independent’s margin. For Integrated, $1.40, or 70 percent of each additional sale, contributes to bottom-line profits. For Independent, only $0.60, or 30 percent of each additional sale, falls to the bottom line. Integrated’s break-even calculations for a 10 percent price change are, therefore, quite different. For a 10 percent price cut to be profitable, Integrated has to gain only 16.7 percent more sales. But for a 10 percent price increase to pay off, Integrated could afford to forgo no more than 12.5 percent of its sales.

It is easy to see why Integrated is more attracted to price cuts and more averse to price increases than is Independent. For Integrated, sales must grow by only 16.7 percent to make a price cut profitable, compared with 50 percent for Independent. Similarly, Integrated could afford to lose no more than 12.5 percent of sales (compared with as much as 25 percent for Independent) and still profit from a price increase. How can it be that two identical sets of costs result in such extremely different calculations? The answer is that Independent, like most manufacturers, pays its suppliers on a price-per-unit basis. That price must include enough revenue to cover the suppliers’ fixed costs and a reasonable profit if Independent expects those suppliers to remain viable in the long run. Consequently, fixed costs and profit of both Alpha and Beta become variable costs of sales for Independent. Such incrementalizing of nonincremental costs makes Independent much less cost competitive than Integrated, which earns more than twice as much additional profit on each unit it sells.

Independent’s cost disadvantage is a disadvantage to its suppliers as well. Independent calculates that it requires a 50 percent sales increase to make a 10 percent price cut profitable. Independent, therefore, correctly rejects a 10 percent price cut that would increase sales by 30 percent. With current sales of 1 million units, such a price cut would cause Independent’s profit to decline by $80,000. Note, however, that the additional sales volume would add $240,000 ($75,000 plus $165,000) to the profits of Independent’s suppliers, provided that they produce the increased output with no more fixed costs. They would earn much more than Independent would lose by cutting price. It is clear why Integrated sees a 10 percent price cut as profitable when Independent does not. As its own supplier, Integrated captures the additional profits that accrue within the entire value chain (Alpha, $75,000; Beta, $165,000) as a result of increases in volume.¹⁵

Once Independent recognizes the problem, what alternatives does it have, short of taking the radical step of merging with its suppliers? One alternative is for Independent to pay its suppliers’ fixed costs in a lump-sum payment, perhaps even retaining ownership of the assets while negotiating low supply prices that cover only incremental costs and a reasonable return. The lump-sum payment is then a fixed cost for Independent, and its contribution margin on added sales rises by the reduction in its incremental supply cost. Boeing and Airbus sometimes do this with parts suppliers, agreeing to bear the fixed cost of a part’s design and paying the supplier for the fixed costs of tooling and setup. They then expect a price per unit that covers only the supplier’s variable costs and a small profit. As a result, the airplane manufacturers bear the risk and retain the rewards from variations in volume. That gives the airplane manufactures a larger incremental margin on each additional sale and so a greater incentive to make marketing decisions, including pricing decisions, which build volume.

An alternative approach is to negotiate a high price for initial purchases that cover the fixed costs, with a lower price for all additional quantities that cover only incremental costs and profit. Auto companies use this system; allowing a supplier to be a sole source with high margins up to a certain volume, presumably enough to recover design and development costs. Beyond that volume, they make the design public and usually expect all suppliers to match the lowest price on offer. Since the lower supply price is the incremental cost of additional sales, Sears can profitably price its products lower to generate more volume. In Independent Manufacturing’s case, it might negotiate an agreement with Alpha and Beta that guarantees enough purchases at $0.30 and $0.90, respectively, to cover their fixed costs, after which the price would fall to $0.10 and $0.50, respectively.

Both of these systems for paying suppliers avoid incrementalizing fixed costs, but they do not avoid the problem of incrementalizing the suppliers’ profits. They work well only when the suppliers’ profits account for a small portion of the total price suppliers receive. Lump-sum payments could be paid to suppliers to cover negotiated profit as well as fixed costs. This is risky, however, since profit per unit remains the suppliers’ incentive to maintain on-time delivery of acceptable quality merchandise. Consequently, when a supplier has low fixed costs but can still demand a high profit because of little competition, a third alternative is often used. The purchaser may agree to pay the supplier a small fee to cover incremental expenses and an additional negotiated percentage of whatever profit contribution is earned from final sales.

It is noteworthy that most companies do not use these methods to compensate suppliers or to establish prices for sales between independent divisions. Instead, they negotiate arm’s-length contracts at fixed prices or let prevailing market prices determine transfer prices.¹⁶ One reason is that it is unusual to find a significant portion of costs that remain truly fixed for large changes in sales. In most cases, the bulk of costs that accountants label fixed are actually semifixed; additional costs would have to be incurred for suppliers to substantially increase their sales, making those costs incremental. One notable case where costs are substantially fixed is in the semiconductor industry. The overwhelming cost of semiconductors is the fixed cost of product development, not the variable or semifixed costs of production. Consequently, integrated manufacturers of products using semiconductors have often had a significant cost advantage. Bowmar, the company that pioneered the handheld calculator, was ultimately driven from the market precisely because it was not cost competitive with more integrated suppliers and failed to negotiate contracts that avoided the incrementalization of their fixed costs of product development.

Companies that buy computer software to sell as part of their products should note that software, too, is a high-fixed-cost product that often represents a substantial portion of the cost of software-aided products. Manufacturers of everything from smart phones to robots used in manufacturing can acquire software from independent software development houses. If they agree to pay for that software on a per-unit basis, however, they may ultimately find that they are not cost competitive with companies that either write their own software or that have an up-front pricing arrangement with their suppliers.

Summary

Costs are central considerations in pricing. Without understanding which costs are incremental and avoidable, a firm cannot accurately determine at what price, if any, a market can profitably be served. By erroneously looking at historical costs, a firm could sell its inventory too cheaply. By mistakenly looking at nonincremental fixed costs, a firm could overlook highly profitable opportunities where price is adequate to more than cover the incremental costs. By overlooking opportunity costs, successful companies frequently underprice their products. In short, when managers do not understand the true cost of a sale, their companies unnecessarily forgo significant profit opportunities. They tend to overprice when they have excess capacity, while underpricing and overinvesting when sales are strong relative to capacity.

Having identified the right costs, one must also understand how to use them. The most important reason to identify costs correctly is to be able to calculate an accurate contribution margin. The contribution margin is a measure of the leverage between a product’s profitability and its sales volume. An accurate contribution margin enables management to determine the amount by which sales must increase following a price cut or by how little they must decline following a price increase to make the price change profitable. Understanding how changes in sales will affect a product’s profitability is the first step in pricing the product effectively. It is, however, just the first step. Next, one must learn how to judge the likely impact of a price change on sales. That requires understanding how buyers are likely to perceive a price change and how competitors are likely to react to it.

The coordination of pricing with suppliers, although not actually economizing resources, can improve the efficiency of pricing by avoiding the incrementalization of a supplier’s nonincremental fixed costs and profit. Any of these strategies can generate cost advantages that are, at least in the short run, sustainable. Even cost advantages that are not sustainable, however, can generate temporary savings that are often the key to building more sustainable cost or product advantages later.