Message from the Chair
Steve Imke, Chapter 206
Colorado Springs, Colorado
Considerations beyond simple cost-plus calculation
The other day I found myself discussing with a colleague the fire sale of the Banning Lewis property northeast of town to a Houston-based oil company. As we discussed some of the contributing factors to the demise of the Banning Lewis project, the subject of “what the property was really worth” came up. It was at that moment that the topic for this month’s article became clear to me: “Pricing at the margin.”
Understanding this concept is a key to why some businesses will survive and others will fail. Most service- and/or product-based businesses define their prices using a cost-plus approach. That is, they calculate the direct and indirect costs to deliver a service and/or to produce a product (aka, the break-even price) and add a reasonable profit margin to cover the risk capital for the initial and subsequent investments in the business. While this strategy might make sense in geographically isolated areas, it does not take into account that many services can be off-shored and products can be produced elsewhere in the world, often at lower costs.
To explore this idea a bit more, let’s look at fuel prices, a popular topic for the media these days. The price to extract a barrel of oil from the ground and ship it to a U.S.-based refinery varies, depends upon a huge basket of factors. In Saudi Arabia it costs about $5 to produce a barrel of oil and ship it across the ocean to a U.S. refinery, while in the U.S., it costs about $75 to do the same. Lots of factors contribute to this cost differential, including cost of labor, material, depth of extraction, etc. But what is important to understand is that if the entire world’s demand for oil could be met by the “cheap to produce” Saudi Arabian oil sources alone, the margin cost for a barrel of oil would drop to $5 per barrel and producers with higher cost structures, such as those in the U.S., would be kept out of the market. However, as global demand exceeds the supply of cheap-to-produce oil (whether physically restricted by production or strategically restricted by self imposed OPEC supply limits), the margin price rises until demand is met.
That margin price right now is about $100 per barrel to meet the world’s demand. At $100 per barrel, a U.S.-based company that can produce a barrel of oil for a cost of $75 per barrel can make $25 per barrel while that Saudi Arabian-based company can make $95 per barrel, or nearly four times as much profit, in terms of real dollars on the same product. This gives Saudi Arabia and other countries/companies with lower cost structures considerable power and influence in that industry.
Margin pricing not only affects rising prices but also affects falling prices, too. Consider how a new Walmart store drives smaller business with higher cost structures out of business. With the exception of a monopolized industry or organized union, unregulated market forces will bring prices down to the lowest level (the margin). If prices in a particular industry rise, more businesses with higher cost structures will enter the market, as the higher margin price makes it economical for them to do so, and the increased competition will prevent prices from rising any further, reaching a sort of “price equilibrium.” Likewise, if supply can be met by either increased production capacity or lower demand, the margin price will fall and companies with higher cost structures will no longer be able to compete on price, and will likely be forced out of business, unless they change their business model.
Keep in mind that most industries do not live in a completely unregulated industry. When providers or producers with lower cost structures feel at risk of new competition, they often use their very high profit margins to protect their future profits by erecting barriers to newcomers or they drive out competitors. For example, they may contribute cash generated from excess profits to the campaigns of lawmakers or Political Action Committees (PAC) that support increased regulation beneficial to them, or they may support creating unions that control new entrants into a market, and thereby place a lid on supply.
The important take-away is that pricing is not only the breakeven price plus a reasonable return on invested capital, but perhaps is the result of as little as one transaction occurring at the margin. In the Banning Lewis discussion, real estate developers were no longer interested in buying up lots for new homes and dropped the margin price of the land back to agricultural or other usage levels. This forced the project developers to be upside-down on their debt and ultimately forced them to file bankruptcy.
Many factors are at play in establishing the margin price. A successful entrepreneur is one who keeps his eyes and ears open and takes stock of events happening around him to not only determine the margin price, but to consider the impact likely events could have on the margin price in the future, and develop contingency plans to deal with them.