Price & Cost:
Product Costing and Pricing play a key role to successfully commercialize a product. Costing helps to meticulously attribute all the expenses incurred by the company to the product. Any omissions to attribute the cost to the product might give the company the illusion of a successful and profitable sale while impacting the profit in the balance sheet of the company. Over attributing costs to a product could price the product out of the market resulting in a loss of business. Such omissions or dis-proportionate attribution often occur because of shared infrastructure, resources that are being used to produce the product but unaccounted or over attributed.
To successfully price a product the company needs to know the cost of the product and about the company’s market position, unique value proposition of the product, competition and the price sensitivities of consumers. Then the company can strategically decide the margin to sustainably run the business as well as wade off the competition. Companies might choose to sell off a product at loss due to low demand in an effort to recover the fixed costs, salvage the situation and survive the tough times. Strategically incurring a loss might not be a bad idea to manage the crisis situations. Pricing a product appropriately optimises and maximises sales and profits.
What factors influence cost and price?
Several factors influence the price of a product / commodity. Take water, for instance. In most places water is free or almost free. You might pay a small fee for the water supplied by the local municipality. The commercially sold bottled water available in supermarkets and various other retail outlets may be priced slightly higher. The cost of a litre of water might vary depending upon the bottled unit quantity such as a litre or a gallon pack. Higher volume packs generally tend to be priced lower per unit weight or volume. The retail, wholesale and distributor’s price would be less than the retail price. The same bottled water when served at fast food, dine-in and fine dine restaurants could be priced slightly higher than the retail price and in that order. The bottled water from french rivers or pristine mountains or the water with the right ‘PH’ suitable for a healthy body would be priced at a premium to the regular bottled water.
In the above example, there are several factors that influence the price of the product. A commodity when packaged becomes a product and when carefully crafted for specific purpose becomes a premium product. The cost and the underlying factors impacting cost, if put mathematically could be having a linear, multi-linear or a polynomial equation. Between the manufacturer and the end consumer, there are distributors, wholesalers, stockists, retailers / suppliers in the value chain of creation to consumption. The prices vary depending upon the Supplier and the buyer in the value chain. While cost depends on the factors discussed above, the price of the product depends on the Supply and Demand, competition and substitutes available in the market. While Supply and Demand are tough to factor in our analysis, Competition, Substitutes can be factored in as brand value. Though Cost and Price of a product are different, they are often used interchangeably for the current context.
Cost & Price of a product are dependent on several factors mentioned below:
A. Cost of the Product :
- Cost of Design
- Cost of Raw material
- Cost of Production
- Cost of financing
- Cost to Market the product and
- Cost to Distribute the product.
B. Price of Product :
- Supply and Demand for the product
- Competition and substitutes available. Brand value
A. Cost of the Product :
1.Cost of Design:
Products are engineered by qualified professionals who are subject matter experts in the fields of engineering sciences with industry knowledge and an insight into human behaviour. Hiring such qualified professionals costs money. Also there are aspects such as reliability, repeatability, quality, aesthetics that Customers care about while using the product. Organisations invest in Research and Development of materials, design aspects, utility, usability and other aspects for innovating new products.
Though we cannot examine the data of the factors mentioned above, the costs tend to converge based on the ‘Industry’ and ‘Application’. For example take pipes used for the water industry and the oil & gas or nuclear industry. A slight leakage of pipes used in the water industry might have a catastrophic effect, whereas a leakage in an oil and gas industry might lead to a fire accident. Also to fix such leakages might need the plant to be shut down leading to a loss of operational income. So, the amount of money invested by a company on design is directly proportional to the application of the product and the industry it caters to.
The design costs and its expected impact on price can be correlated to the ‘application’ of the product and the ‘Industry’ it is being used in.
2.Cost of Raw material:
The Cost of raw material is one of the important factors influencing the product cost. The cost of a water packaged in one litre and 5 litres are almost directly proportional to weight / volume of the amount of water. The bigger volume pack might offer a slight discount in price per unit volume due to reduced packing and production charges, but the prices have a strong correlation to the weight/ volume of water. The industrial products made out of steel, copper aluminium or such metals or polymers will have a cost strongly correlated to the raw material costs. Manufacturers having raw material cost as one of the prominent costs have risk management teams working to offset the risks by hedging in commodity markets.
While we won’t be able to determine the raw material costs to the Manufacturers, we could look at the dates of the pricelist or purchase order or the delivery dates to approximate the date for considering the raw material price. The raw material prices are available in the commodity exchanges such as London metal exchange.
The grade of the base material / raw material also has significant influence on the cost of the product. For example grades of steel such as carbon steel, Stainless steel, Duplex stainless steel have significant variation in the cost of the final product. Manufacturers need to use a series of processes to maintain the chemistry of the material to manufacture specific grade material.
In addition to the material grade, the manufacturing process has an impact on material properties and influences the cost. For example a compressor shaft is manufactured through a princess called forging, while the calve body is made of casting. For the same material the cost of forging is higher than the cost of casting. Another example is the pipes made through different processes such as Seamless pipes, Longitudinal Submerged Arc Welding (LSAW), Helical Submerged Arc Welding (HSAW) all have a significant difference in the cost per equal unit of weight.
To summarise, we need to look into the raw material, its grade and manufacturing process will give a significant insight into the cost structure of the product.
3. Cost of Production
Manufacturers need infrastructure and assets to produce products. The assets are very expensive and the costs are written over a period of 10 years. They need to procure the raw material, and execute a series of operations. They also need a qualified operations team to successfully manage the production process.
As discussed in the earlier section weight is one of the factors impacting the product price. If we are manufacturing a centrifugal pump, the sequence of operations to manufacture a smaller pump and bigger pump would be identical in nature. So the cost of production proportionate to the overall cost is expected to be higher for a smaller pump compared to a bigger pump.
Since production involves machinery and people, countries with low labour cost are expected to have lower production costs and it is one of the reasons why production centres move from developed countries to developing countries.
Cost of production includes cost to maintain quality of the product, safety of the personnel and minimise the impact on the environment. Additional quality checks and testing are needed at various stages of production to reliably ensure the quality of the product.
There are international bodies to rate and certify companies based on their safety standards and policies. Manufacturers need to hire qualified professionals, create systems and policies, train staff, support them with adequate and appropriate infrastructure to ensure safety during operations. It adds to the cost of the manufacturing.
The production process creates waste and it needs to be disposed of properly. For some production processes might need effluent treatment plants, Zero liquid discharge infrastructure etc to comply with regulations.
Third world and developing countries are often lax in their safety policies or at least in implementation in an effort to attract investment and partially due to corruption. This is one of the reasons why these countries look attractive investment destinations for production centers. Though the cost of production is lesser, the costs are borne by the local workers and community in the form of accidents, polluted waters and air. Several European garment manufacturers have textile mills in India and Bangladesh that supply clothes operating under unhealthy worker conditions and safety standards. China’s ‘Xintang’ which produces one third of all the jeans made in the world is a fine example of compromised safety and environmental standards.
In some industries, end users / Consumers approve manufacturers only after auditing the safety standards of manufacturers. We often witness a consumer backlash when accidents happen at the factories supplying to the established brands. Apart from the brand value due to marketing, a brands commitment to quality, safety and community well being results in improving and enhancing the brand value and image.
To summarise the cost of production can be correlated to the product, brand value, international certifications for quality, safety and manufacturing, country of manufacture / origin.
4. Cost of financing
Manufacturers purchase and process the raw material, ship the product and bill the customer. The Manufacturers need to fund the operations with their own money and are expected to include such costs into the cost of the final product. A slight glimpse of the cost of financing can be seen through the payment terms agreed by the manufacturer and the lead time to deliver the product. Though it’s not possible to make any conclusions about the cost of financing, the companies that do not manage these costs wisely, often end up making losses or face other adverse effects.
5. Cost to Market the product
Some manufacturers create a really good product that consumers love and propel the word of mouth marketing. Retail companies use celebrities, models, athletes and actors to market the product. Companies with products for business might use industry events, road shows etc to market the products. Almost all of them use various online and offline channels for marketing and advertising. We would examine the brand value of the product or manufacturer as an indicator for the marketing costs.
6. Cost to Distribute the product
Companies need Sales representatives, distributors, stockists and channel partners to distribute the product. The cost of distribution structure adds to the cost the Customer pays. This is covered by examining the Supplier and buyer in the value chain.
B. Price of the Product:
The price of the product is dependent on the factors impacting the cost of a product discussed in the previous sections, Profit margins. The profit margins a company can command on depend on the competition and substitutes along with the supply demand Gap which are discussed in detail as below:
1. Supply and Demand for the product
The price of the products are directly proportional to the difference between Demand and Supply. A good indicator of the Supply and Demand are commodity prices such as prices of metals, crude oil which can be easily captured from the data available on commodity exchange.
2. Competition and substitutes available.
Increased competition has a downward effect on the product pricing. Manufacturers , suppliers choose to compete for specific segments which helps in reducing competition and improve efficiency through product and strategic focus.
Summary:
The following factors are considered and where the inputs are available.
- Engineering and Technological complexity
- Raw material, Grade and Manufacturing process
- Design and Dimensions
- Quality, Safety and Environmental compliance and certifications
- Brand Value
- Purchase and Delivery dates, lead time
- Payment terms of the purchase
- Supplier and Buyer relative positions in the value chain
- Country of Manufacture / Origin
- Supply and Demand
- Competition