Now that we have examined the difference between the labor and subjective theories of value, we are ready to see how these two valuation techniques affect companies' pricing policies.
For all of the economic evidence assembled on why costs do not “add up” to equate to value, it is amazing how many businesses still cling to the cost-plus pricing method, a direct cousin to the Labor Theory of Value. Doing something stupid once is just stupid. Doing it twice is a philosophy.
If one were to lay the two theories of value––labor and subjective––side by side, it would look like this:
Cost-Plus Pricing––Labor Theory of Value
Product » Cost » Price » Value » Customers
Pricing On Purpose––Subjective Theory of Value
Customers » Value » Price » Cost » Product
Notice how value pricing turns the order of cost-plus pricing inside-out, by starting with the ultimate arbiter of value––the customer. Goods and services do not magically become more valuable as they move through the factory and have costs allocated to them by cost accountants.
The costs do not determine the price, let alone the value. It is precisely the opposite; that is, the price determines the costs that can be profitably invested in to make a product desirable for the customer, at an acceptable profit for the seller.
A Tale of Two Automobiles
When Lee Iacocca developed the Ford Mustang, he reversed the order of the usual car-making pricing up to that point. Rather than giving his engineers carte blanche to develop a sports car and then marking up the resulting costs to arrive at a price—as GM did with the Corvette—he solicited the opinions of potential customers as to what features they would want in a sports car and what price they thought they would be willing to pay.
Knowing people liked the Corvette, but thought it was too expensive at $3,490, Iacocca wanted the price to be low enough to entice the potential sports car enthusiast. He then went to his engineers and asked if they could manufacture a sports car, with the desired features, sell it for no more than $2,500, and still turn an acceptable profit for Ford.
By building the Mustang on the Falcon’s chassis, in the first two years, it generated net profits of $1.1 billion (in 1964 dollars), far in excess of what GM had made on the Corvette. The average customer was spending another $1,000 on options, and while Ford projected that 75,000 units would be sold in the first year, the 418,812th Mustang was sold on April 16, 1965, only 13 months after the first rolled off the assembly line.
By comparison, the Corvette reached 1 million in sales in July 1992, with the release of a white convertible with red interior, mimicking the first one introduced in 1953.
Cost-Plus Pricing, RIP
With all of the evidence assembled, why does cost-plus pricing remain so endemic in the business world today? This turns pricing into a sort of wishful thinking, with no attention being paid to the external value created.
As an economist grounded in the assumption that people, generally, are rational, and businesspeople, specifically, are profit optimizers—or at the least, satisficers—one is drawn to the conclusion that executives perpetuate this pricing method because it is safe andsimplistic. Sometimes a theory is accepted because it serves a purpose for the individuals using them, not because it is right or wrong.
Another reason for the popularity and widespread use of cost-plus pricing is the rule of the bean counters. Cost accountants have had a significant impact on pricing decisions in companies, and it is time to bring their tyrannical rule to an end.
Fortunately, this is beginning to happen with the appointment of pricing managers in many companies, often at the C-Suite level.
There is a long history of companies that became obsessively focused on cost, at the expense of providing a product or service of value to the customer. The fact of the matter is you can make a pizza so cheap no one is willing to eat it.
Cost accountants focus on the inside of an organization, yet all value takes place in theexternal world, beyond the four walls of the organization. By and large, accountants are not well equipped to judge and measure value, despite all the recent blather about activity-based costing.
It is time we lay to rest cost-plus pricing, and for businesses to embrace The First Law of Marketing: All value is subjective. Pricing is far too important to be left to the worldview of the bean counters.
In my next post I will examine The Second Law of Marketing: All prices are contextual.