‘Price is what you pay. Value is what you get.’ – Warren Buffett
Last week we brought out the need for the entrepreneur to have a captive costing method and a wise pricing model in their business. To be able to achieve these dual objectives, we need to understand the difference and relationships between the trio of value, cost and price.
Value: The value your business creates is about the features of the product (goods and/or services) it produces or provides. From a customer’s point of view however, value is a measure of the benefit that is derivable from a product. As a business, therefore, you have not created any value if the customer doesn’t not see any benefit in your product for which they will be willing to pay a price. Furthermore, value is personal and about the worth the customer attributes to a product which can differ from one person to another. At an auction, we see an artwork ultimately purchased for a couple of millions of dollars by a particular collector when some of those who participated in the auction had already dropped out at a just few hundreds of thousands of dollars.
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The entrepreneur must be clear about the features of their product that give it a selling proposition. Which features of your product are actually valued by the customers? Which features add to product costs but aren’t valued by the customers? A core objective is to always ensure that the sum of the costs of the input value a business brings from outside and the input value it creates/adds inside is less than the value of the final product it delivers to the market as shown below.
Cost: Costs can be broken down into ‘direct’ and ‘indirect’. Direct cost (‘DC’) are all the costs associated with the direct manufacture of a product on the factory floor. They comprise of direct materials (‘DM’) costs and direct labour (‘DL’) costs. Direct materials refer to all the materials that go into the manufacture of your product by applying direct labour and factory overheads (‘FOH’). For a shoe production business, that will include the hide, the thread, the wood, and other accessories that go directly into the shoe. Direct labour refers to all the labour on the factory floor that are involved in directly manufacturing the finished goods from raw materials. Direct labour costs include the salaries, wages and benefits that are paid to this labour force. Factory overheads refer to indirect expenses related to manufacturing the finished product, but which are not easily or directly traceable to a unit of production. Factory overheads comprises of indirect materials (‘IDM’) such as grease for machinery; indirect labour (‘IDL’) such as factory quality assurance staff, production supervisors, etc.; and other factory overheads (‘OFOH’) that fall neither under indirect materials and nor under indirect labour. They may include, for instance, factory equipment depreciation. Finally, we have another class of indirect costs called the selling, general and admin (‘SGA’) expenses. Understanding your business cost composition and structure is fundamental to developing your business strategy. How does your cost compare to that of your competition? Which costs can you cut out or reduce to a barest minimum? How do certain cost elements trigger increments in your sales revenue? There are different costing methods, such as process costing, product costing, batch costing, project costing, etc. Each may be more appropriate for one type of businesses or situation than another.
Price: The price of your product is the currency value which your customers pay to acquire the product you offer. It is your financial ‘reward’ for providing the product. But it should be noted that the market price you are paid may be higher or lower than the value a customer actually attributes to the product. For instance, a customer may gladly pay you five thousand Naira, being the market price, for the pair of shoes you produced but are, perhaps, actually willing to pay seven thousand Naira if that was the price. In such a situation the value of the shoe to them is higher than its market price. On the other hand, they may also purchase the same shoe at the five thousand Naira only begrudgingly because there is no alternative. But left to them the pair shouldn’t be worth more than three thousand Naira. In this situation the customer values your product less than the market price.
There are different ways businesses price their products based on pricing objectives and pricing strategies. The objectives might be profit-related, sales-related, competition-related, customer-related, etc. The strategies, on the other hand, include cost-plus pricing, market-oriented pricing, and dynamic pricing.
Profitability and wealth creation depend on the value you create, the value as perceived by the customer, the cost at which you create the value and the price at which you are able to sell the product. Next week, this series will take up costing methods and pricing strategies, mentioned above.
