Unfortunately, accounting statements can often be misleading. One must approach them with care when making pricing decisions. Let us further examine the publisher's error presented above, and others, to better understand the pitfalls of accounting data and how to deal with them. By accounting convention, an income statement follows this form:
This can lead managers to think about pricing sequentially, as a set of hurdles to be overcome in order. First managers try to get over the gross profit hurdle by maximizing their sales revenue and minimizing the cost of goods sold. Then they navigate the second hurdle by minimizing selling expenses, depreciation, and overhead to maximize the operating profit. Similarly, they minimize their interest expense to clear the pretax profit hurdle and minimize their taxes to reach their ultimate goal of a large, positive net profit. They imagine that by doing their best to maximize income at each step, they will surely then reach their goal of a maximum bottom line.
Unfortunately, the road to a profitable bottom line is not so straight. Profitable pricing often calls for sacrificing gross profit in order to reduce expenses further down the line. The publisher in our last example could report a much healthier gross profit by refusing to sell any book for less than $20, but only by bearing interest expenses that would exceed the extra gross profit, leaving an even smaller pretax profit. Moreover, interest is not the only cost that can be reduced profitably by trading off sales revenue. Discount sales through direct mail often save selling expenses that substantially exceed a reduction in sales revenue. While such discounts depress gross profit, the greater savings in selling expenses produce a net increase in operating profit. Discounting for a sale prior to the date of an inventory tax may also save more on tax payments than the revenue loss.
Effective pricing cannot be done in steps. It requires that one approach the problem holistically, looking for each trade-off between higher prices and higher costs, and cutting gross profit whenever necessary to cut expenses by even more. The best way to avoid being misled by a traditional income statement is to develop a managerial costing system independent of the system used for financial reporting, as follows:
The value of this reorganization is that it first focuses attention on costs that are incremental and avoidable and only later looks at costs that are nonin-cremental and sunk for the pricing decision. In this analysis, maximizing the profit contribution of a pricing decision is the same as maximizing the net profit, since the fixed or sunk costs subtracted from the profit contribution are not influenced by the pricing decisions and since income taxes are determined by the pretax profit rather than by unit sales.
One could not do such a cost analysis simply by reorganizing the numbers on a traditional income statement. The traditional income statement reports quarterly or annual totals. For pricing, we are not concerned with the cost of all units produced in a period; we are concerned only with the cost of the units that will be affected by the decision to be made. Thus, the relevant cost to consider when evaluating a price reduction is the cost of the additional units that the firm expects to sell because of the price cut. The relevant cost to consider when evaluating a price increase is the avoided cost of units that the firm will not produce because sales will be reduced by the price rise. For any managerial decision, including pricing decisions, it is important to isolate and consider only the costs that affect the profitability of that decision.