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.
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.
Reducing costs will let you be profitable, but it doesn't help distinguish you from your competitors. If you want to do that, consider the added-value approach to solving the price-based-costing problem.
There are two basic ways to add value for the customer. The first provides the same or a similar product or service at a significantly lower price. The second provides a better product or service at a higher price.
The only way to provide the same or a similar product or service at a significantly lower price is to rethink and/or redesign how the product or service is provided. An example of this could be the accessory input shaft for a particular helicopter engine. At each inspection, the shaft has to be examined and if the shaft or its coating is damaged, it has to be replaced. A new shaft costs $4,500 and provides a very small profit to the supplier. Close scrutiny by one organization showed that most often, it was the coating that was damaged. By developing a re-coating process, this organization was able to sell a re-coated, airworthy shaft at a price of $1,500. While it is unknown what profit this organization makes on the re-coated shaft, it is safe to say that it is much more than on the new shaft. Now customers are falling all over themselves to get re-coated shafts. In this case, the key to adding value was to recognize that customers didn't want new input shafts, they only wanted airworthy input shafts. The organization that came up with the re-coating process saved the customers substantial money and increased their own profits significantly.
The way to provide a better service or product at a higher price is also done by focusing on the customer's needs and learning what the customer is really looking for when purchasing your product or service. For example, when a customer sends a component to you for overhaul, their interest in the overhaul of their component is not nearly as great as their interest in getting their aircraft airborne again. Thus they may be willing to pay a premium for a quick turnaround, or an even larger premium for an overnight exchange. Admittedly, it will cost more to provide these, but the premium price for the premium service usually provides significantly more profit.
Another good example of adding value by focusing on the customer's real needs is provided by the various guaranteed maintenance programs for turbine engines. Users not only want reliable engines, they also want minimum downtime when repairs and overhauls are needed, maximum assistance when problems or unscheduled maintenance occur, and no-surprise prices. In addition, many would prefer to avoid the cost peaks associated with conventional engine maintenance. The guaranteed engine maintenance programs accomplish all this by covering all scheduled and unscheduled maintenance, providing loaner engines when needed, and having hourly payment plans. Thus, these plans provide a whole array of services that address the complete spectrum of engine maintenance needs for the average user at a predictable price. And because of the economies of scale, the prices for these programs are very competitive when compared with the conventional way of paying for engine maintenance.
In short, when the competition is fierce, price-based-costing is the only way to survive. One type of price-based-costing focuses on the cost side. The other focuses on adding value for the customer. Both are necessary to create loyal customers and profits.