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The Demise of Gross Margin Pricing : ICMS – Success is NOT Logical
The Demise of Gross Margin Pricing
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9 August 2013 - 23:24, by , in Customer Profitability Analysis, No comments

Are you still pricing your products or services to achieve a specific gross margin percentage. If your answer is yes, you had better watch out. Your competition may have just gotten smarter and switched to a more insightful method called Activity Based Cost pricing. Let me explain.

Manufacturers, distributors and retailers have used for decades a pricing method based on gross margin. Here’s how gross margin pricing works:

  1. 1. Lets assume your company’s operating overhead costs are 30% of total sales revenue. Lets also assume that you desire a pre-tax profit of 5% for your company.
  2. 2. Marketing proposes a new product that will cost $25.00 to manufacture or purchase.
  3. 3. Using the gross margin pricing method, you would set the sales price at $38.50 to achieve a 5% pre-tax profit. The $38.50 is calculated as follows: $25.00 is divided by 65% e.g. (100% minus 30% overhead minus 5% profit = 65%).

Gross margin pricing is a simple method that has been used for decades. Yet more and more companies are switching to ABC pricing. Let me explain using the following story……

President: “I really love the new product you have proposed, but I’m afraid that we can’t add it to our product line.”

Marketing: “Why? Don’t you think our customers will buy it?”

President: “Yes, I think they would. But I don’t think they’ll pay $38.50 for it.”

Marketing: “Then why don’t we sell it for less than $38.50?”

President: “We can’t because our overhead costs are 30%. Unless we make a 35% gross margin, we’ll lose money on every one we sell.”

Is the president’s argument reasonable? To answer that question, we must review the basic set of assumptions that serve as the foundation for gross margin pricing. Gross margin pricing, as depicted in the story above, was logical and reasonable when manufacturers, distributors and retailers had (1) a small number of products; (2) a small number of customers; and, (3) overhead costs were relatively small and totally unrelated to the products sold or customers served. When these three conditions exist, gross margin pricing works well.

The basic conditions necessary for accurate gross margin pricing no longer prevail. The majority of today’s business owners (1) offer an ever increasing variety of products and services; (2) serve a larger customer base that have diverse service demands; and, (3) now have overhead costs that often exceed the cost to produce or purchase the product. The best method to define prices when these three economic factors exist is called ABC pricing.

ABC pricing disregards gross margin. Instead, ABC considers total cost, no matter where costs are currently reported on the P&L. Here’s how ABC pricing works:

  1. A. A Bill of Activity is created that lists all the activity costs directly traceable or consumed by the product, service or customer.
  2. B. Non-traceable business sustaining activities, such as “Do Monthly Closing”, are then allocated to the Bill of Activity.
  3. C. Traceable costs + Non-traceable costs + Profit = Sales Price

An ABC Bill of Activity reflects total product cost, regardless of whether the cost is currently reported above or below the gross margin line. For example, lets assume that the new product proposed by Marketing in our story above is a purchased finished good produced by a TQM manufacturer. Non-value added activities such as “Inspect Receipt”, “Expedite Order”, and “Return Product” will not be consumed by this new product. By excluding these activity costs from the ABC price calculation, it is possible to sell the new product for less than $38.50 and still achieve the desired 5% profit. Under the old gross margin pricing methodology, these non-value overhead costs would have been assumed as being a cost of doing business for every product.

Here are a few other benefits provided by ABC Bill of Activity pricing:

  1. ABC reports value versus non-value added cost. You may want to exclude non-value added costs from a bid if a plan exists to eliminate the waste.
  2. ABC can report both “as is” costs as well as practical capacity “to be” costs. You may want to set pricing based on what costs can be if you win incremental new volume business.
  3. ABC Bills of Activity lists the highest activity cost to the lowest. ABC serves as a terrific tool to prioritize cost improvement targets and action plans.
  4. ABC Pricing financially quantifies and exposes the higher cost of purchasing low quality raw material or products e.g. low cost versus cheap.
  5. ABC pricing exposes that gross margin pricing was overcosting high volume product/services/customers and undercosting low volume products/services/customers.

Should you convert to ABC pricing? The answer is most likely yes. Even if your current costing/pricing method is relatively accurate, ABC will still provide you important new decision making and profit improvement facts. While the marketplace will always influence pricing, the most successful organizations today are those that fully understand their costs. You can ill afford to overprice high volume products and underprice low volume specialty items in today’s marketplace.

Does ABC pricing really work? For an answer just ask Tom Sherry, VP of Sales & Marketing for Owens & Minor, one of America’s largest medical products distributors. He stated at a 1996 health industry executive conference “We have successfully demonstrated the benefits of ABC. We are replacing gross margin pricing with ABC.” If you recently said “I can’t believe our competition is selling at that price!”, it may be because your competition has switched to ABC pricing. Your competition may be setting prices based on total costs, not just gross margin costs.

Don’t take our word for it. Try a simple test. Take a cross section of your current products, services, or customers and compare their ABC Bill of Activity costs to your existing pricing method. You’ll be pleasantly surprised at the insight and improved accuracy provided by ABC.some Bill of Activity examples, simply give me a call at 817-475-2945. It may be the most important call you make this year.

For a free Gross Margin Profiling template, e-mail Tom Pryor at: tompryor@icms.net.

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