The Pricing Death Spiral

Today I wanted to write about perhaps one of the most important lessons I learned in managerial accounting (as opposed to financial accounting), and it is something that I have seen improperly applied in many organizations (both profit and non-profit). It can be a very subtle concept related to accounting and pricing, but it can have very bad effects. The situation is called the "pricing death spiral".

Imagine a company that manufactures and sells gumballs. Suppose that the gumball company produces and sells 100,000 gumballs a year. The cost of manufacturing each gumball is $0.01 per gumball and the sales and marketing costs are $1,000 per year. No other costs apply. If one tries to unitize sales and marketing costs, over the number of gumballs produced, the sales and marketing costs are an additional $0.01 per gumball. If the company sells the gumballs at $0.02 per gumball, it makes no profit.

Now suppose that that sales are falling and so the company only produces and sells 50,000 gumballs in a year with the same sales and marketing costs. Now sales and marketing costs are double when one looks at the per gumball price. Costs are then $0.01 per gumball (manufacturing) and $0.02 per gumball (sales and marketing). So the company needs to raise prices to $0.03 per gumball just to breakeven. Herein lies the death spiral of pricing. Raising prices in this context artificially creates less demand for products, and thus, fewer sales. Weak sales seem to generate higher costs which causes higher prices which creates less demand and even weaker sales, etc. If the company (incorrectly) tries to unitize the sales and marketing costs across the gumballs produced and then folds that into the pricing of its products, it can wind up in a self-reinforcing situation where it is raising its prices despite falling demand and without regard to the competitive environment.

Some variations of death spirals I have seen in organizations I’ve worked with:

• a non-profit child care center has low enrollment (below breakeven) and raises monthly fees for next year’s class to amortize the administrative office costs across all children
• a professional services firms prices its services too high because it spreads out the costs of G&A of all areas of the business into the cost structure of a services group of a smaller division of the company (which in turns creates less demand for services and fewer subcontractor partnerships than optimal)
• the standard costing for a construction job is based on amortizing the entire cost of the field force the number of jobs performed – in a weak construction season, the next year’s costs are calculated to be too high to feed the pricing equation.

While the realities of an organization’s financials may dictate how closely cost structure should affect pricing, the error in the above pricing methods come down to this: the organization needs to separate out fixed costs (or sustaining costs) from variable costs. The organization also needs treat excess production capacity (or in the opposite case production levels in excess of normal operating levels) separate from unit costs.

Thus, in the example I had above on the child care center, rather than calculating the cost of providing care for a child by spreading out all G&A costs over the number of children enrolled, a unit cost per child should be calculated by spreading out a proportion of G&A by the child care center’s normal operating capacity. When the child care center runs below normal operating capacity, it runs a temporary loss equal to the costs times the number of children below normal operating capacity. The shortage in income could be made up by assessing the families of the children by a monthly (or lump sum) fee. One key benefit of pursuing this latter pricing mechanism is that the price of low sales is separated from the cost of production. Families of the children are only assessed fees to cover temporary shortages in enrollment, and the situation does not evolve into a case where the "permanent cost structure" is raised (thus forcing ongoing prices to be raised excessively).

The other cases of pricing errors I describe above are a little more subtle. In the second case, the error is that the company should again calculate variable unit costs for producing individual business unit services. While spreading out G&A for the business unit itself may be less suspect, spreading G&A from the entire corporation may be excessive (although computationally convenient) and should be viewed as a sustaining cost for the business. In the third case, the construction company would be better to allocate a portion of G&A to the individual job cost structure presuming that the construction company is operating at healthy levels.

So while there is no single, silver bullet for avoiding a pricing death spiral, first steps are recognizing the situation and then separating out the considerations so that more accurate responses can be taken (i.e., if production problem then solve production problem, if sales problem then solve sales problem -> improper accounting can mask the problem at hand). If one finds that the price of one’s products or services have more to do with the size of the finance organization in your company that the manufacturing or services costs, this may be a good warning sign.