It is easy to fall into the trap of the “cost-plus” method. That is, to consider prices for consumer goods to be a function of the costs of production. Unfortunately, the cost-plus method of pricing is commonly taught to MBA students worldwide, thereby cementing a bureaucratic view of business and the economy.
Producer Costs Don’t Determine Prices
The fact is that prices are not a result of costs; it is the other way around. Actually, prices and costs are not even “set” by the same types of economic actors. Prices are ultimately set by consumers through their valuations of goods and services offered to them. Costs are, for each production undertaking, a choice based on the judgment of the producer. In other words, prices aren’t set by entrepreneurs and their businesses — they are discovered by them. Costs, on the other hand, are assumed by producers — chosen because they are estimated to be less than the anticipated price that the final good warrants on the open market.
The important choice whether to produce or not, therefore, is based, first, on the entrepreneur’s anticipation of what price can be charged for the final good (consumers’ price), and, second, on whether he can produce that good at sufficiently low cost to make it worth his while (his choice of cost).
Businesses that apply the cost-plus method therefore attempt to avoid being entrepreneurial. What they do is take costs as given and “choose” (using simple arithmetic, like costs plus 15% profit) what to put on the price tag. While the method is arguably faster, it sets the business up for failure in the open market. It is easy to see how the cost-based price can end up too high, thereby not catering to enough customers, or too low, thereby missing out on possible profits. The chance of getting it just right by adding markup to one’s costs is very small.
The Problem of Government-Granted Monopoly Power
There are two exceptions to this rule, however. One is interventionism, that is, when businesses operate in a regulated market. Regulated markets are different from open, free markets in that they have artificial barriers to entry: they redistribute costs of business to protect some incumbent firms by forcing the cost on (some) entrants. In other words, there are fewer new businesses and thus less competition.
Under interventionism, businesses do not always need to discover accurate consumer prices because the threat from new entrepreneurs entering the market is smaller than it otherwise would have been. So cost-plus might just work, especially if all or most protected incumbent firms are run by managers with the same type of management training. Competition won’t undermine their pricing decision as it would in a free market.
The other exception, which is of lesser force, relates to diversification or economies of scope, where an existing firm with existing and sufficiently profitable cost structure adds an additional production line of a similar (or even substitute) good. To the degree that the previous and similar good was sold close to consumer valuation of the good, the firm’s cost structure should already be sufficiently aligned with consumer valuation to allow for using the cost-plus shorthand (that is, using the same markup as discovered for the previous good).
Even so, the firm would likely lose out on possible profits by not adopting the proper entrepreneurial approach of “prices first, costs second.” In fact, what to a manager might appear to be an obvious and low-risk addition to the firm’s existing goods offering can, from an entrepreneurial perspective, be a potentially disastrous move.
When Managers and Bureaucrats Replace Entrepreneurs
Large corporations in interventionist “mixed economies” are commonly run by managers without much entrepreneurial oversight. Entrepreneurship in the sense discussed above is limited to the startup and growth stages of the firm, and is then relegated to the passive ownership of shareholders whose primary interest is in continued nominal profitability of the legal entity (the corporation). In highly innovative markets like technology, managers must take on the role of the entrepreneur by coming up with new products that require new production processes. For instance, Apple Computers’ decision to produce the iPhone was necessarily entrepreneurial — not because Steve Jobs wanted to stay away from cost-plus arithmetic, but because there was no available information relevant to this new type of good.
Cost-plus, in other words, only “works” when there is little innovation (dynamism) in the market, that is, in an interventionist market with high barriers to entry. And even then, it is bounded by (limited) entrepreneurial judgment — the cost-plus method is actually only used by firms when the calculated price isn’t obviously outrageous.
A recent example of the cost-plus method, and therefore the lack of entrepreneurship, is how prices of imported goods shift with fluctuating exchange rates. In a market without barriers to entry (but keeping fluctuating exchange rates), the price of consumer goods in stores in the United States would not go up as the dollar gets weaker, or vice versa.
Had the producers of, for example, Irish grass-fed butter been run as entrepreneurial businesses, they would have estimated consumer valuations of their products first and then chosen the appropriate cost structure for the preferred quantity. As domestic consumer valuation of butter doesn’t change with a stronger dollar (at least not in the short term), the appropriate price for the anticipated sales quantity remains the same.
In other words, in a free market we would not see exchange rate fluctuations reflected in the price charged in stores. But we do, at least in response to significant and sustained differences in exchange rate, even though it is often with a lag (which hints at how producers don’t fully rely on the cost-plus method). An entrepreneurial business in a competitive setting, in contrast, would adjust the only thing that is truly variable: their cost structure. They wouldn’t be able to up the price.
Using cost-plus as a pricing method, even if only as a rule of thumb, is symptomatic of a lack of real market forces — or poor judgment on the part of management. Had it been used in a free market, those actors would quickly be forced to exit. The only reason it at all seems reasonable is that the market is not free and people in business thereby can get away with not understanding the market. In fact, the cost-plus method relies on the very reverse of true market pricing, and places the power over the production apparatus in the hands of corporate bureaucrats. The satisfaction of consumer wants is secondary.
This article was initially published on Mises.org.