Shouldn’t cost determine price?
Q: We have a question that’s challenging one of your columns about pricing. It’s the column telling us that, according to Henry Ford way back in the mid-1920s, we should price according to what the market wants and not according to costs.
We’re in the confectionery, biscuit, and canned meat and canned fish industries. We’ve always priced according to COG (cost of goods) plus other direct costs sometimes. We’ve been very successful, except for those few recession years. We also do not know of any of our competitors whose price determinant is not cost but “what the market wants.”
It seems to us that you’re probably just reminiscing about your “good old days,” and those of Mr. Ford some 80 or 90 years ago. What our CEO, who was an AIM MBA student of yours, said is that it’s one of those things that professors in their ivory towers prescribe that’s good, or good-sounding, in theory but not in practice. So please, tell us who successfully practiced that Ford pricing system that is market-driven rather than cost-driven.
A: It’s worth repeating what exactly Ford said in 1923: “Set the price where the market wants it. Then let those jokers in manufacturing and finance manage costs to suit the price that the market wants. Let the market price force the costs down.”
You asked: “Who practiced this market-driven pricing system and was it successful?” Obviously, Henry Ford did. Ford applied it on pricing his famous Model T car. The New York Times reported on Dec. 24, 1999, that the international automotive journalists voted Model T as “the car of the century.” Marketing history also tells us that the Model T made the Ford Motor Co. the most successful automobile manufacturing company in the world for over a quarter of a century. Henry Ford himself attributed the Model T success to its pricing, a pricing that brought the car within reach of the masses. Before this, cars were a luxury because of their unaffordable prices.
Today, most leading consumer goods companies follow a market-driven, instead of a cost-driven, pricing method. But it is not in enumerating who and how many are the practitioners of market-driven pricing that is important to consider. The real practical issue is: “Which pricing system has made companies more revenue-productive as well as more profitable?”
When I referred to “most leading companies” as practicing market-driven pricing, it’s clear that some are not. Those others are into cost-driven pricing, but they are still among the leading and successful companies. And that’s precisely the point. Both cost-driven and market-driven pricing methods work and can lead to market success. But my own research and consulting experience indicate that you are more likely to succeed, or will have a higher success level, with the market-driven pricing system. Reason? It’s simple. With the market-driven method, you’re pricing according to who’s buying and not according to who’s selling. It’s pricing according to the consumer’s value perception and not according to the marketer’s value proposition that often diverges from “what the market wants.”
This is not to say that cost is not a consideration in pricing because it is. So what’s the right role of cost in the pricing process? A closer look at Ford’s market-driven pricing formula tells us that cost considerations come after learning about the market’s price sensitivity, which must count as the basis and determinant of price. Finance’s cost-plus pricing puts the relationship the other way around. Costs are the pricing determinant.
The cost-plus pricing formula deserves just as much a closer look. So let’s do that.
As a process, cost-plus pricing proceeds according to the following three steps: First, you estimate your product’s variable costs as its baseline costs; next, you add an overhead or fixed cost burden; and last, you add a profit number to arrive at the product price.
So what’s the role of costs in this process? Price determinant role or starting point role? It’s clear it is the latter.
You’re skeptical of and rejected the market-driven pricing method not only because you thought nobody has successfully practiced it. You also didn’t like market-driven pricing because your CEO said that market-driven pricing is “one of those things that professors in their ivory towers prescribe that’s good, or good sounding, in theory but not in practice.”
You have to be careful about this kind of reasoning. It is misguided.
Today, pricing theory is also known as pricing model or pricing framework. Whenever you are asked why you prefer pricing according to costs, you find that you have to invoke a cost-based pricing theory, model or framework.
The same goes for those adhering to the market-driven pricing. They also base their pricing system on some market behavior-based pricing theory, model or framework.
In other words, practice is either good or bad because its basis is a theory, model or framework that is either good or bad. It was the founder of modern social psychology and pioneer in applied psychology, Kurt Lewing, who had the final words on “theory versus practice.” He said: “Nothing is more practical than a good theory. If it’s bad in practice, it came from a bad theory. If it’s good in practice, a good theory made it happen. A good theory is responsible for good practice.”
You should pass this on to your CEO so he would know better about the true relationship between good practice and good theory, and between bad practice and bad theory.
Keep your questions coming. Send them to me at [email protected].
