SMBs usually think of cutting costs through increased efficiency as a win-win situation. You win by increasing profits and your customers win by receiving a better service or product. What could be bad?
In a mind opening MBA course on pricing, I came across a fascinating irony. Here’s the simplified story.
A company decides to implement a new system to increase business efficiency, such as eliminating the expensive infrastructure of PBX boxes, and moving to a cloud based telecom system. Despite the increased efficiency, through lower telephone fees, automation of roles that cut labor costs, and improved customer service, the company notices that their stock price begins to decline. Why?
The real source of the harm is the cost plus pricing method, but the declining profits surface after the company cuts operational costs. How could the implementation of a more efficient business method be the reason behind declining profits?
First, let’s all make sure we’re on the same page. What is cost plus pricing? Here’s a quick answer from Answers.com’s wiki:
Cost-plus-pricing is one of the simpler methods of price setting. Cost-plus-marketing basically is adding a standard mark up to a product after production and distribution costs have been met. This method which ignores demand and competitor pricing is not highly recommended for a company looking for high profit margins.
Optimizeyourprice.com sketches the picture in a detail, in a great blog post, “Cost Plus: If Something Looks To Good To Be True”:
Cost-plus pricing provides absolutely no incentive for efficiency. Think about it – if your cost basis increases 25% from $100/unit to $125/unit guess what happens to your price? It increases 25% as well. A 50% increase in cost? A 50% increase in price. So what if you go out and work out a super-duper fancy-schmancy deal with your vendor to drop your per-unit cost by 80%? You get to watch your price drop by 80%. So tell us what your incentive is to invest your time, energy and money into negotiating a more attractive per-unit cost structure? Bingo – there isn’t one.
What does this mean for SMBs? Should SMBs strive for inefficient business practices, so that they can keep their prices high, and maintain higher profits? Obviously not!
So what’s the moral of the story? Here’s a few invaluable lessons that I learned in a three hour class:
1) Cost plus pricing may be the most popular pricing method, because of its simplicity, but it does not take into account the full picture of competitors’ pricing and profit margin, which are the company’s bottom line.
2) In order to businesses to maintain their profit margin while decreasing prices, their quantity increase needs to offset the price decrease. But lower prices do not necessarily mean higher quantities. Increasing the number of sales depends on either taking a larger piece of the market share pie or increasing the size of the market. The latter case occurs only if the lower prices mean that the product or service is now more accessible to more potential customers, or if the current customers consume more of the product at a lower price. Before you decrease prices, think about how it will affect your customers, market and level of sales. In our cloud telephony example, the business can actually measure certain sales goals like phone leads through the analytics reports.
3) Pricing interacts with everything we do in a company, even when we don’t see it. A business that implements a new cloud telephony system may be excited at the opportunity to cut costs while increasing efficiency, especially during tough economic times. But, don’t forget to look at the full picture. If you’re using cost plus pricing, beware that the increased efficiency of cloud telephony does not end up harming to your bottom line.
To read more about the dangers of cost plus pricing check out Business and Jobs.
Image: Salvatore Vuono / FreeDigitalPhotos.net
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