Price Taker or Price Maker – Cost Matters

A frequent refrain of businesses is “there is no need to understand the cost (of the product, service, process, line of business, division…), because the market sets the price”.  The market may indeed set the price – usually there is somewhat of a range to the market price which relates to elements of business that include service, quality, location, image/brand, and other tangibles and intangibles.  Whether your business is a price taker (market sets the price – commodity products) or a price maker (you set the price), the cost of what you are selling does matter.

How Does Cost Matter?

Cost has an impact in a number of ways, including the following:

  1. The Gross – How much you make on a sale, excludes the operational expenses of being in business – gross margin
  2. The Net – How much you make on a sale includes the cost of operations, sales, and administration – all the expenses of the business – profit margin
  3. The Contribution – How much a business activity adds to or drains resources from the business – return on assets and return on investment

For most businesses there is opportunity for improved financial performance at all levels of results through gaining an understanding of the numbers – the cost of a sale, the cost of a customer, the cost of a project, the cost of doing business – in the aggregate and at a more detailed level – where the profits are decided with each deal.

What is included in “Cost”?

Every product, activity, process, or resource has a direct cost associated with it.  The direct cost is the total of all the inputs required to generate that item.  The direct costs would not exist without the “root cause”.

In addition to the direct costs necessary to generate an activity, product, or process, there are costs which are shared across the organization.  These indirect costs are the “overhead” and “general and administrative” costs of being in a line of business, having a group of activities, or simply because the organization exists.  These activities and their associated costs benefit (or burden) everything the organization is or does.

Benefit or Burden – The “Cost” of Business

Whether a cost is viewed as a benefit or a burden depends upon the return generated by the cost.  If a dollar is invested in equipment which increases the capacity to produce goods the market wants and is waiting for, then the equipment is of benefit.  If that same piece of equipment is purchased and used but doesn’t increase capacity or produce goods the market wants, then it adds to the “burden” of costs the business must fund through activities other than the sale of goods to the customer.

That same piece of equipment, when run under maximum efficiency may reduce the cost on a per-unit basis.  On the other hand, if it is poorly managed and quality is low or rejects are high, the equipment can increase the cost of each unit produced.

The Cost/Price Impact

The costs of “production” impact how much gross margin and profit are made per unit and overall.  If you are able to price your product on a cost and margin basis – where the cost of the product determines price – then cost is important, but profits are somewhat insensitive because price will increase as costs rise. You are essentially a price maker.

If, on the other hand, you are a price taker, the market sets the price and the operation determines its efficiency in producing the product.  Controlling costs decides how much, if any, profit results.

Price Maker or Price Taker: Who Decides

Whether you are or will be a price maker or a price taker depends upon many factors.  These factors are both internal and external to the business.  For instance, if you are producing a new technology – how much someone is willing to pay is a function of:

  • The amount of pain or degree of need the customer has
  • The number, type, and cost of alternative solutions available
  • The degree of risk associated with changing how things are currently done
  • The degree of risk perceived or real with dealing with new technology provided by a new business
  • The value perceived by the customer and the market

Notice – the cost of producing the new technology isn’t in the list.  From a market prospective, your cost has little to do with what a customer is willing to pay.  If you are selling a new technology, what matters to the customer is the value to him/her.  The value equation contains cost and benefit elements from the customer’s perspective, but not YOUR perspective.

Becoming a Price Maker

If you want to be a price maker, then you must be able to convince your customers of the value – the benefit versus the cost – of your product.  The customer who sees benefit and return on investment in acquiring your technology will still have an acceptable range of price, but that range will differ substantially from a customer who perceives your technology as “the same” as the current range of product options or “riskier” than current options or doing nothing.

Price makers are able to educate, inform, and persuade the market that their particular product has value, quality, impact, differentiation, results, and more than the other alternatives.  Price makers have an element of branding, marketing, and product features which enable them to position not on price but on form, function, and uniqueness.

To become a price maker, begin by understanding your market and its needs.  Does the market recognize the need for another solution?  Has it been searching for “the answer”? Or is your potential market “getting by”, “making do”, and “resisting change”?  Are the market players currently price takers or are they price makers?  Who are the market leaders and how do they compete?

Price makers can enter markets which have been commodity (price taker) and succeed.  They do so by moving the market through innovation, education, and disruption.  Disruptive technologies and business models are most visible in the “retail” market – Starbucks and Google, for instance.  Few markets exist which aren’t vulnerable to disruptive technologies, products, or business models.  The key is to understand the impact of how you do business, your cost structures, and how your markets work.

Copyright © 2007 F.O.C.U.S. Resource, Inc.

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