Episode #0073 - What the forex market can teach us about cost plus pricing?

Pricing College Podcast

In this episode we discuss the forex market and how that really highlights common issues with cost plus pricing.

The foreign exchange market - forex - changes millions of times a day, every day - and is a major cost input to lots of businesses.

If a cost reduces - should you reduce the sell price? Go on guess!

In today's episode, we want to give an example of why cost-plus pricing can create problems. This is relating to the world of foreign exchange or Forex. It highlights for us one of the major issues with using cost-plus as your pricing methodology.

Many of our clients and businesses that we've consulted to, especially in the B2B manufacturing and distribution space. Have led their strategy, their pricing strategy using cost-plus. At the beginning of the journey were very adamant that that was the best way forward. That it was clear. That it was going to be fair. And that was the best way to calculate costs. However, as we went further into the data, and to see the operations of their business. How it all works? Where do they get their products? Often we'd find for instance in a distribution business that they would buy their products overseas in China for instance. Maybe to try and get a lower cost, try and get a cheaper product. Then, when we looked further into that we found that the cost calculations were just an aggregate average of foreign exchange mechanisms. Which can change multiple times in a day. Often they'd find as a result of that, they're either overcharging or underselling their offers.

The example I would give is, just imagine you're a fancy restaurant in London or New York and you're serving Argentinian steak. Argentina is a country that's gone through a couple of regular, massive devaluations over the years. In theory, if you're operating a cost-plus environment. Whether you're the butcher shop, a hotel or a nice restaurant serving that Argentinian steak that's flown in that day. Say you fly and that steak and yesterday cost 15 American dollars for a steak. Then the next day the exchange rate collapses. But you're still buying them at Argentinian pesos. So what do you do then? Do you just do reduce your prices by 50%? Of course, you don't because logically that makes no sense. This simple fact can really be applied to pretty much any cost-plus environment. Just because your prices drop, should you decrease your selling price? The answer is clearly not. The customers are coming into your restaurant they're buying the steak not based on the cost-plus methodology. They're not researching Argentinian, Uruguayan farm sales prices. They're really just going in for a nice evening and experiencing the value of what they're purchasing. Which is unrelated to the actual cost of the production or delivery of the product.

To look at it the other way, as a business if you're setting your prices using cost-plus to understand to target some kind of margin. But ultimately your calculations on cost based on a fluctuating and very complex Exchange Rate Mechanism are incorrect. And pretty much you’re just aggregating sort of guessing using rounding things up and down just to suit. It is pretty much guessing what the costs are. Then, are you going to get the margin that you're targeting? Or, are you just hoping that you're going to get it? It just sort of lacks, it gives a semblance of rigour that isn't there.

I suppose another example I'll give is I previously worked in accounting, and we were doing due diligence on a company. It was an American toy company that was buying a British traditional toy company. That in reality was just a shell at that point or manufacturing or research or development. Everything was done in China. This is about 20 years ago now. The reality of it was they were reporting better and better results over that last year they had profits were up 50%. But in reality, when we looked through the books what had happened was, it was just a British Sterling versus Chinese exchange rate that had dropped or had to improve my British perspective. So they're reporting higher profits in reality even gone the other way. Nothing to do whatsoever with their business practice. It would have shown a major decline in profitability. So the American company walked away from that transaction. But you have to look into things, why are you making decisions? Why are you selling these at a certain price? You have to be aware of what it costs you to produce it. But showed that influence the selling price. I supposed and we're going over again, what cost-plus pricing the flaws with it. But we thought this was a great example of where the flaws could lie. The other thing we'll say is when you get into the realms of dynamic pricing where pricing changes multiple times a day. There is nothing more dynamic than the forex market. I think it's only closer to a couple of hours a day. Or when there's a gap in the world between maybe Tokyo opening and wherever is the last place to be closed over weekends. But the reality of it is for say 20 hours a day. It's been traded in huge volume globally, and so the price is changing, infinite times per day. Dynamic Pricing, obviously in a cost-plus model no one's going to implement that. Unless you're dealing in a Forex environment yourself. Unless you're selling Forex services. But otherwise, if it's a B2B, B2C environment, it should really be a very limited impact on what you sell.

I think if you're trying to maximise margins, simply by sort of outplaying the exchange rate. Or trying to utilise your view on getting a cheaper product via exchange rate benefits. Then you'd have to have good analytics as Aidan said that is a dynamic strategy in itself on the supply side. Often companies in B2B are really still using Excel. The excel just refers to the exchange rate now and again. They don't have a dedicated pricing function to manage that either. It's often done ad hoc, even I would say on a yearly basis, and as I said exchange rate can change millions of times. So just make sure if you're trying to maximise margins. It is not particularly risk-free just to do it via the exchange rate. You've got to be on the ball with that and think again about value. Try to think about maximising margins by looking at supply and demand dynamics. And that truly does require a dynamic pricing capability with a dedicated pricing team to manage it full time every day. So things are flowing and everything's recorded and the price-setting process is updated.