“If the price of a product is [then] based on a markup on the respective costs, one can justifiably speak of Marxist pricing. Karl Marx’s labour value theory is considered completely obsolete. Nonetheless, cost-plus pricing, which is nothing but Marxist pricing, not only lives on, but predominates. If one doesn’t believe in Marxism, one should get rid of Marxist pricing. That would certainly be beneficial from a profit standpoint.” (pp. 132-133)
True Profit! …Hermann Simon
I hope Simon is making a rhetorical point because he is such a huge contributor to the art and science of pricing that I can’t believe he would make a statement that obviously contains several inconsistencies and logical fallacies.
Marx’s labor theory of value was an explanation of the source of value. He argued that labor creates value and that market exchange ultimately reflects socially necessary labor time. Interestingly, so did Adam Smith and David Ricardo. However, cost-plus pricing, by contrast, is nothing more than a managerial pricing tool—a simple, understandable, and in competitive markets, considered to be a fair basis for exchange – an algorithm. It starts with direct and allocated indirect costs and adds a desired profit margin which, it could be argued, represents what the price-setter considers to be the opportunity cost (best alternative use) of all the resources directed at the creation and distribution of the product or service which hereafter I will call the work product.
The two concepts address entirely different questions: Marx is asking what determines value and how it is distributed between labor and capital? Cost-plus pricing is asking how a firm can set a selling price easily, fairly, and competitively?
The error in Marx’s logic, in my opinion, is his assertion that the transaction price of a work product represents its value. This is patently wrong. To the seller, the value of the work product is the difference between the price accepted to by the buyer and the costs incurred in its creation and distribution (some of which will be allocated).
To the buyer, the value of the work product is the difference between the price s/he would be willing to pay (WTP) and the price accepted by the vendor. The total value of the work product is the difference between the buyer’s WTP and the supplier’s costs. Price, therefore, is how that value is distributed between the buyer and seller and reflects the relative bargining power of each party to the transaction.
To be fair to Simon, I suspect (hope perhaps) his comment is not intended as a formal syllogism. Simon is a pricing strategist, and throughout his work he argues that managers are excessively focused on costs and insufficiently focused on customer value. I agree with him. The reason managers are cost-focused is they have some measure of control over costs, meaning they can predict them with a reasonable degree of accuracy. What they can’t predict is what their customers will do even though they know that customer behaviour is going to be determined, at leasst in part, by price and, to complicate it even more, often with a delay between a price change and the customer response which is how a complex system works.
Simons argues: “If one doesn’t believe in Marxism, one should get rid of Marxist pricing. That would certainly be beneficial from a profit standpoint.” The weakness in the argument is not that value-based pricing is wrong. Rather, it is that the rejection of cost-plus pricing is justified by associating it with Marxism rather than by demonstrating its practical shortcomings—it’s a tug at a reader’s emotional sensitivities.
Whether cost-plus pricing is effective depends on its ability to generate profitable outcomes, not on whether it bears some superficial resemblance to Marx’s labor theory of value. To dismiss a pricing methodology because it is labelled “Marxist” is to commit a logical fallacy and, in the process, a form of guilt by association. The validity of an idea should be assessed on its merits, not on some ideological baggage attached to its supposed origin.
In Simon’s defence he concludes the paragraph with the words: “That would certainly be beneficial from a profit standpoint.” He has no argument with me on that point although from my own research, there is no conclusive evidence that the use of a value-pricing approach, that seeks to capture more of what economists call the consumer surplus, will guarantee higher profitability because pricing is only one element (albeit extremely important) of a complex business operating system. Profitability is the outcome of that complex system not the result of just one of its elements and if the demand for the product or service is relatively elastic, a grab for more consumer surplus will most likely result in a significant reduction in revenue and a reduction in profitability. On the other hand, if demand is inelastic profitability will increase at least in the short term.
One strong argument for seeking to ascertain the value recognized by a customer, i.e. using value pricing, is that by seeking to understand a buyer’s WTP price a vendor is effectively getting a sense of where a particular buyer sits of the industry demand curve. By seeking to attract and retain buyers with a high WTP is importent marketing intel.