Price Based Costing

Price Based Costing

Gobbledygook or good business?

By Bill de Decker

October 1999Bill de DeckePrice Based CostingrBill de Decker

There are two ways to determine the selling price for a product or service. One way is to figure out what it costs to make the product or provide the service and then add the required overhead and the desired profit. This approach, called cost-based-pricing, works when there is no competition or the price you have calculated is lower than the competition. But what if there is competition and your price is higher than what the competition charges? At that point, you will have to figure out how to make a profit while your basic price is dictated by the competition. To do that requires price-based-costing.

In price-based-costing the starting point is the price for the product or service that is allowed by the competition. If that doesn't allow you to make a satisfactory profit, there are really only three alternatives available to solve this crisis. One is to lower your costs to the point where you can make a profit. The second is to add value so that the customer is prepared to pay a higher price, which allows a profit. And the third is to get out of that part of the business. Assuming that the third alternative is not very attractive, let's take a look at the first two.

Lower costs
Are you and your competitors really selling the same service or product? It is not uncommon to discover that you and your competitor are selling products or services that on the surface seem the same, but after close examination, have significant differences in content, capability, warranty, after sales support or durability. In that case, one approach is to "unbundle" your product or service. For example, suppose you sell a service that consists of the overhaul of a hydraulic servo. Included in your published overhaul price is the overhaul, plus all normal parts that need to be replaced and the bench-check to return the part to airworthy status. If your competitor's price does not include either the parts or the bench-check, you will be at a cost disadvantage until you figure your costs and prices the same way as your competitor. The alternative, of course, is to start marketing the difference, as will be discussed in the next section under "adding value."

Next, you must examine your costs. At first, it may not seem possible to lower them very much, but careful analysis will often yield surprising results. Consider the following examples. At one organization with multiple sites, each site provides a repair service for a particular component. The repairs tend to be expensive because no one site does enough of them to be really be proficient. But, if all the repairs of this component are centralized at one site, that site can have some dedicated people who will become really proficient at this repair. Sure the cost of shipping will increase, but the overall cost of the repair will decrease significantly. Another area to examine is whether all the work for a particular service has to be accomplished by highly experienced technicians, or whether personnel with less experience and/or lower labor cost can do a significant portion of the work, perhaps under the supervision of one highly experienced technician. Maybe the number of labor hours required would increase by 10 percent, but if the labor cost is 30 percent less, there will still be a significant savings. A third example occurs when the fixed costs are spread over a larger production volume. Assume that the proportional share of the annual rent of the facility, insurance, utilities, janitorial service, investment in tooling and test equipment, etc. for a particular product or service is $250,000. If only 250 of that product or service are sold, the fixed cost per unit sold is $1,000. On the other hand, if an investment of $50,000 in marketing will increase to annual sales volume to 500, the unit fixed cost will decrease to $600. And lastly, perhaps part or all of the work can be subcontracted to an organization that has lower labor costs or lower overhead or both.