When Pricing Low Makes Sense

There are many reasons that should cause your company to justify, and then charge, premium prices for technical services, engineered products, and other value-added deliverables. You should be hesitant to lower your pricing for “strategic” opportunities, as this usually results in a one-time, low-priced order, with significant potential to generally lower the overall price levels for your company and the competition. When business is slow, however, strong consideration should be given to a lower pricing tactic, on a case-by-case basis. If you have excess capacity, including floor space, machines and equipment, and personnel, for which you are paying, the revenue lost for each day that goes by where they are idle can never be recovered.

It can make sense to price the work as low as even $1 above your marginal cost of production in order to bring the work in house. Your marginal cost is the sum of the materials you must purchase or take from inventory, and the cost of directly applied productive man-hours of your hourly employees, plus any other subcontracted services necessary specifically for this order. It does not include supervisory personnel, overhead, burden, liquidation accounts, or any other “sunk” cost that you will pay whether or not the capacity is utilized.

A common accounting approach is to “liquidate” overhead costs in a manufacturing facility or industrial services business by taking the total projected overhead costs (or burden) for the accounting period (month or year), and dividing it equally among each projected direct labor hour for that same period. Overage or underage in the estimates are trued up on a periodic basis, resulting in higher or lower hourly liquidation costs going forward.

As long as you are not diverting resources from more profitable jobs, any opportunity that will cover ANY of your overhead liquidation is preferable to having your resources sit idle when you are paying for them anyway. You are not really losing any money until the price charged is less than the combined cost of material, subcontracts, and direct labor.

Of course, in order to pay for the remaining overhead in the accounting period, the burden rate for future jobs must go up, or more jobs to generate more man-hours must be obtained. In many businesses like these, however, not only does the overhead (indirect costs) not go up with increasing volume, it can actually go down in several categories. Examples of costs that can go down as volume goes up include:

– training: employees have less need for classroom or completely non-billable training if they can be assigned as helpers on billable jobs, under the direct mentoring of an experienced employee.

– layoff: in businesses that pay their employees a partial or even full wage when laid off, this cost is eliminated if they are charging their time to billable jobs.

– shop cleanup, preventive maintenance, and similar accounts: it’s amazing at the lack of difference in cleanliness or machine condition in facilities that are busy and those that are slow, even though the latter often seem to charge much more time to these non-productive accounts.

Another benefit is to the apparent profitability of other billable jobs in the facility. Several symptoms can occur among an hourly workforce: a) work pace slows down as the employees see less work upcoming, hoping to “milk” the remaining jobs to which they are assigned, or b) if management emphasizes a minimization of charging to non-billable accounts, such as “clean-up”, many more hours than are justified end up being charged to billable jobs.

Contact us at The Operations Group, LLC for an assessment of your company’s current pricing strategies, and to learn specifically how this and other alternate approaches can improve your revenue, earnings, and cash flow.

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