What a field day for the heat
A thousand people in the street
Singing songs and carrying signs
Mostly saying, "hooray for our side"

Saturday, February 27, 2010

The Cost of Tea in China

There are two ways to price a service or product. The first way is the way most people believe products may be priced, and that's by cost. However, most product are priced the second way, on value. Pricing by cost is fairly simple, you take how much it costs to produce a certain product, market it, ship it, shelve it, etc., ad on a profit margin and blammo, you've got your MSRP. However most products are priced by value, also know as "what the market will bear." You can think of this pricing as based on, in the case of books, "how much enjoyment you get out of the book compared to how much money you've got to spend." There's a little but more to it, like how much other products in the market place for the same sector cost, the experience, quality, all those other things compared to what you want to sell.

Price by value will typically (but not always) be more than price by cost. And there is usually more cost in a product than people really give a thought about. Like that blue color used on your blue jeans, not only does that need to be specified (and if you don't think there isn't big money in spec'ing color, you have no idea), it needs to be formulated, blended to change the denim used in your jeans. And you'll notice that each make of blue jeans have a slightly different shade or tint of blue to them.

Now, the value side of the equation works more on this equation, "How much value (there's where this formulation gets its name) does this product/service provide? We think it's worth this much." I first saw how this works in management consulting, specifically in tax consulting. The argument typically went like this, "Our audit and tax practices can save you an extra $X on your tax bill, we think it's worth at least $1/3X (you still save 2/3X)." With an effective practice this increased billing by nearly 10x over straight cost+ models.

You can also think of these models as commodity versus service (although, it's a little misleading as some services are priced on the cost+ model and many commodities are priced on "what the market will bear"). Maybe "value-added" is a better word than service.

You can look at this as how much you pay for your commodities. Say, clothing. Most clothing sold in the US about 30 years ago were produced in the US. Now, most are produced elsewhere (including growing cotton here in the US, shipping it abroad, manufacturing the cloth, cutting and stitching it into the final product and then shipped back to the US). The overall cost to produce has been reduced (not that much as you've introduced costs of shipping, high costs in long distance management, spoilage, and higher manufacturing errors - ie. quality). Notice they didn't really pass the savings on to the end consumer. So what happened is the pricing on the wholesale side went to commoditization and on the consumer side it went to value (this is why brand name and identity are so important, even through they've lost cache in the past twenty years). This is why Wal-Mart (and great mover in the commoditization of production) can "roll back" prices. Really, they aren't loosing money (for the most part), they're only reducing their gross profits (and is a whole different post on how you can sell some product for less than cost but still make an overall profit - both as loss leader and shipment cost structures).

Over the past forty years the cost to physically produce a product has dropped dramatically because of modernization, miniaturization, and automation. However, the incidental costs, the parts most people don't see or recognize as part of the product, have increased.

And here is where we come to a current discussion, the price of books. Back in the 70s the cost of the book was mostly in the product itself (the paper, ink, and binding). The actual production costs of the printed book is less today (even before adjusting for inflation) than it was forty years ago. However, the other costs of the book (the part hidden from the consumer) have increased to offset the reduction in production. Editors, marketers, packagers, illustration, layout/typsetting, etc have all increased until they are the largest part of the cost of the books. These are all upfront costs. That is, before you see the actual product, someone needs to pay for all that. Once paid for, though, they don't all need to be done again (or at least they shouldn't need to be done again). However, their cost needs to be amortized throughout the expected sales cycle.

This is part of why, as print runs keep being reduced, the one-time costs become greater parts of the final price per piece. Again, forty years ago it wasn't uncommon to print 20,000 books as an initial run (and expect to sell 80%). These days 10,000 books is a sizable run (and you're doing good to sell 70%). So instead of costing out your production for 16,000 pieces, you now need to make the same (well, more because it's adjusted for inflation) on only 7,000 pieces. So you see how the cost of the physical production of the book can be reduced by over 60%, but why books now cost more?

This is also why when the discussion comes up about ebooks most people miss that the actual cost of the pulp, ink, and glue of the thing they hold in their hands isn't what they're really paying for. So they don't understand why ebooks aren't heavily discounted. It's pretty simple, the costs that were bourn by the 7,000 physical pieces are now being reduced to 2-3,000 physical pieces and 6,000 electronically delivered pieces (and, just so we're clear, that delivery of the electronic products is not $0: server storage, bandwidth, virus protection, quality control, storefont software, etc all cost money). edit And actually it'll be more like 5,000 hard copy and 1,000 ebooks (another post is how even in these days, two-thirds of music unit sales are still CDs).

Now, the good news, once all those precosts are amortized out, the price of the ebook version of a text should drop dramatically. And this whole argument about how the big publishers are against ebooks is a bunch of crap. Ever listen to one of those big publishers talk about the cost of returns? Yeah, the big publishers love the prospect of ebooks and their elimination of the need for returns. They just want to make sure they're able to stay in business to continue providing their readers with a quality entertainment experience and their authors (and themselves) with a livelihood.


Dr. Phil (Physics) said...

Another excellent discussion of why a book is more than paying for paper.

Dr. Phil

Steve Buchheit said...

Thanks, Dr. Phil. I don't know how many times I've had the discussion with a client about how they really want to print 1000 pieces of a brochure and sit on 500 for half a year instead of printing 500 expecting to reprint in 6 months.

And ink on paper used to be my day job (and hopefully will be in the future). Ink on paper, by itself, is exceptionally cheap these days. Even the prepress stuff is cheaper now (with computers). The design side of it is now looking at a direct commoditization model. That way lay madness. The Akron Print Industry went that way ten years ago. There's about 1/10th of the print shops left, and those are limping along as they all tried to undercut each other.

In the last few months of the day thing, we were competing against quotes that were less than our paper costs. While we probably weren't the cheapest printers out there, how can you compete against a price that's less than your physical costs?

My guess was printers were cutting everything to simply get cash flow (not meeting their payables, but keeping the press moving and money coming in). Once that happens the market is prepped for a crash (as that's not sustainable and creates an unrealistic price expectation in the client who will now fight you back to the cost losing price).