Cost plus pricing has always been the worst pricing strategy to employ, although the most common. It is because it is superficially easy, understandable, and requires little thought.
In my experience, the use of a cost-plus pricing model is an indication of a lazy, or uninformed and poorly advised management.
The chances are they have no idea of what the real costs are.
Such a pricing model indicates that there has been no effort to isolate the cost drivers and determine a strategy that reflects their competitive and economic context.
All that has been considered are internal factors that the customer has no interest in at all.
It is also often an indicator that the costing system is driven by accountants, who manage by variances from some mythical standard that rarely reflects the reality of a production process, but over which they can absorb overheads.
Rubbish system, and here’s why:
- Standard costs. Most operations have a standard COGS system in place that is revised up or down against a schedule, often annually. In the meantime, variances are theoretically tracked and explained, but they tend to get lost in the chaos of day-to-day operations, and a budgeted gross margin.
- Costs included in a standard system are wrong the day after they are put into the ERP system. It may be a year before they are updated, and even then, remain inaccurate.
- Cost variability. Real costs will go up and down, often daily, and even hourly, depending on a range of factors, Factory throughput, supplier price changes, overtime, WIP losses and a host of other factors all impact actual cost. At the very least, you need to know if you are winning or losing at Gross Margin because of these changes.
- Sales management is compromised in the absence of robust gross margin analysis. Depending on the degree of autonomy the sales force has, they can be ‘generous’ to customers for a range of excuses, normally associated with sales budgets expressed in volumes, rather than gross margin dollars and percentages. This enables all sorts of ‘gaming’ of sales to exist.
- Increasingly in a commoditised market, value is delivered by intangibles rather than the physical product. It is geometrically harder to put a price on this value to a customer, so the potential for sub-optimal pricing is magnified by poor product costing.
- Customers do not care about your costs at all. Not a whit!. What they care about is the value delivered to them. Price for that value, just make sure you can make a sustainable profit on the way through.
At the very least the P&L should be broken up into cost of goods sold, further broken into customer and product categories, trading variable costs, and fixed costs. At least then you have the chance of identifying where the cash is leaking out, as it is leaking.
When you need some outside expertise to maximise your profitability, call me.
