The hardest principle for many business decision makers to accept is that only avoidable costs are relevant for pricing. Avoidable costs are those that either have not yet been incurred or can be reversed. The costs of selling a product, delivering it to the customer, and replacing the sold item in inventory are avoidable, as is the rental cost of buildings and equipment that are not covered by a long-term lease. The opposite of avoidable costs is sunk costs — those costs that a company is irreversibly committed to bear. For example, a company's past expenditures on research and development are sunk costs since they cannot be changed regardless of any decisions made in the present. The rent on buildings and equipment within the term of a current lease is sunk, except to the extent that the firm can avoid the expense by subletting the property.
The cost of assets that a firm owns may or may not be sunk. If an asset can be sold for an amount equal to its purchase price times the percentage of its remaining useful life, then none of its cost is sunk since the cost of the unused life can be entirely recovered through resale. Popular models of airplanes often retain their value in this way, making avoidable the entire cost of their depreciation from continued use. If an asset has no resale value, then its cost is entirely sunk even though it may have much useful life remaining. A neon sign depicting a company's corporate logo may have much useful life remaining, but its cost is entirely sunk since no other company would care to buy it. Frequently, the cost of assets is partially avoidable and partially sunk. For example, a new truck could be resold for a substantial portion of its purchase price but would lose some market value immediately after purchase. The portion of the new price that could not be recaptured is sunk and should not be considered in pricing decisions. Only the decline in the resale value of the truck is an avoidable cost of using it.
From a practical standpoint, the easiest way to identify the avoidable cost is to recognize that the cost of making a sale is always the current cost resulting from the sale, not costs that occurred in the past. What, for example, is the cost for an oil company to sell a gallon of gasoline at one of its company-owned stations? One might be inclined to say that it is the cost of the oil used to make the gasoline plus the cost of refining and distribution. Unfortunately, that view could lead refiners to make some costly pricing mistakes. Most oil company managers realize that the relevant cost for pricing gasoline is not the historical cost of buying oil and producing a gallon of gasoline, but rather the future cost of replacing the inventory when sales are made. Even LIFO (last-in, first-out) accounting can be misleading for companies that are drawing down large inventories. To account accurately for the effect of a sale on profitability, managers should adopt NIFO (next-in, first-out) accounting for managerial decision making.
The distinction between the historical cost of acquisition and the future cost of replacement is merely academic when supply costs are stable. It becomes very practical when costs rise or fall. When the price of crude oil rises, companies quickly raise prices, long before any gasoline made from the more expensive crude reaches the pump. Politicians and consumer advocates label this practice “price gouging,” since companies with large inventories of gasoline increase their reported profits by selling their gasoline at much higher prices than they paid to produce it. So what is the real incremental cost to the company of selling a gallon of gasoline?
Each gallon of gasoline sold requires the purchase of crude oil at the new, higher price for the company to maintain its gasoline inventory. If that price is not covered by revenue from sales of gasoline, the company suffers reduced cash flow from every sale. Even though the sales appear profitable from a historical cost standpoint, the company must adding to its working capital (by borrowing money or by retaining a larger portion of its earnings) to pay the new, higher cost of crude oil. Consequently the real “cash” cost of making a sale rises immediately by an amount equal to the increase in the replacement cost of crude oil.
What happens when crude oil prices decline? If a company with large inventories held its prices high until all inventories were sold, it would be undercut by any company with smaller inventories that could profitably take advantage of the lower cost of crude oil to gain market share. The company would see its sales, profits, and cash flow decline. Again, the intelligent company bases its prices on the replacement cost, not the historical cost, of its inventory. In historical terms, it reports a loss. However, that loss corresponds to an equal reduction in the cost of replacing its inventories with cheaper crude oil. Since the company simply reduces its operating capital by the amount of the reported loss, its cash flow remains unaffected by that “loss.”
Unfortunately, even levelheaded businesspeople often let sunk costs sneak into their decision making, resulting in pricing mistakes that squander profits. The case of a small midwestern publisher of esoteric books illustrates this risk. The publisher customarily priced a book at $20 per copy, which included a $4 contribution to overhead and profit. The firm printed 2,000 copies of each book on the first run and normally sold less than half in the first year. The remaining copies were added to inventory. The company was moderately profitable until the year when, due to a substantial increase in interest rates, the $4 contribution per book could no longer fully cover the interest cost of its working capital.
Recognizing a problem, the managers called in a pricing consultant to show them how to improve the profitability of their prices in order to cover their increased costs. They did not expect the consultant's recommendation that they instead run a half-price sale on all their slow-moving titles. The publisher's business manager pointed out that half price would not even cover the cost of goods sold. He explained to the consultant, “Our problem is that our prices are not currently adequate to cover our overhead. I fail to see how cutting our prices even lower — eliminating the gross margin we now have so that we cannot even cover the cost of production — is a solution to our problem.”
The business manager's logic was quite compelling, but his argument was based on the fallacy of looking at sunk costs of production as a guide to pricing rather than looking at the avoidable cost of holding inventory. No doubt, the firm regretted having printed many of the books in its warehouse, but since the production cost of those books was no longer avoidable regardless of the pricing strategy adopted, and since the firm did not plan to replace them, historical production costs were irrelevant to any pricing decision.
What was relevant was the avoidable cost of working capital required to hold the books in inventory.
If, by cutting prices and selling the books sooner instead of later, the publisher could save more in interest than it lost from a price cut, then price-cutting clearly would increase profit even while reducing revenue below the cost of goods sold. In this case, the publisher could ultimately sell all books for $20 if it held them long enough. By selling some books immediately for $10, however, the company could avoid the interest cost of holding them until it could get the higher price. shows the cumulative interest cost of holding a book in inventory, given that it could be sold immediately for $10 and that the cost of capital at the time was 18 percent. Since the interest cost of holding a book longer than four years exceeds the proposed $10 price cut, any book for which the firm held more than four years of inventory could be sold more profitably now at half price than later at full price.
EXHIBIT 9-2 The Cumulative Interest Cost of Holding a Book in Inventory
The error made by the business manager was understandable. It is a common mistake among people who think about pricing problems in terms of a traditional income statement.