The same thing is true of product pricing. A price set too high becomes a lost sale that would have been profitable at a lower price. A price set too low is rewarded with unprofitable work. Only when products are priced appropriately with respect to cost does a company have a chance to both make a sale and make a profit.

While this is an oversimplified view of a complex issue, many companies are losing big money on a handful of products because they are blissfully ignorant of the relationship of the price and true cost of their products. One small company CEO was surprised to find that several products that he had quoted personally were being sold at 25% of their true cost to produce.  His traditional direct labor-based cost accounting system had been unable to tell him what to do with set-up, material handling and administrative costs on low-volume or difficult products.

Exhibit A, below, shows the normal relationship between true cost and sales volume. On the right hand side of the graph, a company using traditional labor-based costing methods will routinely set a price that is a little too high, losing bids for these "good" high-volume jobs to competitors who have better cost information. On the left hand side of the graph, the same company will set price too low on low-volume "dog" jobs, winning the contract but losing money on the sale.

The fault of traditional labor-based cost accounting methods is that they arbitrarily allocate large portions of costs based on the direct labor consumed, treating all costs as if they were variable. Every product has costs that are fixed, variable and step-variable. An accounting firm, for example has fixed costs related to each new audit client. Before the first year's audit can begin, "permanent files" must be created documenting the client's procedures and systems of internal control. The amount of effort to prepare the permanent files is independent of the number of years that the firm will have the audit. Preparing permanent files is a true fixed cost.

John Daly is author of Profitability: Activity-Based Pricing for Competitive Advantage, John Wiley & Sons, October 2001. Click here for more information on this title, or visit Wiley.com

While many companies have struggled to use activity-based costing (ABC) in their cost reduction efforts, ABC applied to product pricing has made true believers out of most of the companies that have tried it. A big difference in the experiences of these two groups of companies is the number of activities that they attempt to define and analyze. In theory it would be possible to define hundreds of activities in most companies and some ABC texts use the cost of paying a vendor invoice or creating a purchase order as examples. In few companies would these activities be a material part of cost.

Activity-based pricing implementations normally take a different approach, seeking to identify only those activities whose costs are material to the operation of the business. Costs with the same cause (or cost driver) are aggregated together into macro-activities.  Using this method, immaterial costs such as paying an invoice or cutting a purchase order might be aggregated with other purchasing activities. As a result, a company might examine a few dozen, rather than a few hundred activities. This modest product scope can allow a medium-sized company to generate usable activity-based costing data in a matter of weeks using electronic spreadsheets rather than expensive specialized software.

If your company is not already using Activity-Based Pricing, it may be at an extreme competitive disadvantage. Activity-Based Pricing is an area where financial managers can make an important difference in their company's bottom line. Make plans to learn more about ABP today.

John L. Daly, MBA, CPA, CMA, CPIM, is President of Executive Education, Inc. a Chelsea, Michigan management-consulting firm. Executive Education provides consulting services in business turnarounds, pricing strategy, and part-time/temporary Chief Financial Officers. He is the author of Pricing for Profitability: Activity-Based Pricing for Competitive Advantage published by John Wiley & Sons. Executive Education also produces continuing professional education for financial managers that are available through many accounting associations. A schedule of Activity-Based Pricing classes is available at www.ExecutiveEducationInc.com. Mr. Daly may be reached at Daly@ExecutiveEducationInc.Com.