Read Peter Drucker, Case #3, “What is a Growth Company” in Management as a Liberal Art: A Selection of Readings, pages 75-76.
Many American and European firms set the price of a new product as the sum of the costs and the desired profit. This is known as Cost Plus Pricing. The rationale is that the company must earn sufficient revenues to cover all costs and yield a product. Peter Drucker writes: “This is true but irrelevant: Customers do not see it as their job to ensure manufacturers a profit. The only way to price is to start out with what the market is willing to pay.”
In Case #3, you will read about a company of bread and cakes that was bought by a large, publicly traded, private equity firm. How does Cost Plus Pricing figure into the issues that this bread and cake company faced? How can we put Drucker’s principle to work here?
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According to Blocher et al. (2019), cost-plus method refers to a method that determines the price based on the unit cost plus a predetermined gross profit percentage assuming that a company is supposed to earn enough to cover all costs and make some profits. In the case study, a bakery was acquired by a private equity firm which later was unsatisfied with the bakery’s low profit margin. The private equity firm was planning to make significant changes to the bakery so that it could meet its expected growth and profit goals. This is because the private equity firm had been using the cost-plus pricing across its investments.
In the bakery industry, as explained by the founding member of the bakery, the profits of the bakery are derived from being efficient, which brings probably insignificant but stable margins. Even though automation is likely to increase efficiency, it may not be cost-efficient to invest the capital to realize the automation because the pay-off may not be significant either. There is no promising demand with bread and cakes after adding the cost of automation to the selling price.
Peter Drucker’s principle regarding cost plus price explains the dilemma faced by the bread and cake bakery. It is irrelevant for customers to make sure that manufacturers can make profits when they make their purchasing decisions. They respond to the prices with their actions which varies based on the values of different types of products and services.
According to Blocher et al. (2019), cost plus pricing is an accounting method for setting up the selling price through adding the cost to the estimated gross margin which should be enough to cover all costs (including production and marketing) and make some profits. In the case “What is a Growth Company”, the bakery was using the cost plus pricing on their bread and cakes. Later on, the bakery was acquired by a private equity company. And the private equity company was not satisfied with its current gross margin. The bakery decided to cut the cost to increase the gross margin. However, in order to decreasing the cost, the bakery was thinking to use automated production to replace the human.
Unfortunately, the automation can not really decrease the production cost. In addition, customers will not change their attitude about the selling price just because the bakery starts to use automation. Just like what did Peter Drucker mention before, “This is true but irrelevant: Customers do not see it as their job to ensure manufacturers a profit. The only way to price is to start out with what the market is willing to pay.” I really think the bakery market is very stable nowadays, and there is very limited room to reduce the cost. As such, the bakery really should focus on the market to increase the sales volumes instead of focus on how to reduce the production cost.
Tags: business management Peter Drucker cost plus method gross profit percentage