Cost and Price

A Treatise on Pricing
By Paul Herbig


Price and cost are complex concepts. They can be simplified as to say price is the final value that is exchanged between two parties. Cost can be simplified as what it takes to make something. But saying it and doing it are entirely different items.
Cost is basically an accounting term. Costs derive from two different sources: variable cost (those costs that deviate with changes in the level of output) and fixed costs (those costs which would be place even if no units were produced and that do not deviate with output--such as administration salaries and facility rent). Which costs fall into which category can be disputed. Although an entire discipline (accounting), government entity (IRS) and an entire set of regulations exist concerning costs, still determining the exact ‘cost’ of an item turns out to be an exercise in assumptions and guesses.
To complicate matters, price is often an extension of cost. To many laymen, the final price often appears to be outrageous when compared to the initial cost of producing the item. For example, pharmaceutical manufacturers have been heavily criticized by consumer advocates for pricing their drugs as high as they do. The variable costs involved in the manufacture of a pill could be as low as pennies (or less) per pill. So, says the consumer advocates, how can the companies justify charging a dollar or more per pill, a hundredfold market-up. The reality is different. The company may have well spent hundreds of millions of dollars on research, development, testing, regulatory approvals, and manufacturing equipment to enable it to produce the drug. In economic terms, the first pill cost $200 million, the second pill 5 cents, and so on. But since no one is going to pay to recoup the cost of the first pill, the entire fixed costs must be prorated among all the pills. Even at a billion pills, it amounts to a fixed cost per unit of 20 cents. When added to the variable cost, the ensuing cost of 25 cents compared to the selling price is not extraorbitant. Examples in other industries are readily found: semiconductors (where the costs of building plants now are estimated in the billions of dollars) and telecommunications (infrastructure costs) are just two.
Still, to compare price to the COG (cost of good) even acknowledging the cost includes both variable and fixed costs, is not a true indicator. Physical distribution costs (transportation, warehousing) average nearly 8 cents on the revenue dollar. Overhead activities not directly related to the production of the good must be included (administration, sales and marketing). Marketing costs can be huge. For example, General Mills spends 33 cents of every revenue dollar in marketing; its competitors spend nearly the same proportion. For consumer products, advertising and promotional expenses are often 15-20 percent of sales revenues. These costs must be factored into the equation. Then distribution costs must be included: traditionally retailers set their prices as double the manufacturer’s price. If a wholesaler or industrial distributor is included, their margins must be calculated. And if all of these costs are not enough, the company still has to make a profit and that profit margin must be included. With these factors in mind, it is not unreasonable for a product with a variable cost in pennies to be priced twenty fold at the retail transaction.

Examine the cost-price relationship of a product such as a Pepsi drink. Twelve ounces of Pepsi is basically some syrup with the rest carbonated water. Total price could not be more than pennies. Yet put it in a can and sell it retail (Scotts has advertised a 24 can pack for $5.00 or approximately 20 cents a can). Place the same can in a vending machine for 50 cents or more. A fast food outlet will sell the equivalent amount in a paper cup for 85 cents (adding ice to create more volume). The same can in an upscale hotel room refrigerator “honor” bar can sell for $1 or more. And movie theaters and sporting events can charge even more. Twenty times or more for the basic cost of selling the item. And consumers will buy it. How can they do so? Because there are other ingredients involved in price than just the basic product. Pepsi spends extraorbitant amounts in marketing, advertising, and promotion on the product (perhaps not at the same rate as General Mills but still 15-20% of revenues). Distribution costs must be added (the retailers mark-up and the vending machine operator’s costs). These costs are often several times that of the basic product costs. The difference in prices can be attributed to convenience (for vending machine and honor bars and events). Therefore, just comparing basic product costs to final selling price cannot be made without including a considerable list of other cost elements and customer buying influences.

Cost is an accounting term; Price is a marketing term based upon what the market will bear. Keep them separate.