Cost Plus

Do customers really care what it costs a company to provide a good or service to them? We have all heard that the vendor – customer relationship is supposed to be more like a partnership these days, but does it really? How much more would a customer be willing to pay to have that partnership? Do we really care what the cost of the car is that we decide to buy, and by extension how much that automobile manufacturer makes on each car we buy? I don’t think so. Do we really want to have a “partnership” with that automotive manufacturer, or do we just want to buy a car? I think people, and companies are more concerned about the price they pay and the value they receive for the good or service, more so than the cost the provider bears to provide the good or service.

I think this is a pretty interesting distinction. Customers are concerned with a supplier’s price, not with the supplier’s costs. Customers are concerned with the value they perceive they will get from the good or service, not the profit (or possibly lack thereof) that the supplier will recognize from the sale. In short, costs and associated profitability are an internal supplier issue, and prices are an external customer issue. In short it seems that it is the customer’s decision on whether or not they make the purchase decision, and it is the supplier’s decision on whether or not they stay in business.

I will look at a couple of examples to illustrate this point. People do not seem to care how much Apple makes on its iPhones or Macs or any of its other products. Apple is hugely profitable. They make an incredible amount of money on every product unit they sell, yet every year we see people line up (or even more unexplainably, camp out) in order to get the next new iteration of Apple’s products. They willingly spend the money. They don’t care how much Apple is making. They perceive the value and make the purchase. And every year Apple creates a new iteration of the product to feed this cycle.

On the other end of the spectrum, people did not perceive the value proposition of the products being produced by Studebaker, American Motors, Chrysler and General Motors at various times in the past. They didn’t care that these companies were not making enough margin on their products to remain in business. They did not like the designs, the quality or the prices enough to pay what the manufacturers needed to stay in business. Studebaker and American motors are long gone. Chrysler and General Motors would also have departed were it not for governmental intervention.

Economics teaches that the market sets the relative price for all readily substitutable goods and services. This price point is usually referred to as the intersection of the “supply” and “demand” curves. Unless you can influence or control the supply curve, you are pretty much at the mercy of the market when it comes to the price of the good or service.

Aha! You should be pointing to the fact that Apple does not control the supply of smart phones into the mobile phone market. As such, how can they set their price so high and make so much money? The answer here is that Apple does not in fact control the mobile smart phone market. Apple controls the supply of iPhones in the mobile smart phone market, and it has been shown that more than forty two percent of people buying smart phones want an iPhone.

While other manufacturers might like to try and convince the market that their product is a readily substitutable alternative to the iPhone, it looks like they have not been entirely successful there.

While on the other side of the example, it has been shown that one manufacturer’s car can be substituted for another’s. We have seen this in the branding and segmenting that goes on in the automobile market. Segmenting is a process where a very large market is in essence broken down into several smaller market segments. That is why we have “economy” cars all the way up market to “luxury” cars.

It may not be logical to expect that a Hyundai is readily substitutable for a Mercedes-Benz, but it could be expected that a BMW, Audi or possibly a Cadillac, could suffice. It has been shown that there are certain brand loyalties in the various automotive segments, but as market trends, automotive designs and prices move, these can be overcome and new loyalties established.

However the point remains the same. Customers are not so much concerned with the cost of the Hyundai, Mercedes, BMW, Audi or Cadillac. They are concerned with the price. And even more specifically the relative price and the relative perceived value. A person looking for a “luxury” car could buy a cheaper “economy” car for a lower price, but would not receive the perceived value they want. Conversely an economy car patron might want a luxury car, but can’t afford it.

So now the question that this leads to is:

If customers do not care what the supplier’s cost for a good or service is, why do so many suppliers create their customer market pricing based on their internal costs associated with their good or service?

This is known as “Cost Plus” pricing.

If it is the market price, or the relative competitive market price that is of primary concern to a customer, why would a supplier base their prices on their costs, which are irrelevant to the market? If you are a low cost supplier and use this method you could undershoot the competitive market price and forego significant revenue and margin. You can bet that Apple did not make this mistake, judging by their revenues and earnings reports. They saw the price the market would bear and adjusted their price upwards accordingly. They are letting the other suppliers try to compete on price.

On the other hand, if you are not the low cost supplier, but rather a less efficient higher cost supplier, basing your prices on your costs could bring you in well above the market price. While Apple may be able to sell its products at a premium, I’m not aware of too many other suppliers that enjoy a similar market position. You can ask the extinct Studebaker or American Motors how that higher cost versus the market price thing worked out for them.

I guess Oracle might be another company that tries and somewhat succeeds it setting its own market price. Larry Ellison, the CEO at Oracle has always done things his own way. But then again, he likes to build yachts to race in the America’s Cup (a really expensive pastime) and he does own his own Hawaiian island (Lanai) so he must have figured something out.

The major difference between Apple and Oracle is that I am not aware of anybody that “likes” Oracle the way the like Apple (they are rarely, if ever mentioned in the same breath), and I have never seen anyone line up in the street to be the first to buy the latest iteration of Oracle’s database systems and applications.

“Cost plus” pricing assumes that a supplier has a competitively based cost structure. This may or may not be the case. Regardless, the market doesn’t really care. What the market (and the associated specific customers) cares about is the price and the relative perceived value that is derived from the good or service.

Those goods and services where there is a perceived high value and not a readily substitutable alternative can and do charge a premium in the market regardless of their cost structures. Those goods and services where there is a perceived readily substitutable alternative, regardless of the market value, can only command the market price, also regardless of their cost structures.

It seems that the only times that cost plus pricing can be used is if the supplier has a competitive cost structure (which will be difficult to ascertain since suppliers rarely share such information), or if the supplier controls the supply of the desired good or service, in which case the supplier can price in any manner they choose include cost plus methods.

In most other cases suppliers need to be cognizant of the prevailing market prices and trends, and strive to keep their costs reduced so as to retain their profitability at those market pricing levels.