With the current collapse of demand and supply in many industries, it is inevitable to anticipate cost reductions for many manufacturers. It is always the silver lining of an economic crisis. However, with the good news also comes the challenge of managing cost reductions and price changes, especially when customers have access to the same cost information along the value and supply chain.
In a very chaotic world, cost-plus pricing is straightforward. Costing, however, can be rather complex. So it makes managing dynamic cost-plus pricing for manufacturing companies very tricky.
Cost transparency in general is never good news when things go south. If your main pricing orientation, meaning the primary way you set your prices, is cost-based or cost-plus, you should consider the following points:
1. Your costs are going down. Are your prices going down? That is the evil about cost-plus. You have educated your customers on your cost-plus pricing method, especially when costs go up. When they go down, are you passing savings to your customers as a straight pass-through? If your costs go down by 20, 30 or 40%, how far down do you adjust your prices?
2. Your costs are based on standards. Are your cost-plus prices wrong? If you run your financial models using standard costs based on cost estimations that are outdated due to cost decreases, then your prices are wrong. You have two choices: 1) move to actual costing for a while and uploading information in your IT systems with new cost information; or 2) spend hours calculating variances every day, week or month and adjust pricing accordingly. During times of cost volatility, doing cost-plus pricing is tough. It is hard to know what your true margins are in a dynamic way and to also really adjust prices to reflect cost savings pass-through.
3. Your costs are wrong: In large companies, different costing systems are used, and cost allocation mechanisms are not unified. In other companies, there is a lack of costing discipline and precision. It is at time due to the lack of expertise or the lack of resources to reach cost excellence. Bottom line, if your costs are wrong, your prices are wrong, and you are giving away margins.
4. You costs are not clear nor complete. Do you have the right accounting systems to price dynamically? Are you costing large and complex projects accurately? Costs going down is one thing. Costs changing dynamically and moving in different directions requires the proper cost accounting systems that can handle this level of cost dynamism. Add to this potential intercompany pricing and formula-based pricing contracts, and you have chaos on your hands if you do pricing manually in Excel. Cost accounting software can take you halfway, if matched with the proper dynamic pricing software.
5. Your real material costs change every hour. Are you ready to reprice every hour? Some manufacturing companies update their price lists once a quarter at best. Most of them do that once or twice per year. When costs of commodities change every hour or every day, you might need to separate what is material cost versus what is processing and added-value activities. The result is dynamic pricing fluctuating with raw material cost, combined with value-based pricing for your higher value activities. Without factoring this in, you are giving away the farm.
6. Your sales force might know your costs. Are they communicating too much information? You often hear the expression “OK, I give it to you at cost”. This is a trap that most buyers want you to fall into. They want more information on your cost so that they can predict your cost-plus pricing and request the proper discounts. Are you sellers trained not to discuss cost in front of customers?
7. Your formula-based pricing is driving your pricing down. Formula-based pricing is a particularly good cost-based method to avoid discussing pricing all the time. Once loaded in the proper ERP system, it applies pricing changes based on cost changes. Of course, you can make serious mistakes in your contracts when you define the formula. Are you including floor and ceilings? What happened if prices turn negative as we recently saw with oil prices? Have you thought of force majeure and exit clauses? Now is the time to revisit all of your contracts using formula-based pricing and make sure they include all the above.
8. Your offers now include software and data. Most manufacturing companies are good at costing products and parts. They are not always exceptionally good at costing what is more intangible and dematerialized. That includes data, software, apps, and some services. Applying cost-plus to what might be extremely low cost for the manufacturer but high value to the customer is giving away great value for nothing. My experience here is that these costs are folded in the product costs, and these items are given away for free. If an app costs $1,000 to produce and generates $10,000 of average customer value, how do you price? Cost-plus pricing might lead to a price at $1,400 to $1,600. Value-based pricing would price it at $5,000 (50/50 rule).
The current crisis is a good opportunity to think about how pricing is managed in your firm and to start improving on your pricing discipline. I am not saying that it is the right time to deploy value-based pricing today when you have done cost-plus pricing for the past decade or more. I am saying it is the right time to think about these points and consider moving from chaotic and manual cost-plus pricing, to a more data-driven and dynamic cost-plus pricing system.
Eventually, having discussions about the value of services, software, and very differentiated offerings is going to be a good idea. Right now, when you are in a firefight, start paying attention to your cost and adapt your pricing quickly. Change the business rules and put safeguards in place. Be bold—join the pricing revolution.
Stephan M. Liozu, Ph.D., is chief value officer at Thales Group, research fellow at Case Western Reserve University, and founder of Value Innoruption Advisors, a consulting boutique specializing in value-based pricing, digital pricing, and industrial pricing. Stephan wrote nine pricing books and is a frequent keynote speaker at industrial and digital conferences.
