“Perceived Cost Plus” as a New Pricing Mechanism

“Cost Plus” is one of the most basic pricing mechanisms for goods and services. Under this mechanism, the manufacturer calculates the Total Direct Cost of an item by adding its direct material, direct labor and direct overhead costs. To this, they add the sales, general and administrative overhead costs to arrive at the Total Cost. By loading a markup / margin to this Total Cost figure, they arrive at the Selling Price.

Many people I know tend to have an opinion of what an item should cost i.e. what it should cost for the manufacturer to produce the item. Let me call this “Perceived Cost”. For example, if they’re about to buy a writing pad, they’d quickly break it up into paper, cover page, stapling and binding and assign a cost to each of these “sub-items”. By adding up these costs, they’d arrive at the Perceived Cost. They’d then add a markup, which could range from 5% to 25% or even higher – depending upon their views on “profit motive” – and arrive at what they’d consider a fair price. If the actual selling price is close to this ‘fair price’, they’d conclude that the item is priced “reasonably”. If the actual selling price is way above (or way below) this figure, they’d tend to question the price or the genuineness of the product and put their purchase decision on hold.

Based on this sort of empirically observed consumer behavior, I am putting forth a new pricing mechanism in which a company arrives at the selling price by adding a certain markup to the ‘perceived cost’ (instead of the ‘actual cost’ as is the case in the traditional “Cost Plus” mechanism). Let me call this the “Perceived Cost Plus” pricing mechanism.

Will perceived cost equal the actual cost? Probably not.

In the following situations, perceived cost tends to be higher than the actual cost.

  1. Whenever a middleman is involved. Most buyers tend to conclude that a middleman introduces a layer that adds to the total cost.
  2. Buyers, especially in the lower economic strata or in developing economies, tend to think that things sold in an organized retail environment — such as a plush, air conditioned supermarket, with superior ambience — would cost more.
  3. Whenever goods have to be transported, especially across a country’s borders, buyers tend to ascribe a higher perceived cost.

However, buyers’ perceptions of higher costs is not always right. That is, actual costs in these situations could be lower than the perceived costs. Let’s look at a couple of examples.

Wal-Mart is perhaps the world’s largest middleman, buying from the manufacturer and selling to the consumer. Its plush stores offer better ambience compared to a typical mom-and-pop store (aka ‘kirana’ shops in India). Still, prices in Wal-Mart are lower than almost anywhere else.

Despite doomsday predictions made about the future of middlemen (distributors, dealers and retailers) at the height of the dot-com era of the late nineties, the fact is that most successful dot coms of today are not original manufacturers or service providers but middlemen like Amazon, Expedia, Travelocity, and so on. Web 2.0 leaders like Digg, Flickr, Jigsaw and YouTube offer virtually no content of their own. Instead, as middlemen, they provide the platform on to which users post and share content with one another.

All these middlemen have demonstrated a consistent track record of delivering lower prices — which is clearly contradictory to the widespread belief that costs would be high if a middleman is involved.

What gives?

Many middlemen are able to deliver lower prices due to economies of scale, trade promotion policies, lower overheads, and so on.

The pricing power wielded by middlemen is very well illustrated in the hotel industry where leading chains have been making announcements that they offer the lowest tariffs for rooms booked directly on their own (i.e. the hotel chain’s) websites rather than on the websites of middlemen. Some go a step further: for example, Hilton guarantees that if you do find a lower rate on some other booking channel, they’ll match that rate PLUS offer a $50 gift cheque for your trouble!

Click here to view Hilton’s guarantee.

Supermarkets that have opened up in India in the last one year provide another excellent example of offering products at lower prices than the ‘kirana’ stores. Despite being plush and air conditioned, these supermarkets were the first to actually sell products at ‘below MRP’. (As per government regulation, all packaged goods in India must display a so-called Maximum Retail Price or MRP, which is the highest price at which the item can be sold — by anyone, anywhere in the country. Until recently, nobody expected to buy a product lower than the MRP either. The recent spate of supermarkets have changed that).

The above examples clearly show that actual costs and selling prices are not necessarily higher when middlemen are involved. Let’s now take another example which, while illustrating the same thing, sounds a warning bell to marketers to take the concept of perceived cost seriously while formulating pricing policies or risk losing customers.

A couple of years ago, an emerging financial institution (FI) in India ordered a PC from its original manufacturer, which happened to be a large and reputed IT company. The FI never received the PC within the promised delivery period of four weeks. They got tired waiting for another two weeks and decided to buy another PC from the market. When they looked around, they found that they could buy the same model of the PC off-the-shelf from one of the dealers of the same IT company — and at a slightly lower price!. In other words, the middleman was able to supply the same item readily and at a lower price than the original manufacturer. You can imagine the shock of this FI when this happened.

What appears to be puzzling to a customer or the common man has a perfectly valid explanation: It has to do with pricing and dealer management policies like ‘First Dollar Rebates’, ‘Target Achievement Bonuses’ and ‘Over Target Achievement Bonuses’. FDR is the margin received by the Dealer on each unit starting from the first unit. If the Dealer achieves the quota, they get a TAB. If the Dealer exceeds the quota by a certain percentage, they earn an OTAB. In the computer hardware industry, FDR is typically 20%, TAB is 5% and OTAB is 2%. The important point to note is that TAB and OTAB are applicable on all sales during the quota period – not just on sales exceeding the quota. Therefore, it was possible for a Dealer to make money by selling the PC at a lower price to this FI than the original company’s discounting policy would have allowed it to sell to a new customer.

It’s obvious that the Dealer had the PC in stock and stood to earn TAB / OTAB by selling it to this FI at a higher discount than the discount to a new customer by the original company’s discounting policy.

However, the FI didn’t need to know all this. Because they felt very strongly that prices should be higher when a middleman is involved, they thought the IT company was fooling around with them. They got so pissed off that they blacklisted the company for all their future hardware purchases … a fate that the IT company could have avoided had their marketing professionals adequately heeded customer perceptions regarding costs while formulating their pricing and dealer management policies.

In this article, I have introduced the concept of “Perceived Cost Plus” as a new pricing mechanism. In a future article, I will discuss its applications for a few specific products and services. Stay tuned.

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