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.