Production Costs Influence Intelligent Pricing Strategy
Last time, Marka and the FEI tribe discussed how understanding price inelasticity can help businesses arrive at an effective pricing strategy. This week, Marka discusses the role costs should play in determining product pricing. Remember, fire = print.
“If demand sets a ceiling on the price FEI can charge for matches and other products, costs set the floor,” Marka explained to the tribe. “If we don’t charge a price that at least covers the costs we incur by producing, packaging, distributing and selling the product, we will simply be unprofitable.”
“Not an option,” Numo said emphatically. “I don’t agree with a predatory pricing strategy.”
“Predatory pricing?” Zoot asked.
“Predatory pricing is when marketers price products below their costs to clear out competition,” Marka said.
“Businesses that engage in this kind of pricing may be breaking the law,” Org added.
“Let’s take a look at two types of production costs and see how each affects pricing decisions,” Marka said, steering the conversation back on track by writing on the whiteboard:
“Also known as overhead costs, fixed costs do not vary based on how much we produce or sell,” Marka explained.
“Examples of fixed costs?” Zoot asked.
“Facilities rent, liability insurance, management costs and similar expense items,” Numo offered.
“Because fixed costs can’t be avoided, they must be factored into any price we set,” Marka continued, and gong back to the whiteboard she wrote:
“Variable costs are directly correlated with levels of production,” Marka pointed out. “These include the cost of materials and workforce labor used to make our products or deliver our services.
“Fixed and variable costs together comprise total costs,” Numo said.
“Do per-unit variable costs change based on production quantities?” Zoot asked.
“Not in the short run,” Numo replied. “Over time, per-unit costs will decline as production becomes more efficient. Fixed costs, however, will definitely be spread across more units, lowering total manufacturing cost.”
“There are other internal costs that FEI must consider before setting price,” Marka said. “We’ll go over those next week.”
Today’s FIRE! Point
A company’s prices must at least cover the costs incurred for producing, distributing and selling the product. Fixed costs do not vary based on how much a company produces or sells and include facilities rent, management costs and liability insurance. Variable costs are directly correlated with levels of production and include the cost of materials and workforce labor. Fixed and variable costs together comprise total costs. Generally, the price a company charges for its products must at least cover the total production costs at a given level of production.
FIRE! in Action
Parker Hannifan Eschews Traditional Pricing Models and Succeeds
Donald Washkewicz, CEO of the manufacturing parts supplier, decided to implement a new pricing strategy based on how much consumers would pay, instead of simply adding a flat amount on top of total production costs as had been done before. Following Washkewicz’s lead, one division of this company concluded that it could price 28 percent of its products higher and increase its revenue.
Next week: The FEI tribe continues to discuss the influence of internal costs on overall pricing strategy.