Lessons in Pricing: The Fallacy of Incremental Volume
The large paper companies have lots of smart people. Financial people. Marketing people. Engineers.
Lots of MBAs.
We can learn a lot from these smart people…from the mistakes they make.
Accountants will tell you that every order should cover full cost or it loses money. Makes sense. But paper company accountants also figured out how much downtime costs. Idle paper machines cost you a lot of money.
The same is true for printers and printing presses.
And some of the MBAs figured out that incremental volume can be very profitable. The fixed cost is already spent, so if you get an order for more tonnage (or for printers, more printing), it keeps the machines running and every dollar beyond variable cost goes right to the bottom line. Pure gravy.
Or, to put it another way, it’s better to have some contribution toward paying the overhead than no contribution. Makes sense.
The MBAs also figured out that what we were really selling is paper machine time, and lost machine time is lost forever. Just like press time. That makes sense, too.
Have you seen William Shatner in those “Priceline Negotiator” ads? Unsold hotel room nights are the same thing.
The math was right. The logic was right. So, what went wrong?
Of course, hotel rooms and paper machines and printing presses aren’t the same thing. But there are two bigger problems with the theory of incremental volume.
The first is that the incremental volume is not the lowest-cost business; it’s actually the highest-cost business. If you produce less and use less raw material, you will cut the most expensive production costs, not the least expensive. So the last unit of production, therefore, uses the highest-cost materials.
The bigger problem is that cutting prices can cost even more than downtime. I remember once asking the question, “What costs more, a five-percent price cut or two weeks of downtime across all of the mills? The first reaction is to say that the downtime is worse, but the answer is that the price cut costs more.
The price cut takes five percent of sales right off the bottom line, but the downtime represents less than five percent of a year’s output. And when production is down, you are not consuming raw materials or energy, and some labor costs might also be reduced. Moreover, it’s an opportunity to catch up on maintenance.
• True, the price cut might be temporary, but it rarely is.
• True, the price cut might only apply to “incremental volume,” but that idea is flawed.
I’ll never forget the time that I took an “incremental” order for a large volume of paper at a price that was “below market.” Within an hour, I got a call from a paper merchant who was also bidding on that business. He knew he lost that order, and even though I told him nothing, he had a pretty good idea of what happened and where the price point must have been. That meant he knew where he had to be on price the next time. That “isolated” order affected the market and wasn’t so isolated after all.
We need to remember that what looks good in theory doesn’t always work out that way in the real world. Customers and competitors react in ways that don’t always fit the theory.
So which is the right approach? Only sell above full cost, or take the incremental volume? In reality, you need to look at it both ways, and then use good judgment.
It is true that incremental volume at discounted prices can add cash flow and provide positive margin or contribution, but it’s a slippery slope; those discounted prices can very quickly become the market price. And once the market price goes down, it doesn’t come back easily.
If there is any doubt, don’t cut the price.