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I talked to Douglas T Hicks, a pioneer in the use of Activity Based Costing for pricing. His latest book, Profitable Expectations, is a novel all about cost. We talked about the difference between cost and price, how to set your price, and the importance of the model in costing.
Here are three key terms used throughout this post.
1. Cost v Price
Cost and price are often used interchangeably, however, they are different. Cost is the total expense incurred when making a product or to deliver a particular service. When sold, the price is what someone then pays for the product or the compensation given for a service. The difference between the price and the cost is your profit.
So I’m talking about leverage in a negotiation setting rather than leveraging which is using debt finance. It’s the power and influence that one negotiating party has relative to the other. A supermarket has little to lose if you do not buy there, so sets the price of a loaf of bread, that you can’t negotiate. You need that loaf of bread to survive. In a future episode I will get in to the specifics of types of leverage and how understanding your cost position and the other party’s cost position can be beneficial when getting to an agreement.
3. Cost model
Let’s keep it simple. Cost models are a simplification of the real world to understand the cost of a product or a project. These can be simple equations or functions to complex mathematical algorithms, that might take into account specific tasks performed to produce a product, the cost of labour, equipment. Essentially cost models try to measure and quantify the likely time, effort and of course cost of the product or project.
Like all models, cost models simplify the real world to produce insights on likely future costs. Their accuracy is dependent on lots of different factors. Again, a future show will cover the accuracy of cost models!
Is there a link between Cost and Price?
Cost and price are (wrongly) used interchangeably, but is the price you set based on the cost to make the product or to produce the service in the first place.
No. The market decides the price. But if you have a new product, the idea is not to roll up your costs so that you can price a percentage above that to make a profit, because you might not have the right price for the market, you might under or overprice.
Cost is the Language of Negotiation!
Where does cost come into the picture then? Ok, we said that price is not based on cost, but they are related. They don’t directly influence each other. But, if you want to understand your position in your negotiation, your leverage, or even understand the position of your supplier or your customer, cost is the language of negotiation.
How do you set a price for a new product?
You want to understand your negotiating position, which is easier for a product which already exists in the market. You know what customers are willing to pay for it, what differentiates the various products and their relative prices might be readily available information. Likewise, but a bit more difficult to get a hold of sometimes, is supplier information such as their costs and the price they need to sell for. But what about new products?
For new products you might start off with trying to understand what you might price based on your costs. You need to understand your true cost, not deceiving yourself. Make sure you really understand the costs you are incurring for that product. This could be hidden if you have a certain way of costing your overhead for example.
Fom there it’s about your strategy, are you selling to make a profit, to get into the market as a loss leader to gain a market share? Knowing your strategy will start to help you understand what price you might be able to set. But it’s a starting point, which means you need to understand scenarios and to model these.
How do we model costs?
Some of you will have created your fair share of cost models, and many of you will know what models are in general. Right now we have access to a lot of data, and with more data should mean better models, right?
Well, a cost model should reflect reality. It’s not just about getting the good numbers to input into the model. If your model is wrong and the data is great, you can be precisely wrong. You then need the right data to help the model. Don’t just rely on plugging in more variables because the data is available. Measure the right things, the right things will change over time, your costs and cost drivers will change as the world changes.
One of the key takeaways for me is that, especially in this information age, how it’s important to have a set of principles to help you understand what things you should be modelling. More data availability might help with that, but it shouldn’t be relied upon to help you understand your costs.
There is so much data available to us now, but if we have no real standards to produce a model that reflects reality we could get stuck. Causality is the key in these situations, and having a set of principles is key to developing the right cost models.
Listen to the full interview with Doug in our podcast episode linked here. He has so much knowledge and experience, I’m hoping to get him back on the show in the future to discuss more in depth.
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One reply on “The Model is More Important than Data!”
Well written. As an economist, it drives me crazy when my non econ friends use cost and price interchangeably.