It’s human nature to stick to the status quo, even when the facts are laid out before us.
For centuries, people believed the sun — and the rest of the galaxy, for that matter — revolved around the Earth. It wasn’t until about 500 years ago that Copernicus, Kepler, and Galileo theorized and provided evidence that the earth orbits the sun. Despite centuries of research, studies, and, heck, proof straight from space exploration at our fingertips, some remain unconvinced. In fact, one in four Americans still think the sun revolves around the Earth. Let that sink in for a moment.
In economics, it’s just as hard to sway someone who is set in his or her ways. Basic economics is deceptively simple. The concept is easy to understand, but companies ranging from international corporations to local mom-and-pop shops still get it wrong. They let cost determine the price of products rather than the other way around. In turn, they’re missing out on hefty profits.
‘Cost Plus’ Is a Path to the Poorhouse
When it comes to pricing products, many entrepreneurs think in a linear fashion. They create a product, base its price on development costs, and take it to market. Their actions are largely based on anticipated outcomes.
In reality, humans are rarely linear. There are numerous variables that determine consumer tastes and willingness to buy, and any one of them can change at the drop of a hat.
Business schools frequently harp on the “cost plus” method as the gold standard of product pricing. In this scenario, an entrepreneur imagines a product that solves a problem and hopefully appeals to a sufficient number of consumers. Based on her judgment, said entrepreneur produces the product; tallies up the material, labor, and operating costs; and sets a price that generates some sort of profit.
The problem with the “cost plus” method — also known as the “production linear” model — is that our entrepreneur must assume production costs before she knows whether said undertaking is worthwhile. Practically no production happens because entrepreneurs blindly have a bunch of resources they combine to create products people want. When a product is successful, there’s a good chance Lady Luck played a role.
“Cost plus” is only workable for incumbent firms in markets they’ve already mastered. They simply amend their production structures to produce variations of existing or new (but related) products. For countless other companies, “cost plus” is a ticket to Trouble Town.
Consumer Value Should Fuel Operations
In the same way Copernicus, Kepler, and Galileo provided the foundation for heliocentric theory despite staunch opposition, we must flip the script on the “cost plus” standard. Determining whether a product is “worth” producing — in short, whether it can be profitable — boils down to the price consumers are willing and able to pay for it.
Through the “value based” method, an entrepreneur gets down in the trenches with prospects to research and figure out what a solution to a given problem might be worth financially to consumers. Our entrepreneur can then use that information to determine the exact functionality of the product and how to produce it in a way that turns a profit while meeting consumer financial constraints.
When price is determined by consumer value, the main business choice becomes the cost structure of production. This flies in the face of the “cost plus” model drilled into the heads of countless MBAs.
Think about the iPhone. Would Apple have invested in touch screens and mobile software without knowing it would be able to sell the final product at a price that would cover its facilities, labor, and materials? Of course not.
Apple had a product idea and then estimated what consumers would be willing to pay for different configurations and features. It then used that assessment to inform how much it could spend to produce those products at different volumes. Apple estimated demand before deciding whether to invest in the new device and which features to include.
The “value based” method works even if someone is trying to launch a company in an established market. Let’s say an entrepreneur wants to open a dry-cleaning shop. Before deciding what to charge for services, she would want to check out competitors to determine the market rate. That research will help her create a budget to see whether the business is worth her time. It would be pretty reckless to go to the bank, withdraw her nest egg, and start a business without estimating whether the costs will be less than the price she can charge.
The same scenario is true of large corporations that expand their product offerings. Procter & Gamble has had tremendous success, but the company doesn’t simply start producing a new product and pray consumers will like it. P&G does extensive market research to figure out what consumers want, how they want it, and what they’re willing to pay. The choice to produce a new detergent or dish soap is based on the price P&G imagines it can charge for the product.
Making the Switch
Whenever I tweet about this topic, I get quite a bit of push back. People frequently reply to suggest I had a typo or was confused about economics. Yeah, not so much.
After decades of studying companies in all industries, I’ve seen the financial consequences that come when entrepreneurs rely on the “cost plus” method. When companies base prices on their own investment, they completely disregard consumer needs. Consumers will respond in kind by keeping their wallets closed.
For entrepreneurs, it’s no longer economically reasonable to rely on the “cost plus” method when pricing products. Much like the shift from geocentrism to heliocentrism — at least for three-fourths of Americans — we sometimes must take a hard look at the facts and adjust our way of thinking. As for business owners who don’t? They’ll quickly learn the world doesn’t revolve around them.
Per Bylund is Assistant Professor of Entrepreneurship and Records-Johnston Professor of Free Enterprise in the School of Entrepreneurship at Oklahoma State University. His areas of research are entrepreneurship, management, and economic organization. Connect with him on Twitter.