Inflation. Labor shortages. Supply chain delays. Manufacturers have had a lot on their plates the past couple of years. Across the board, the result has been increasing prices. But raising prices without factoring in market-based considerations might not be enough.
What is Production-Based Pricing?
Direct production costs are a logical starting point for pricing new and existing products. For example, suppose Manufacturer A spends $4 in raw materials and $6 in labor to manufacture a widget. The owner adds up these costs ($10) and applies a 10% markup to arrive at the selling price of $11 for each widget. The problem is that markups are often based on historic performance or gut instinct.
What happens when Manufacturer B sells its widgets for $10? This often happens to smaller manufacturers that compete with larger companies that can negotiate lower supply costs or companies located in areas with lower labor rates. Unless Manufacturer A can provide a compelling reason for customers to pay a premium, such as superior quality or more responsive customer service, its market share will likely diminish — and overhead costs will eventually consume profits.
Conversely, what if the $11 price point is significantly below competitors’ prices? Below-market pricing may cause demand to skyrocket — and the factory might not be able to produce enough widgets to keep up with demand. As a result, quality may suffer, or customers may become frustrated by production delays.
When demand outpaces production capacity, cash flow shortages also may occur because of lags in the cash conversion cycle. That is, Manufacturer A will need to front production costs (cash outflows), but it will take a while to bill and collect payments from its customers (cash inflows). A slight price increase can help reduce demand and the pressure it’s putting on plant workers.
Are You Conducting Market Research?
To be a market leader, you’ll need to factor more than direct costs into your pricing strategies. This means conducting market research, which improves the accuracy of your sales forecasts. For example, salespeople can informally survey customers about which features they value most, how the company can improve the customer experience, and how much customers would be willing to pay for new products or improvements to existing products. To entice customers to participate in these surveys, consider offering free trials of new products or discounts on future orders.
It’s also important to research competitors. Pay attention to the products they offer, the prices they charge and how they position their products in the marketplace.
Any research aimed at competitors must be ethical and legal, however. For example, you shouldn’t hire a competitor’s R&D director and solicit proprietary information. But you can legitimately visit a competitor’s website and review copies of print marketing materials that are available to the general public.
Market research can help you position your company’s offerings relative to those of competitors — and determine whether future sales volume will be similar to past performance. Forecasts are often based on historical sales volume. But changes in market conditions, such as the introduction of a new competitor, changes in technology and evolving customer needs, may require adjustments to what worked in the past.
Have You Allocated Overhead Costs?
You’ll need to forecast and allocate overhead costs to products to help make better informed pricing decisions. As with sales, future overhead costs may not mirror what you’ve paid in the past — especially in today’s inflationary, labor-constrained marketplace.
Materials and labor costs are just a few of the expenses manufacturers incur. Overhead items may be variable (such as sales commissions, packaging and shipping costs) or fixed (such as depreciation on equipment, managerial salaries and rent). As a company grows, it may need to obtain a larger factory or additional salespeople, leading to incremental fixed costs.
Looking Forward
Today’s market demands product pricing based on more than just direct production costs, even if adjusted for spikes in the costs of raw materials or labor. Contact us to review and implement pricing models based on personalized market research and comprehensive costs.
@2022
Principal
john.krizansky@hwco.cpa
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