The Australian Small Business Blog

Thursday, February 09, 2017

Cost vs Price - A Case Study

by Dr Greg Chapman

I recently purchased a video recorder from a well known electrical goods outlet. It was a big name brand with great features and a huge improvement on our old one which was nearly 10 years old and was now becoming unreliable. It was a good unit, but now was old, tired and out of date, and was not a great match to our spiffy new TV. So after doing the deal with the salesman, and before I could walk off with my new unit, he asked, do you want to get a warranty for a free replacement if it has any problem at all in the next five years- only 50 bucks extra on top of the $500 I had already agreed to pay. What a deal! (This was on top of the usual manufacturer’s warranty.)

Then I thought about what he was actually offering. Insurance. At $50, with no margin, that would mean that 1 in 10 of the units were likely to break down in the 5 year period. If you allow a margin for the sale of the warranty, that might go up to 1 in 20. But this was a big name Japanese brand, and if 1 in 20 units broke down, that would be a major reputation problem for them. I am sure their quality control would be such, that not even 1 in 100 would break down, and probably less than 1 in 1000. If the latter was the figure, the actual cost of the warranty would be about $0.50. In this example there is no connection between cost and price. The margin would be 99.1%. The salesman was shocked, shocked that I would not take this offer, and proceeded to explain all the benefits, and the costs I would have if I needed to repair it.

Most people in this situation I am sure would have taken his generous offer because the way he presented it, there was no reference to the production cost of this item, only the benefits and the pain that I might experience. When you break the connection, as this salesman did, between cost and price, people will focus on value and massive margins are possible.

No system can last forever and there should be a regular review of the performance and relevance of all systems even if no problems have been identified. The frequency will depend on how critical the system is to the business.

While each system should have an owner responsible for its maintenance, the responsibility to drive overall system integrity and performance lies with the owners. That is, they must create a Business Management System which enables them to manage their business by reports. This will greatly reduce, if not entirely eliminates the risk of system failure.

May Your Business Be – As You Plan It!

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Dr Greg Chapman is the Director of Empower Business Solutions and is Australia's Leading Advisor on Emerging Businesses and provides Coaching and Consulting advice to Australian Small Business Owners in Marketing & Business Strategies Planning & Systems. He is also the author of The Five Pillars of Guaranteed Business Success and Price: How You Can Charge More Without Losing Sales.

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Dr. Greg Chapman is also the author of
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