In Part II of Game Changer my co-author Arnab Sinha and I devoted a chapter to the Cost Game and its core pricing model, the much-maligned cost-plus approach. Many companies succeed with this model by making cost management their superpower, but face challenges when their input costs decline significantly.
In this week’s guest contribution, our colleague Ricard Vila shows how companies that play the Cost Game don’t need to follow the classic zero-sum logic when they decide to adjust their prices.
How to Cut Prices Without Cutting Prices
After severe price spikes in 2021 and 2022, some pockets of the economy spent most of 2023 in deflationary territory. By January 2024, prices for metals and metal products had fallen by 10% from their 2022 peak, industrial chemicals by 24%, and lumber by 45%, according to the respective US producer price indices.
These significant changes in commodities pricing confront players of the Cost Game with a difficult challenge: how much of these rapid and steady cost declines should they pass on to customers in the form of lower prices? The pricing mechanism in the Cost Game tends to be a straightforward mark-up of underlying costs – known as the cost-plus method – and a simple interpretation leads directly to a classic optimization dilemma: pass on too little of the lower costs to customers, and you become uncompetitive and risk losing market share, but pass on too much, and your bottom line may suffer relative to your peers.
The Game Changer book refers to this dilemma as the “high–low anxiety of zero‐sum pricing.” But pricing in the Cost Game doesn’t have to be a nerve-wracking zero-sum pursuit to extract the most value from each individual transaction. We believe that companies playing the Cost Game can unlock value for their customers and themselves by shifting the conversation away from lower prices and instead making changes to their pricing model to accomplish the same effect.
Several alternatives to direct price cuts
To manage their costs effectively and share value with customers, players of the Cost Game have several options beyond direct price cuts:
- Surcharges: Raw material surcharges – linked to well-established price indexes – offer a viable option for better cost and price management. If customers have the flexibility, surcharges allow them to choose materials that have experienced less inflation, such as substituting recycled metals for virgin metal. If cost inflation rises again, surcharges share that burden with customers without subjecting them to unpredictable and steep price hikes. In our experience, industrial suppliers that had such contractual provisions during the 2021-2022 inflationary period fared far better than those who didn’t.
- Rebates: If a customer orders goods in a steady or linear pattern, the supplier can lower its distribution costs and pass on some of the savings to the customers in the form of rebate. Such arrangements are common in large-scale manufacturing, chemicals, and distribution, but they remain an underutilized lever for smaller companies in these industries or in other industries like services.
- Pricing basis: The pricing basis in the Cost Game is a critically important decision, because it should correlate closely with the primary input costs. There are abundant examples of how a new pricing basis has positively reshaped customer behavior. The shipping industry incentivized more efficient packaging when it moved away from pricing per unit in simple weight brackets and adopted dimensional weight pricing, which considers both weight and volume to more accurately reflect the cost of shipping items that are heavy and bulky. The waste disposal industry incentivizes waste reduction when it charges based on volume or weight, rather than charging a fixed fee.
- Bidding process: Bidding is the pricing mechanism for many companies in the Cost Game. Rather than submitting a closed bid with a single number, however, companies can seek to influence the bidding process to include catalogues of choices and their corresponding rate cards. When the supplier unbundles the price, customers can study tradeoffs and make selections that optimize costs for both the seller and themselves.
If you are playing the Cost Game in an industry with deflationary pressures, think carefully about bringing potential pricing model changes into the conversation. You will often create more value for your customer and capture your fair share of it. That outcome is more worthwhile in the short and long term than spending all your effort on figuring out how to extract the maximum value from every price negotiation.
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