Is That Price Right?

We live in a volatile investment environment in which investors are throwing dollars at companies drowning in red ink. The companies are drowning in large part because their misunderstanding of pricing theory is preventing them from achieving their primary goal — making a profit.

Investors need to know how much every dollar in sales is going to cost a company. Unfortunately, the sales revenues you hear about in the news only reveal a glimmer of the complete picture. To get a more accurate idea of profitability, let's look at what's involved.

COSTS AND REVENUES

The dangers of misunderstanding pricing theory were recently brought home in a news report on Webvan, Inc., the now-defunct online grocery store. At that time (early June 2001), the company was paying $146 for every $100 of groceries it was selling. The report did not give a breakdown of what was included in that $146. On July 9, 2001, the company declared bankruptcy.

What happened? Let's start at the beginning — the launch of a business, looking at the situation with an economically rational eye.

A principle drummed into the head of anyone who has labored through a basic course in economics is that marginal cost (the cost of producing that one additional unit) should equal marginal revenue (the revenue generated from that one additional unit). Few start-up businesses, unfortunately, start out this way; at the beginning, more often than not, costs outweigh revenue. Start-up costs can be overwhelming. However, reasonable cost-benefit analysis in a business plan requires that these numbers come together at a given time in the company's formation, a point known in economics as equilibrium. As time goes by, those costs diminish as revenues rise. But if these costs do not become smaller, then something is definitely wrong.

The easiest way to visualize this would be with the establishment of a lemonade stand, like the example in an opinion piece on the editorial pages of The Wall Street Journal several years ago. The author explained how to calculate the costs for bringing in the first sale, including every nail and wooden plank that went into building the stand, as well as all the ingredients for making the lemonade. The time it takes to pour the next glass is the only cost involved in bringing in the second sale.

In the first stage of growth, the cost of doing business decreases after the initial outlay. But eventually, the cost of doing business reaches the point where it begins to rise. (See Figure 1.) That occurs because at that stage, in order to bring in the next customer, you have to pay more than you did for your last one.

Figure 1: Initially the cost of doing business decreases, but eventually it comes to a point where it begins going up in order to gain market share.

PRICE THEORY AND GROWTH

At some point in the growth of all companies, expansion becomes key and also instrumental in pricing. Consider, for example, a community newspaper that clunks along for a number of years on an old printing press. Then for some reason, the newspaper decides to expand. In order to grow, the newspaper must produce more issues per printing, which the old press cannot accommodate, and so that means a more modern press must be purchased. But — and this is an important but — in most such circumstances, there has been no planning for this inevitable need, so the newspaper's costs spiral out of control. Without proper planning and the capital required, the newspaper could be bought out by a rival or go out of business altogether.

In a real-life example, America Online, Inc. (AOL), and its struggles during this growth point were in the headlines every day. The company struggled in front of the news media to get in enough new phone lines and modems to meet its customer demands. This struggle was reflected in the stock price and the price that AOL charged its subscribers.

GRABBING MARKET SHARE

Another overlooked factor is a company's plans to grab market share. The costs involved in acquiring market share include marketing, advertising, and promotional expenses. These costs affect how the company prices its product line. The Internet service providers (ISPs) or software companies that made public their struggles to gain prominence in their niche must now budget for more marketing dollars than they have in previous years. These companies argue that if they eliminated their marketing costs, they would be more profitable. This indicates that they have a faulty understanding of pricing theory; a company that spends a sizable portion of its budget on constant marketing cannot do away with this expense abruptly and maintain its foothold or continue to grow.

To overcome obstacles, a company must recognize its need for expansion in its business plan before starting operations. A certain percentage of every dollar of revenue brought in must be set aside for that growth hump. The necessity of expansion must be factored into what customers will be charged for products/services. Failure to do so either means the company will be forced to sell out or find a merger or acquisition partner to try to circumvent this inevitable need.

NO GUARANTEES

There are no guarantees and certainly not on Wall Street, but there is one certainty: Investing your hard-earned dollars in companies that do not understand pricing principles will put your investment portfolio into red ink. On the bright side, though, these days it is not difficult to do your own homework. Those companies may be doomed for not doing their homework, but there's no reason why you should follow them!

Laura Bell, a freelance writer based in California, may be reached at writer@well.com.

REFERENCES

www.pricingsociety.com.

www.topica.com