Cost-led pricing or price-led costing?
S. C. Vaidya
IN 1990’s management guru Peter F. Drucker wrote of five deadly business sins—avoidable mistakes that have damaged many businesses in the past. Drucker’s third deadly sin is ‘cost-led pricing’. He argued: "The only thing that works is price driven costingonly sound way to price is to start out with what the market is willing to pay — and design to that price specification". Avoiding this mistake makes a great economic sense to any business situated in any part of the globe.

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Red Alert !!

Cost-led pricing or price-led costing?
S. C. Vaidya

IN 1990’s management guru Peter F. Drucker wrote of five deadly business sins—avoidable mistakes that have damaged many businesses in the past. Drucker’s third deadly sin is ‘cost-led pricing’. He argued: "The only thing that works is price driven costingonly sound way to price is to start out with what the market is willing to pay — and design to that price specification". Avoiding this mistake makes a great economic sense to any business situated in any part of the globe.

Contrary to this, a good number of Indian companies still arrive at prices by adding up costs and then putting a profit margin on top. Due to competition in the market place they start cutting the prices, have to redesign the product at enormous expense, have to take losses and quite possible have to drop the product line because it is priced incorrectly. And if you ask them why it has happened like that. Very often the reply will be, "we have to recover our costs and make a profit."

Gone are the days when it was not difficult for a business to get paid not only for product’s cost but also for its inefficiencies. Manufacturers and suppliers dictated the rules of the game to customers: "you can have it ‘fast’ or you can have it ‘cheap’ or you can have it ‘right’ — but you can not have all the three". But in the changed scenario, the customer is gaining power.

Value for money (VFM) has become a primary consideration with the customer and he does not mind value from any part of the world, an appeal like — be Indian buy Indian, will not work. He has choices because of global competition.

Product life cycles are dwindling, global players themselves at times, cut short the life span of a product. Business organisations are thus passing through a very revolutionary transformation. But all this has not surfaced all of a sudden. There have been economies which were able to foresee the impending tough competition.

In 1970s a team of Japanese businessmen was taken around an automated warehouse by an enthusiastic American automobile manufacturer. Instead of getting admiration, as expected by the American, the team made a comment. "Why do you store what you can’t sell".

During the same time in Japan, a supplier’s truck was stopped at the gates of Toyota for no other reason than early arrival which was against the spirit of ‘Just in time’. In addition, the Japanese emphasis on cost management has focussed on the pre-production stage in a product’s life cycle when the key decision about product design, resourcing and production technology are made, and when up to 90% of a product’s total costs are committed.

The idea once again is to "get costs right" before production commences. Source of profit, in fact, is not the physical efforts involved in production and selling but in the intellectual efforts in planning and designing the production and sales processes. Those involved in intellectual work should not be diverted from it by other responsibilities. Line managers and workers are there to realise the plan created by the intellectual efforts of others.

However, in the west more emphasis has been placed on the assessment of actual costs incurred after the production is under way.

It must always be remembered that profit is an outcome of two forces—costs and revenues. In a market-oriented economy, revenue (which itself is made up of selling price and volume of product/service sold) is influenced by the market forces. Therefore, it is only cost that presents itself as a factor to be managed so as to maximise profits.

Cost is not simply incurred, it should reflect only purposeful spending. Further, if cost incurrence is to be fully understood, it should be viewed not simply as an event occurring at one point in time but as a process involving several stages. Japanese cost managers say: "Cost management is like wringingout a wet towel. The biggest reaction is obtained first, but we must keep wringing. Even when the towel appears dry to touch, we must wring it to extract more." Achieving this level of effort and success in cost management requires commitment of resources, formulation of appropriate policies and procedures and establishment of a flow of relevant cost-based information.

Thus, cost cutting has to be a continuous endeavour always, ensuring that it should not result into cutting corners or cutting quality or cutting workforce.

In order to enhance global competitiveness, a lot of effort is being put in by various businesses across the globe. Even a war-shattered country like Israel is making its corporates competitive. It has been reported that Israeli companies (e.g. Israel Aircraft Industries, Teva Pharmaceutical Industries., Scitex Corporation are providing best illustrations on ways to avoid Drucker’s five deadly sins.

The main reason pointed out is the hostile environment that Israel faces which in turn has developed a national character demanding that things be done right the first time. This character dominates national consciousness and has surfaced in the philosophies and mission statements of many Israel companies.

In order to enhance global competitiveness, Indian companies have to re-orient themselves to the changing environment. Public sector undertakings in particular have to do much more in this context. In situations where one undertaking happens to be, if not a sole but a major supplier of a product/service.

State Electricity Boards cost-plus pricing mechanism is advocated. Reason being that there are not many market players. Hence, marker-driven pricing is out of question. Here the customer of such services becomes vulnerable unless a mechanism exists so as to ensure that the supplier charges only for the true cost and not for inefficiencies or lack of corporate professionalism.

These issues were addressed by a team of experts headed by Prof Roger Noll at a seminar recently organised by Punjab in partnership with the Centre for Research on Economic Development and Policy, Stanford University, USA.

The writer is a professor University Business School Panjab University

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